Self-Directed Retirement Plans for Tax-Free Wealth

A vast majority of Americans have nothing saved for retirement. This is a tragedy of epic proportions, but people that DO have retirement savings in a 401(k) or an IRA are probably losing out on incredible potential investment returns and will be paying taxes where it isn’t necessary. If you don’t want to end up in either of these positions, read on.

The standard 401(k) or IRA you open with a financial advisor will only hold paper securities offered by Wall Street. I am referring to stocks, bonds, ETFs, and mutual funds. When you look at the mediocre performance of many of these investments over time and combine that with all the fees you are charged, it isn’t a surprise why too many people retire in poverty. If you invest in index funds and keep your money invested for 30+ years, you can expect to average about a 6% return. Using certain sector ETFs and other techniques might boost this average up over time, but overall, you will earn the market average. Now, if you start early enough and contribute enough money this strategy can work, but I have learned only doing this isn’t going to achieve the results I want to achieve.

That is IF you don’t sell during market crashes and wait on the sidelines for years before having the guts to jump back in. That also assumes you don’t try and “beat the market” by trying to be a stock picker and end up picking the wrong investments that wipe out significant gains in other areas. It doesn’t mean don’t use these vehicles, but I would argue don’t use JUST these vehicles.

There is a group of entrepreneurs and investors that have used alternative investing to build up enough income to cover their monthly nut. In essence, these people are “retired” in the sense that they don’t need to work to bring in money to cover their monthly expenses any longer, but still run small businesses and use self-directed retirement plans to create tax-free wealth for the future. Self-directed retirement plans are powerful vehicles to not only invest for retirement but also a way to build tax-free wealth.

Self-Directed Retirement Plans are Tools for the Wealthy

There is an alternative to the dismal picture I painted above, but as with most strategies I talk about, it will require that you do a fair amount of self-education and take charge of your investing. The wealthy have used a tool called self-directed retirement plans, and these plans are exactly what they sound like, retirement plans that YOU manage and invest with.

These plans come in the same form as non-self-directed programs; 401(k), Traditional IRA, Roth IRA, and Roth 401(k). For all intents and purposes, these plans work just like any other plan you may be familiar with, but you will be self-directing the investments, and you will have some additional rules to follow that are very important.

You may be wondering who uses self-directed retirement plans? The wealthy do—tech billionaires like Elon Musk and Peter Thiel, for starters. Mitt Romney is purported to have a self-directed Roth IRA worth over $100 million!

You may be thinking that with an account that you can only contribute approximately $6K into each year, how he picked the right stocks to get to $100 million. The answer is he didn’t. Let’s eliminate the first misconception about self-directed investing as I present it. You are NOT investing in stocks, bonds, ETFs, or mutual funds or more accurately you are not ONLY investing in these vehicles. As I pointed out above, if you did incredibly well with these investments, you *might* average 6-7%.

Several studies have examined financial advisors, fund managers, hedge funds, and individuals’ ability to pick enough winning stocks overtime to beat the market over the long run. Some can have an incredible short-term run, but the long-term is different. Most people can’t do it. Everyone wants to believe if Warren Buffet can do it, so can they, but reality proves otherwise.

If you open an account with TD Ameritrade or Charles Schwab, et al., and only buy stocks, bonds, etc., you are NOT self-directing your account the way it was intended because you are still very limited as to which investments you can choose from. True self-directing allows you to use alternative investments.

Self-directing into alternative investments is how the wealthy people I mentioned earlier grew their IRA accounts into multiple millions. They purchased partial ownership in private companies that exploded into enormous companies. Think buying PayPal when it was little more than an idea. When it became a company and went public, the ownership stake of Peter Thiel exploded into millions. Think of people that bought and held a $10,000 investment in Microsoft in 1978. I happen to love and use real estate and related investments as my own self-directed rocket fuel.

Self-Directing & Alternative Investments is the Secret Sauce

However, I don’t want people to conclude that all is lost if you don’t have a friend willing to let you in on the next Google, Microsoft, or Facebook while it is still in its infancy. There are many other alternative investments that, while they won’t turn into millions or billions of dollars seemingly overnight, can still earn incredible returns that dwarf most stock market returns.

I am talking about ordinary everyday investments such as real estate in your town or the small business you patronize that needs a private loan. There are more incredible alternative investments in your own backyard than you can probably handle in one lifetime. You just have to know where to look and how to assemble them. Once you do that, you do them inside your self-directed retirement plan and are on the road to building serious wealth.

