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Smarter Tax Free Self Directed Plan Investment Tactics - Truly Self Directed Retirement Plans

Over the history of tax advantaged programs, qualified plans and individual retirement accounts have consistently been at the forefront of opportunities to defer tax. Within this context,

Over the history of tax advantaged programs, qualified plans and individual retirement accounts have consistently been at the forefront of opportunities to defer tax. Within this context, self directed investment opportunities have not received the attention that standard IRA and Qualified Plan investments, such as stock, bonds, mutual funds and certificates of deposit, have had.

Although non-standard investments in tax deferred accounts are relatively small as a proportion of overall US investments, such investments may be a significant part of anyone’s diversified portfolio. Self direction of plans and IRAs are straightforward as long as the IRS disqualification rules, unrelated business income tax, and other related tax sections are followed. This articles provides a brief history of tax deferral in Qualified Plans and IRAs, and investing in non-standard opportunities using real estate as an example.

Employee Retirement Income Security Act

In 1974 Congress passed the Employee Retirement Income Security Act or ERISA to clarify and provide non abusive circumstances under which pensions could be created. Tax advantages to the employer and employee would become available in a regulated and the intent of being fair handed.
Variously known as Keogh and HR-10 plans, these eventually became known as Qualified Plans, which are employer originated tax deferral retirement programs. (These include Defined Benefit, and Defined Contribution Plan. Defined Contribution Plans generally consist of Profit Sharing, with or without a 401(k) deferral option, and Money Purchase Pension Plan).

In addition, Individual Retirement Arrangements, or IRAs, which are generally individually originated programs, were also included in this legislation. Employer contributions to IRAs could also be made following specific rules. Contributions to Qualified Plans could be made by employers to employee participants, and employees could, under specific adoption of tax code provisions, (401(k)), defer funds from their pay to their plan account. Individuals could also always make contributions to their Individual Retirement Accounts provided they had earned income.

From the day the ERISA became effective, January 1, 1975, all Qualified Plans and IRA contributions and deferrals could be invested in anything permitted by law. This included any asset anyone could sell or buy in the market place. The limits were and are covered by IRC Sections regarding Prohibited Transactions, and Unrelated Business Income Tax and Unrelated Debt Financed Income Tax.

Because of the abuse by the sellers of certain investments, Congress passed legislation effective on January 1, 1981 prohibiting such investments specifically gems, stamps, coin collections, works of art, antiques. In addition, that legislation also permitted the deductibility of IRA contributions. Significantly, all other investment opportunities were not excluded.

The other investment opportunities which became increasingly interesting to qualified Plan and IRAs included Real Estate, Notes, Options on Real estate, Private Placements, Investment partnerships, and Operating Businesses, just to mention the major areas.

Land, single family, multi family and commercial properties found their way into many portfolios, and the values of Plans and IRAs rose in direct proportion to property values. In some states, investments of $10,000 have returned routinely $100,000 in two years. Properties being rehabilitated offer 30% returns to the savvy investor. On some occasions, options on real estate can turn a tidy profit with a very small investments. Cash flow provides many retires tax free income in Roth IRAs.

Plan participants and IRA owners discovered that leverage was a way to increase the income potential of the land or other property. Leveraged, or debt financed property, was subject to Unrelated Business Income Tax (UBIT) rules, as was operating income generated by assets. Significantly, acquisition debt for real estate in qualified plans are not subject to unrelated business or debt financed income tax. Non-acquisition debt, however, is subject to such tax. IRA acquisition debt for real estate was not given such generous treatment. In addition, tax payments for the debt financed income needs to be paid by the plan or IRA.

Depreciation expense, interest expense and certain maintenance expenses are allowed as deductions on the Form 990-T, Exempt Organization Business Income Tax Return for the affected debt financed asset or operating income asset. The implications of UBIT are consideration in making the investment decisions. Often the results are positive.

Debt financing requires the services of lenders willing to lend to an IRA or plan. Non-recourse loans are the only loans permitted for plan or IRA assets. This also precludes the beneficial owner to use their credit or sign on the loan. Any extension by an IRA owner or participant of a plan to their IRA or plan is specifically prohibited. There are a number of non-recourse lenders but some diligence is necessary to find such lenders.

Many individuals elected to partner with their plans and or IRAs, themselves and others, as undivided interests in real or other property. A growing number have established Limited Partnerships, C corporations and Limited Liability Corporations. Each method has its advantages depending on the situation.

