Most employed Americans’ retirement savings are tied to their 401k plans, employer-sponsored, tax-deferred investments that are automatic and seemingly simple. A part of your paycheck, before taxes, is invested in the stock market, and your employer kicks in some money toward it, too.
These 401k plans have transplanted pensions as the norm for most workers. Depending on your employer match, they may or may not be more advantageous for you than, say, your grandparents’ plain old pension plans were for them. Even so, some economists will argue that many working Americans remain woefully unprepared for retirement.
In economic downturns, many people’s 401k plans drop dramatically in value. In 2018, for example, you probably noticed how big a hit your retirement savings took in the final quarter. If you’re like most, that last quarter’s losses probably erased the gains you made for the year. In other words, circumstances beyond your control (the stock market) dictated that your retirement savings for last year netted out to zero.
On top of that, plenty of market analysts are projecting a recession in 2019, which means your 401k could take another hit. If you’re far from retirement age, this might not be a big deal. But if you’re eyeing retirement in the near future, ANY loss from your golden-year savings might seem big.
You might feel at the mercy of the markets and your 401k, but there might be a way you can independently take some control back when it comes to your retirement savings. And that control could very well lie in what is known as a self-directed IRA.
Self-directed IRAs are actually just about what they sound like – tax-qualified investments in which you control (self-direct) your investments. Once you set one up, you decide what the investments are. Your self-directed IRA could, for example, purchase investment real estate.
If you were to buy real estate inside your self-directed IRA, the IRA would own the investment. Any rental income derived from it would go into your tax-deferred IRA. Any expenses would be paid by your IRA. Your self-directed IRA would own the investment property.
The self-directed appeal is that you decide what the investments are. You could buy rental properties or gold or penny stocks; you’re not limited by whatever your current retirement plan’s stock or fund choices are.
The advantages of self-directed IRAs
With self-directed IRAs, there are two typical advantages:
The first is pretty self-explanatory. With a self-directed IRA, you control what the investment is. If you were to identify a $100,000 property that earns $1,000 per month, you could invest in that property and your annual rate of return would be 12 percent (12 months times $1,000 per month). If you could find one that offers an even better return, you could invest in that. You’re not locked into the 8-percent-or-so the available funds in your 401k are limited to.
Fees-wise, self-directed IRAs usually cost less because there is less management for the executor. For example, that 8 percent 401k fund can come with 2 percent management fees that reduce your actual return to 6 percent, whereas a self-directed IRA that charges only a half-percent brings that 12 percent return to just an 11.5 percent net return. Anybody up for making 5.5 percent more?
What’s the difference?
If you could find a $100,000 property that provides $1,000 per month of income, you could just purchase it outright and pocket that $1,000 each month, no IRA needed. But you would pay tax on all the income for the year you collected it.
If you invest in that same property in a self-directed IRA, that tax is deferred. In simple terms, what this means is that without paying taxes each year you go, you can acquire more investments because you get to keep more of your money.
So if you earn $12,000 in one year, you can use that full $12,00 toward other investments, rather than the after-tax amount. If you sell a property inside your self-directed IRA for $20,000 more than you paid for it, your self-directed IRA can re-invest that whole $20,000, rather than just the after-tax amount.
That can make a big difference over the years. Re-investing real tax-deferred real estate profits vs. re-investing after-tax funds, depending on your age, could be the difference of hundreds of thousands of dollars over a lifetime. And once you reach qualifying age, it’s all taxed at the rate of matured IRA rates.
This isn’t meant to be professional financial planning advice. As always, you should consult a financial planning or tax professional before making any investment decision. Just be aware that if you’re looking to supplement or replace an existing 401k or other retirement plans, a self-directed IRA might be a valuable option.