In my alternative investment primer, I outline a case study of a woman I know that was able to create a 427% return on a single real estate deal in her backyard. In that example, she didn’t do it in her IRA, but she could have. I have personally done real estate deals that hit 37% in a single year. These aren’t isolated examples that only happen to well-connected millionaires. These are everyday people that took the time to learn how to assemble alternative investments. Once you know how to do that, you start doing some of them in your tax-advantaged self-directed retirement plan.

The Retirement Plan Vehicles

This section isn’t an exhaustive overview of every conceivable investment plan. It is a quick introduction. These plans are the same ones you open at TD Ameritrade, eTrade, etc. The main difference is a self-directed plan requires a particular custodian (plan provider) and some additional rules when investing. Further, the investments you can do in a self-directed plan are much more diverse than in a standard plan from a TD Ameritrade or similar company. That is why you need to find a special custodian for your plan; more below. Outside of that, a self-directed IRA is the same as an IRA at Charles Schaub.

Individual Retirement Account (IRA)

The first IRA rolled off the assembly line in 1974. Before this time, an IRA didn’t exist. Today we call this plan a traditional IRA, and it has basically remained the same vehicle since its creation. In 1997 Senator William Roth of Delaware introduced the Roth IRA. Today both traditional and Roth IRA co-exist simultaneously and have similar rules in some respects and very different rules in others.

Both versions have a contribution cap on them. As I write this, the current cap is $6,000 per year, but are occasionally adjusted up due to inflation. if you are under 50 and $7,000 per year if you are 50 or older. This will likely change over time as it has already changed many times since its inception in 1974.

Anyone can have an IRA, but there are some limits based on income of who can have a Roth IRA; see below. The only requirement is that you have earned income. This can be income from an employer or self-employed income. It just can’t be passive income such as from investments or pensions. I believe everyone should have an IRA, preferably a Roth IRA, and max out the contributions yearly.

Traditional IRA

This plan provides a tax deduction when you contribute. If you contribute the total amount of $6,000 annually, it will reduce your taxable income by the same amount. The plan is considered tax-advantaged because you will not pay taxes on your investment gains while the money is in your plan. However, upon withdrawal, you will be required to start paying taxes at your marginal tax rate on your investment gains. Further, you are required to begin taking mandatory withdrawals, currently starting at age 72. The government eventually wants to collect its taxes, forcing you to begin withdrawing from the plan. These are called Required Minimum Distributions (RMDs). You can read about them on the IRS website or work with a CPA to help you through this process.

Roth IRA

This plan does NOT provide a tax deduction when you contribute to the plan. The money goes in after tax. Like the traditional IRA, the investment gains are tax-free while growing in the plan. The real advantage is that when you start withdrawing from the plan in retirement, the gains are tax-free! In addition, there are no RMDs on a Roth IRA because you already paid the tax before you put the contributions into the IRA.

Finally, you can withdraw the amount you contributed before retirement age. I don’t necessarily recommend doing that, but if you needed to raise capital outside of a retirement plan, you could tap some of these funds. If you think that the Roth IRA already sounds like the superior plan, I would agree with you, but it does have some strings attached. First, not everyone can have a Roth IRA, at least not without some maneuvering. There are income limits on people that can contribute to a Roth IRA. These are based on your Modified Adjusted Gross Income (MAGI) according to your tax return. You can read about it on the IRS website, as it will likely shift over time.

If you are a high-income earner and have income too high to contribute directly to a Roth IRA, you can still join the party, but you must do what is called a “back door” Roth IRA. This is a bit of an advanced strategy and a topic I may cover in the future. Alternatively here a quick video from Mark Kohler that explains it. I am a fan of Mark’s work. There has been legislation introduced and discussion about closing the back door Roth IRA for high-income earners, but as of this writing, it is still open, and you can still do it. Just understand that may not always be the case, so if you want in on this, I would say do sooner rather than later.

Tax the Seed or the Harvest

The basic question I was taught about the differences between a traditional and Roth plan is asking yourself if you want to be taxed on the seed or the harvest. In other words, would you rather have a tax deduction going in and pay taxes on all the investment gains in the future, or would you prefer to pay the tax upfront and have all future earnings come out tax-free?

I have talked to two financial professionals with very different views on this. The first said he would rather have the tax deduction right now. He believes the old notion of a bird in the hand is better than two in the bush theory. He believes that Congress could change the rules on the Roth IRA in the future and make some or all the gains taxable, but if he takes the deductions right now, he is safe. The second professional said do you believe taxes are going up in the future or down? If you think they are going up, you should be investing so that your taxes will be lower in the future by using a Roth IRA.

I believe both have valid points. Since our founding, Congress has shown a willingness many times to change the rules as the political winds shift. If the country faced a massive financial crisis and Congress believed it needed the taxes on the money in Roth IRAs, it could and would change the rules. I don’t trust them as far as I can throw them.