Steps to self direction are straightforward:

1. Locate a plan sponsor or IRA provider which offers completely flexible investment options in their plan and trust document.
2. Adopt that plan.
3. Rollover from any existing IRAs or past qualified plans to the new self directed plan.
4. Determine the appropriate diversification you desire and direct the trustee or custodian to make the asset purchases on behalf of the plan or IRA.
5. Income and expense are treated on a prorated basis of ownership of the assets and recorded accordingly.
6. Distributions must be made beginning age 70 ½ for all plans other than Roth IRAs. Distributions may also be made in kind.
   

True self direction of IRAs and plan assets is a positive method to increase diversification and grow retirement income steadily. Following the rules is straightforward and with proper assistance from tax professionals, sponsors, and plan and IRA providers, the benefits can be enormous.

Qualified Plans

Qualified plans, consist of Defined Benefit Plans and Defined Contribution Plans. Define Benefit Plans are those which define a certain benefit upon a specific retirement age, and using actuarial assumptions composted of contributions and income based on earnings in the plan. Define Contribution Plans, require no specific contribution and the benefit is not one which establishes a specific retirement income; you get what you earn based on contribution made or not made. Defined Contribution Plans are generally those which include Profit Sharing (including 401(k) option), Money Purchase Pension Plans, can be written with a multitude of features, and those include broad investment capabilities and many benefits which differ one from one plan to another.

Defined Contribution Plans compared to IRAs

An employer/employee can put more away in a qualified plan than in any IRA. The choices of investments such plans are less limiting than an IRA. In addition, there are numbers of features which are more powerful than IRAs. For example:

• You can be your own trustee and custodian. No third party is needed to complete your deals
• All IRAs require an IRS approved trustee or custodian
• Contribute up to 25% of your adjusted gross income up to $44,000
• Maximum Simplified Employee Pension Plan IRA contributions are 25% of your adjusted gross income up to a maximum of $44,000
• You may make contributions “in-kind” not just cash to single employer Profit Sharing Plans.
• Contributions to IRAs must be in cash
• You can borrow from your plan up to 50% of your plan balance up to $50,000. This is to be repaid to your plan over a 5 year term, with interest, or 30 years if used for purchasing your primary residence. (Available to C corp. owners only)
• You may not borrow from any IRAYour retirement age can be 55 rather than 59 ½ , and begin receiving distributions then.
• You may generally begin distributions from an IRA at 59 ½ .
• The anti-alienation provision in qualified plans provides protection from creditors
• No such provision exists in IRAs.
  

In addition:

• You can withdraw funds from your plan and roll them to an IRA
• Administration for owner only plans can cost as little as $300 annually
  

Individual Retirement Arrangements

Individual Retirement Arrangements, or IRAs are all written trusts based on an IRS formula, and are all subject to the rules depending on IRA type. E.g. SEP IRAs, Traditional IRAs, Roth IRAs, SIMPLE IRAs. Education Savings Accounts and Health Savings Accounts (HSAs) are not IRAs but follow many IRA rules..

Although IRAs may not have the same advantages as employer based Profit Sharing 401(k)s, there are clearly some advantages to IRAs.

• One may have an IRA in addition to a Profit Sharing 401(k). Contribution Limits are based on earned income.
• Tax free, or Roth IRAs provide major benefits to the account holder (qualification requirements apply) When converting from a traditional to a Roth IRA, be sure to calculate the total return from a traditional versus a Roth. This means what is the traditional IRA worth when investing the funds rather than paying the tax to the IRS for the conversion amount, as opposed to the Roth IRA. Tax payment can be made with funds not coming from the IRA. Calculate that opportunity cost as well if you use this method of paying tax due on the conversion.
  

Convert assets to a Roth at their lowest appraisal or valuation. Cash, CDs and treasuries, for example, are at or close to dollar for dollar conversion. Real Property, LPs, LLCs, Notes, mutual funds may not be. Plan ahead. You also don’t have to convert every asset you have.

