The most popular reason for cashing out an IRA or 401(k) plan to make investments is that, in general, all income and gains generated by the retirement account investment will be tax-deferred or tax-free in the case of a Roth IRA or Roth 401(k). This article will focus on the keys to using an IRA to make real estate and other investments without paying tax.
What is a Self-Directed IRA?
Since the creation of IRAs in 1974, alternative investments such as real estate have always been permitted to be invested by IRAs. A Self-Directed IRA is essentially an IRA account which is permitted to be invested in alternative assets, such as real estate or even cryptocurrencies. In other words, a Self-Directed IRA follows the same rules as a Traditional or Roth IRA respectively from a contribution and distribution standpoint.
How Do I Start a Self-Directed IRA?
There are two ways to start a Self-Directed IRA. The first is making an IRA contribution. So long as you or a spouse have earned income, in 2022 you can contribute up to $6000 or $7000, if over the age of 50, to an IRA. The IRS imposes certain income limitations to determine if your IRA contribution will be tax deductible. For example, if you are married and filing jointly and earn more than $214,000, you will not be able to receive a tax deduction for the IRA contribution. Whereas, in the case of a Roth IRA, the “backdoor” Roth IRA allows any taxpayer to make a Roth IRA contribution irrespective of income. Unlike a pre-tax IRA, a Roth IRA is an after-tax IRA, but so long as the Roth IRA owner is over the age of 59½ and the Roth IRA has been opened at least five years, all Roth IRA distributions are tax-free.
The second way to fund a Self-Directed IRA is via an IRA transfer or rollover. Transfers and rollovers are types of transactions that allow movements of assets between like IRAs – Traditional IRA to Traditional IRA. An IRA transfer is the most common method of funding a Self-Directed IRA. An IRA rollover generally involves the rollover of funds form a 401(k), 403(b), 457(b), or other employer retirement plan to a Self-Directed IRA. IRA transfers are-tax free and can be done an unlimited amount of times. Whereas, an indirect IRA transfer, where the IRA funds are first transferred to the IRA owner instead of the IRA custodian can only be done once every 12 months and the funds must be transferred to an IRA custodian within 60 days. In contrast, a rollover of 401(k) funds can only be accomplished when the 401(k)-plan participant satisfies a plan triggering event, for example, employment separation or reaches the age of 59½. Like IRA transfers, 401(k) rollovers are also tax-free.
Tax-Efficient Self-Directed IRA Investments
To take advantage of the tax advantages of using a Self-Directed IRA to make real estate and other investments, it is crucial that the investment be made directly by the retirement account and not the individual IRA owner. For example, in the case of a real estate investment, the investment must be made in the name of the IRA for the income and gains from the IRA investment to be excluded from immediate tax.
Starting in 1974 with the creation of IRAs, Congress wanted to incentive Americans to save. Hence, they created rules whereby income and gains from an IRA investment would not be subject to tax and would benefit from a tax-deferral regime. Tax deferral is when all gains generated by a pre-tax retirement account investment flow back into the retirement account tax free. This allows your retirement funds to grow at a much faster pace than if the funds were held personally, allowing you to build for your retirement more quickly. This is also known as compounding interest, which Albert Einstein has coined the 8th wonder of the world.
Based on the concept of tax-deferral, using an IRA to make investments versus using personal funds has enormous tax benefits. For example, if an IRA owner makes an annual contribution of $1825 a year from age 21 to 70, assuming an 8% annual rate of return and a 25% tax rate, the IRA owner would have $1,045,306 versus just $462,488 with personal funds.
Related: Tax Deferral vs. Tax Free Investing
Cashing Out IRA Pitfalls
When an IRA holder takes money out of his or her IRA by way of a distribution, the amount distributed no longer benefits from the power of tax-deferral and ultimately, the future value of the remaining IRA will be impacted Leakage means that when you take money out of your IRA – it is difficult to make it up
In the case of a pre-tax IRA, cashing out your IRA has significant tax implications. Cashing out your IRA prior to the age of 59½ will trigger a 10% early distribution penalty, plus an income tax on the amount of the distribution. Whereas, cashing out an IRA after the age of 59½ will just be subject to income tax and no 10% early distribution penalty. On the other hand, in the case of a Roth IRA, cashing out a Roth IRA prior to the Roth IRA owner reaching the age of 59½ and/or the Roth IRA being opened 5 years can trigger a taxable distribution, plus a 10% early distribution penalty on the earnings generated from the Roth IRA contributions.
Therefore, making investments, such as real estate in a self-directed IRA or Roth IRA versus using personal funds can generate enormous tax advantages and wealth accumulation through the power of tax deferral. Numbers don’t lie so making sure to make retirement account investments in the name of the IRA versus cashing out and making the investment using personal funds is crucial.