Spend money to make money: A time-honored truth when it comes to any business proposition. As an intelligent investor, you weigh the potential costs of an opportunity against the potential profits and either pull the trigger or walk away. With a few quality deals under your belt, you get into a rhythm and maintain an understanding of what works. Your cost vs. benefit analysis becomes second nature.
As such, when you hear about the prospect of adding real estate to your retirement plan, you may be inclined to immediately dismiss the idea. Why mess up a good thing with the added costs and headaches of adding property to your IRA or 401(k)? Those costs and headaches may not be as dramatic as you think. If we compare the benefits of a real estate IRA to the expenses, you may find the long-term advantages offered by this model are worth pursuing.
Let’s take a look at a few potential costs associated with incorporating real estate into a self-directed retirement plan:
- Administrative Fees – Per the IRS, all retirement plans must remain in the custody of a trust entity or qualified third-party administrator. These IRA providers will assess fees for their services, though such fees have become more competitive as the marketplace for real estate IRAs has expanded.
- Unrelated Business Income Tax (UBIT) – If your IRA acquires property with a loan, any net income attributed to the debt percentage—called unrelated debt financed income—may be subject to UBIT. These taxes would be paid by the retirement plan (never you personally) and can diminish over time as the loan is gradually paid off. If your plan owns the property outright, UBIT will not be a factor.
- Property Upkeep – Your skills as a handyman or woman may help you avoid certain costs for property investments you make with personal funds. However, with an IRA investment, you’re not able to personally conduct repairs or make physical improvements; you would have to cover any such expenses with retirement dollars.
These may seem like a bit much, but the tax advantages presented by retirement plans allow savvy investors to offset these costs if their strategies are sound. Every plan features a unique suite of benefits, so you’ll be able to choose the account type that suits your financial initiatives:
- Traditional IRA – Allows you to defer taxes on your contributions. For instance, if you contribute $5,000 to your Traditional IRA, you may deduct up to the full amount from your income for tax purposes. You would only pay taxes on distributions down the road, ideally when you’re at retirement age and in a lower income bracket.
- Roth IRA – With a Roth IRA, contributions are made after taxes. Growth and qualified distributions will be tax-free. In our previous example, you would pay taxes on your $5,000 contribution as if that money were still in your pocket. On the other hand, if your $5,000 investment grows to $25,000 by the time you reach retirement age, you won’t owe a penny of taxes on a qualified distribution of those funds!
- SEP IRA or Solo 401(k) – Specifically designed for the self-employed, their annual contribution limits are significantly higher than those of Traditional or Roth IRAs to accommodate the higher earning potential of business owners. SEP IRAs bear the same tax advantages as Traditional IRAs, so your larger contributions would mean even greater tax deductions on an annual basis. Solo 401(k)s provide the same opportunities and can also include Roth components if permitted by their plan documents.
These accounts were created to give retirement investors a chance to generate wealth for later in life. With the growing popularity of self-directed retirement plans that hold alternative assets, investors can utilize the business practices they’ve mastered and hedge their bets against the stock market. Doing so comes at a price, but as you can see, the tax benefits provided by these plans can help reduce, if not eliminate, the additional expenses that may deter potential real estate IRA holders.
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