However, I have also heard an attorney say that changing the taxation of Roth IRAs in the future could constitute a breach of contract since you believed while investing that your investment gains would be tax-free. His thesis is that Congress could try and change the rules, but the courts would strike it down. Is he right? I have no idea. I will say that anything is possible with the right political winds blowing and the right political make-up of Congress, the Whitehouse, and the Courts.

However, I don’t believe it is probable. Is it possible? Yes, is it probable? No. Based on that reasoning, I am choosing to use a Roth IRA and counting on my investment gains being tax-free upon withdrawal. I believe that the Roth IRA is a superior vehicle, and it is the one I am choosing to use.

The 401(k) Plan

Most people have probably heard of a 401(k) plan. If you work for an employer, your employer will likely offer a 401(k) plan. If you are a public employee such as a teacher, you may have a 403(b), but the plans are the same for all intents and purposes. 401(k) plans came into existence in 1978, not long after the IRA. Before retirement plans were available most people had a pension or used savings and investments (or both) to provide for retirement.

A 401(k) works much like an IRA because you contribute earned income to the plan, and it grows tax-free until you start withdrawing it. You get a tax deduction on your contribution but will pay taxes when you begin withdrawing it. The contribution limits are higher, and everyone can qualify for an account, assuming their employer has one available.

The main problem with 401(k) plans is that they are sponsored by an employer and are very limited regarding what you can invest in. You will generally be limited to mutual funds and ETFs. Some may allow individual purchases of stocks or bonds, but that is rare. Most offer a choice of curated Wall Street funds, and that is it. So, by default, you are stuck in investments that will, at best, earn you a basic market average over time. You are unlikely to find investment choices that allow you to “beat the market,” assuming you had the skill to do this consistently, which almost nobody does.

In addition, many of the funds and plans you will be part of come with high fees. Most you will not even be aware of. When you start contributing to a plan, you will get statements, and other documents that disclose these fees but finding them in all the small print is beyond the average investor. These fees are like having a bunch of leeches attached to you throughout your working life, slowly draining your returns. These fees are often paid whether your investments are growing or crashing.

The Solo 401(k) Plan

This is just like a regular 401(k) plan, but it is a plan for self-employed people. Suppose you have a business where you generate earned income (no passive income); you can set up a Solo K for your business. There are some restrictions, of course. First, you can’t have employees outside of a spouse in your business. If you do, you will need to create a more traditional (and expensive) 401(k) plan and offer it to all employees. It is for this reason that I believe so strongly in freelance entrepreneurship. As a freelancer, my only employee is my wife, and as a consultant, I have earned income from projects that I can use to fund my 401(k).

In addition, Solo K plans have a lot less paperwork and other regulations than a plan that a larger employer offers. This allows a small business owner to have all the benefits of a 401(k) plan but with much less work and expenses. This levels the playing field and puts incredible wealth-building tools into the hands of solopreneur that didn’t exist in the past.

The Side Hustle & Solo K

If you work for an employer full time but have a side hustle with earned income, you can set up a 401(k) plan, but you need to be careful. There are some rules here. You can’t deliver pizza and call it a side hustle. You could, however, moonlight as a graphic designer or web developer and use the earned income to set up a solo 401(k) plan.

I have a friend who owns a large portfolio of rental properties and lives off the income from his investments but still runs a handyman business. The business allows him to have a Solo K plan and contribute his earned income from the handyman business to his 401(k). He can do some incredible tax-advantaged investments by maintaining his business and keeping his Solo 401(k) plan, which he couldn’t do with just rentals because that is considered passive income.

Solo Self-Directed 401(k) Offers Vast Investment Choices & Configurations

The solo self-directed 401(k) plan is a potent investment vehicle if you set it up and use it correctly. It can provide you with a vast range of investment choices, both traditional market investments, and alternative investments. It has higher contribution limits than an IRA. It can have both a deferred and Roth bucket meaning you can contribute money pre-tax and post-tax into the appropriate bucket, which gives you incredible control over taxes both in the short and long term.

Finally, the Solo K has some attractive exemptions to the rules when you are self-directing them into alternative investments that IRAs don’t have. If you are self-employed with no employees, you should set up a Solo K.

My own Solo K set up has both a deferred and Roth bucket. I invest in more traditional stuff in my deferred bucket, but even that is better than most employer-sponsored plans because I am not limited by the investment choices that my employer allows. I can invest in any fund, stock, bond, options, etc. Yes, these are Wall Street investments, but I have basically an unlimited menu to choose from.