• IRAs may be converted to Roth IRAs if qualification requirements are met.
• IRAs are easy to administer
• Profit Sharing 401(k)s may require more administration time, and also require tax return filing if one adds employees or the plan has more than $100,000 in assets
• Business owner based plans, such as Simplified Employee Pension Plan IRAs can be set up and funded by the employer’s tax deadline plus extensions.
• Profit Sharing 401(k)s must be established by the end of an employer’s tax year
  

Source of Funds in IRAs and Profit Sharing Plans

In addition to normal contributions, the largest source of funds for Profit Sharing 401(k)s and IRAs is from other Profit Sharing 401(k)s and IRAs. Assets are routinely transferred and/or rolled over from One plan to another, and are subject to certain rules. Some of the rules are very important to planning your tax deferred and investment strategies and tactics.

• Rolling over assets from a Profit Sharing 401(k) (including those with a 401(k) option) or IRA to another Profit Sharing 401(k) or IRA may take place only once in a twelve month period. This is per plan. You may have assets directly rolled over to another plan or IRA, or take possession of the assets and roll the same assets over to the receiving plan within sixty days, without a taxable event taking place.
• You may transfer assets among IRAs as often as you like. Your custodian will make sure that tax ramifications of unlike type such as to and from Roth IRAs or Education IRAs are taken into consideration. In addition certain rules regarding distributions will also be taken into account when transferring or rolling over.
  

Choice of Tax Deferred or Tax Free Vehicles

IRAs

The moment you have any earned income open an IRA, preferably a Roth IRA. Most people would like to have all of their investment income be tax free, and this is the best way to start. For decades people have come up with employment schemes for minor children or inheriting IRAs from aged relatives. Whatever you do, make sure that you can substantiate the scheme to the IRS. Check with a qualified accountant or attorney about those issues. The last thing that you want is a disqualification issue for a tax free or tax deferred plan.

What’s good about them:

The concept is to start getting money into a tax free or tax deferred account at the earliest possible time provides a multiplier effect to work over a longer period. You can also cover a non-working spouse with up to a $5,000 contributions annually to IRAs. Administration is easy for all IRAs. Be sure to establish the features of the plan and the investment options before you sign up. If there are special rules or exceptions they should be disclosed to you.

If you own a business consider the options presented above for qualified plans and for business owner contributions to IRAs. The type of plan you have can be effective for your business purposes, as well as long range goals for yourself and your employees.

Profit Sharing 401(k)s

If you are a business owner and have no common law employees and do not expect to have any, a self-directed owner only plan can be the best tax deferred arrangement for you. Many small business owners want the ability to be their own trustee, and have all the other options that a qualified plan offers them. All qualified plans can be rolled over to traditional IRAs. Those assets may also be rolled back to another qualified plan provided that no other contributions are made to that IRA. Such rollovers may then be converted to Roth, or tax free IRAs providing that qualification rules are met.

What’s good about them:

Starting in 2006 you can make Roth like deferrals to them without any salary cap. 100 % of compensation up to $15,000, and another $5,000 if age 50 or over.

You obtain the tax credit for contributions, and you are able to self direct your own plan. The benefits of a Profit Sharing 401(k) outweigh the cost of administration only if you are able to use them.

If you don’t need the benefits enumerated above, then a SEP or SIMPLE will probably do. If at any time in the future the advantages seem to be useful, you can adopt a plan anytime, even if you have a SEP or SIMPLE in place.

SEPs and SIMPLE IRAs

SEP IRAs and SIMPLE IRAs provide small business owners a relatively easy plan to administer, and also provide for self direction of investments through a required trustee or custodian. Although not as comprehensive and flexible, as a Profit Sharing 401(k), it provides many advantages as noted above. You should recognize that these are not transferable or roll overable to a qualified plan.

What’s good about them:

SEPs and SIMPLES are easy to administer. As with IRAs above, be sure to establish the features of the plan and the investment options before you sign up. If there are special rules or exceptions they should be disclosed to you.

Overcontributions

If you make overcontributions to a either a traditional or Roth IRA, there may be penalties involved, if the amount overcontributed is not removed by your tax deadline plus extensions. The penalty is 6% per year for the contribution amount remaining in the account. The contribution may be removed after that deadline, but the profits do not. The advantage can be that one has an IRA, Roth or Traditional sometimes if one doesn’t qualify. If you are under 59 ½ and in the case of a Roth IRA the account has been open for less that 5 years, there may be premature distribution penalties if you elect to withdraw the amount of overcontribution after your tax deadline. You may look at overcontributions as a cheap loan. Overcontributions are reported along with you 1040 form on form 5329.

Inheriting Plan and IRA Assets

In 2001, plan distribution and beneficiary rules changed. However, beneficiary options to name additional beneficiaries for those who have already inherited plan or IRA assets as non-spouse beneficiaries will not be permitted. This is a good time to have a proficient estate professional review the options, and possibly consider trusts as beneficiaries or non-spouse beneficiaries.

Investments in Profit Sharing 401(k)s and IRAs

Profit Sharing 401(k)s, or qualified plans may have a high degree of variability in plan language, including the investment clause(s).

The various IRAs usually differ in one place only, and that is the investment clause.

Truly self directed Profit Sharing 401(k)s and IRAs permits the investment into any legally permissible investment. Some self-directed Profit Sharing 401(k) and IRA providers only permit self-direction into limited investments types, such as annuities or mutual funds or other limitations. Such limitations are typically investments that the providers agrees to accept. Some IRA trustees or custodians may also limit the account owner to a discrete number of deals they may do in their IRA in a year.

When someone states or implies that their IRA is different than any other or that you can achieve a certain rate of return with theirs, review the investment language. All truly self-directed IRAs are the same, and your ability to achieve the results anticipated are also the same. In any self directed environment you make all the investment decisions, and therefore control your results.

Sometimes you see charts of incredible returns based on numbers that seem easy to achieve. Always ask the question: How many people are really achieving those results?
Sometimes you hear about the 50% return on some leveraged IRA or Profit Sharing 401(k) transaction in a single year, but what you didn’t hear is the results after unrelated business income tax.. The lesson here is: Always ask for what the final result is or was. Gross is usually bigger than net, so be sure to get all the fluff and puff out.

For those who make such claims of riches, ask about how many in numbers of people have experienced what kind of results. Graphs and statistics are often deceiving and speak of potential. What we have seen in actual results are that very few make millions, and most people have thousands.

For example, IRAs in generally have been in existence since 1975. They became popular in 1981 when contributions were liberalized. Self directed plans of all types have been inexistence for over 30 years.

• Half of the dollars are in mutual funds
• about one third is in Stocks and bonds
• about 20% s in Bank Deposits and Life Insurance
  

Based on 25 years of data at The Entrust Group:

• The average account balance in IRA self directed assets based on net asset value of all accounts is close to $70,000.
• The highest is $6 million and lowest is $500.
• Average age of clients is 51, with the low, excluding children, 18 and the high 82.
• Average number of assets is 3.4. The low is one the high is 60.
  

The plans with the highest amount of activity in self direction also are those with the highest dollar balance. Self direction is a task which usually has to be worked at to provide maximum benefits..

Profit Sharing 401(k)s, which include all qualified plans have contribution levels five times that of IRAs. Many employers rule Profit Sharing 401(k)s out, usually because of the cost of administration or having to provide benefits for employees. Average balances in these plans are

And provide more investment flexibility than IRAs.

Plan Ahead

Plan ahead. Always. Place the best deals with the maximum profit with the most tax advantaged treatment. If you know you have a great profit potential in large percentages, use a Roth IRA when ever possible. For example:

If you have an option on a property which will result in a 50% gain, use a Roth. Say you acquire the property for a small option amount of $1,000 and exercise it at $100,000 and sell it at 150,000, your gain of $50,000 is tax free. If you converted that $1,000 from a traditional the tax would probably run $280 from the Feds.

If you acquire a property for $100,000 with Roth funds which you converted from a traditional IRA costing you, say $28,000 in additional taxes, you still have a net $32,000 net tax free gain. Be sure to calculate the conversion amount from a traditional plan as part of your tax liability for your tax year. Sometimes people are surprised that the conversion is added to other income subject to taxation. Be sure to do the numbers before your do the transaction. Always make sure that the deal you make makes sense.

If you have a property that you want to receive tax free or tax deferred income in your plan, be sure that you take into account depreciation expense outside of the plan. Calculate the relative amounts out to the end of the life cycle that you have this asset and determine what advantages you have both ways. If you buy an income or other property in a tax free account, when you receive the property as part of a distribution, it will be tax free. If it is in a tax deferred account, the distribution will be taxed at your ordinary tax rate then effective. Again, plan for the assets to be in the right place at the right time.

Debt Financed Property is a leveraged asset in IRS parlance. All such assets are subject to unrelated business income tax UBI. Most people don’t want to talk about UBI because it sounds like it is disadvantageous.

(UBI, also applies to operating businesses, receiving operating income from a business, leases, and limited partnerships and the like doing such business or having leveraged property in them. Often individuals purchase assets in their plan which meet UBI criteria, and don’t know it.)

Why UBI?

The IRS determined that one should not receive tax free or tax deferred benefits in plans for assets which was not entirely acquired by other assets, such as cash, in their plan. This, in shorthand, means that if you buy a $100,000 asset with $20,000 down, and finance the rest, you should not benefit disproportionately from the gain on the $80,000 you financed. Because the Unrelated Business Income tax provisions were handy, the IRS decided to apply them to such transactions. Here is how it works, basically:

You receive income on the $20,000 as tax free and you pay tax on the $80,000. You get to apply expenses against the investment, and the tax doesn’t apply until the total amount of net profit on all debt financed properties exceed $1,000 in a year. You then pay the tax using form 990-T as the filing mechanism. Tax due is paid from your IRA or qualified plan. UBI is not due for acquisition debt for Real Estate..

When Does Paying UBI Make Sense

The big question is when would you do a leveraged transaction in a Profit Sharing 401(k) or An IRA?

The easy answer is that despite the UBI tax, the remainder of whatever net profit you make goes into your plan. You invest that profit tax free. If you do the transaction in a Roth IRA, it will be tax free forever, even when you withdraw any assets after 5 years of having a Roth and reaching age 59 ½. Yes the almost up to 40% tax is steep but it has it’s benefits. You also get depreciation and other expenses on the debt financed portion if it is real estate.

The same concept goes for operating companies and other investment subject to unrelated business income in plans or IRAs. One should do the numbers and compare before making the investment.

Things To Watch Out For:

This includes all IRAs, such as traditional, Roth, SEP and SIMPLE IRAs, and

All qualified plans which permit self direction, such as Defined Benefit, Profit Sharing, 401(k)s, Money Purchase, Target Benefit, and Health Savings Accounts and Coverdell Education Savings Accounts.

• Perform you due diligence on any investment you would like to make
• Make as sure as possible that you are not violating prohibited transaction rules, such as self dealing or dealing with members of your family who may be disqualified
• The IRS says that anything you can do directly should not be done indirectly, so try to avoid going around the intent of the law.
• Know the difference between tax evasion and tax avoidance. Tax avoidance is good; Tax evasion is very bad.
• Employ the services of a competent legal, planning and accounting professional.
• IRS Private Letter Rulings apply only to those cases which applied for them. Not all cases are the same.
• If you think there is a good reason which benefits your plan to make a prohibited transaction, apply for a Prohibited Transaction before the fact, not after.
• Truly self directed™ administrators, trustees and custodians will not give any advice about the quality of investments. They may not give you any answers about the investments, otherwise it is no longer truly self directed™.
• No truly self directed™ investment is insured by the FDIC.
• Any property you may finance in an IRA or Qualified Plan, may be subject to Unrelated Business Income Tax for that portion which is financed only.
• Beware of sham transactions: Those intended to get around the IRS code. Ask your attorney. Your Administrator, Trustee or Custodian is generally not equipped to answer these questions regarding a particular investment.
• You have enormous flexibility using tax free and tax deferred IRAs and Qualified Plans, use them wisely and you will prosper. Use them in other ways and you may find your retirement account disqualified and subject yourself to pain, suffering and a large tax bill.
• Any investment that seems to good to be true is probably to good to be true.
• Beware of comments such as: “You can put more into your Roth IRA than the government allows”; “…make $1,000,000 out of $10,000 in 2 years.”; “You are guaranteed to make money”.
• Ask presenters of information if they personally have done the transactions and have them give you real examples that you can research to be factual.
• Work with administrators, trustees and custodians who are in the field, such as brokers, attorneys, accountants, planners, title company owners, investors, who know your interests and have been there before. It just makes your transactions flow smoother and easier.
• Beware of pyramid, or Ponzi Schemes. It is likely that you are going to loose.
• If you invest in real estate, your plan needs to get a deed or deed of trust or other indicia of ownership. Know what real estate is. If you are investing in a real estate limited partnership or Limited Liability corporation that may invest in real estate, you are no investing in real estate unless the company also gives you a fractional deed. Know what you are buying and get comfortable with it.
  

If you invest in private placements, know what they are being invested in. Always read every document before you invest. If there is some document that you are expecting or was promised, and was not delivered, don’t invest until you are satisfied. When in doubt ask your professional, not theirs.

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