My Roth bucket is all self-directed into alternative investments. The superior returns I can realize on my alternative investments grow tax-free and will come out tax-free in the future. Plus, I still can get a tax deduction for the part I put in the deferred bucket. Finally, I can slowly convert money from my deferred bucket to my Roth bucket over time, so I am positioning more and more assets on the tax-free side. I control how much to convert and when, so I manage how much income taxes I pay when I convert the funds.

Once I was working on a flip, and I also wanted to do a Roth conversion in the same year, but I wasn’t sure how that would work out from a tax perspective. I was close enough to the end of the year that I didn’t need to do both activities in the same calendar year, so I was able to do the conversion in one calendar year and time the sale of my flip to the next calendar year to spread the tax burden out over two years. Had I not been so close to the end of the year, or my flip would have been further along, I could have converted less or set up a lease/option on my flip to move the sale out. I could have done many things to control the situation to create the best tax advantage for me. I can do this because I control the business, the solo(k), and my how and when income comes in.

As you can see, you can create some fantastic advantages for yourself by being in total control of your retirement plans, investments, and business. My plan gives me incredible flexibility and tax advantages. It is one more reason why I believe everyone should be an entrepreneur and use alternative investments. Do you see why those two things are two of three legs of my Money Outlaw trifecta?

While owning and investing with self-directed retirement plans creates some incredible advantages, it also comes with many rules. These rules can be complex, and the penalties and fines for messing them up can be very costly. Don’t let the regulations intimidate or scare you away; have respect for them and learn them. I would advise connecting with an attorney and CPA that have self-directed experience. In addition, build a network of other advisors and experienced self-directed investors around you. Please don’t skip these steps, as the downside consequences can have life-altering outcomes.

I don’t have the space or the professional credentials to spell out all the rules. That is why it is crucial to hire professional assistance, but I will hit a couple of big rules to give you a flavor of what you need to know.

Prohibited Investments

You can invest in just about anything with a self-directed plan, but there are some hard limits the IRS puts on the types of investments you can put in your plan. Here is the is list I found, but you should verify with a professional.

• Life Insurance
• Certain Types of Derivatives
• Antiques & Collectibles
• Real Estate for personal use, i.e., a vacation home, for example.
• Most (but not all) coins, certain coins are allowed.

Some of the items on this list are a bit nuanced and have some rules surrounding how you can hold them. For example, you can’t buy a bag of gold coins stored in your home safe and claim it is an asset of your IRA. I would stay away from just about anything on this list except maybe permitted precious metals. Research your investment thoroughly and ensure it doesn’t fall into these categories. If you are not sure, consult an investment and or tax expert.

Prohibited Transactions

There are a lot of rules built around types of transactions that you absolutely must avoid. Rather than try and write all these out, I will give you the two big ones.

1. Self-Dealing: Doing deals with yourself, i.e., personal selling or buying assets from your retirement plans, will always get you in trouble. For example, you were selling your IRA, a rental property you have owned for years, for pennies on the dollar. In addition, getting any personal benefit from investments in your retirement plans is also totally off-limits. This one broad area is filled with landmines. Don’t push the envelope here.
2. Family Deals: Doing deals directly with family members up and down the family tree is also off limits. For example, your IRA buys a property your dad has for a steal. First, dad is off limits, and the steal of a deal adds fuel to the fire.

The best advice I can give you on staying out of hot water with prohibited transactions is to learn what they are inside and out and stay away from them. I highly recommend The Self-Directed IRA Handbook, 2nd Edition, by Mat Sorensen. The second book I recommend is The Solo 401(k) by Dyches Boddiford & John Hyre. (See resources at the end) The authors of these books are experts and attorneys in self-directed investment plans and have written excellent resource guides.

Understand that these rules are not flexible. The IRS takes them very seriously, and the consequences for breaking them could cost more than you can imagine, to the tune of 50% of the value of a retirement plan!

I don’t want to scare you away from self-directed retirement plans, but I want to instill in you the need to learn how they work and have legal and financial professionals you can call on to ensure you abide by the rules.

The Custodian

A custodian is a legal organization that “holds” your self-directed account. A custodian is legally required for all retirement accounts. The type of custodian you have will control many aspects of what and how you can use these plans. Only some custodians will allow you to invest in alternative investments. Some custodians have different fee structures and rules for what they will and will not let you do. It pays to spend some time shopping around and investigating the different custodians. I lump custodians into two primary buckets to start.

Traditional Custodian

The traditional company in this space is well-known firms like TD Ameritrade, Charles Schaub, eTrade, etc. These companies can set you up with a self-directed IRA or 401(k), but they will not let you invest in alternative assets. They will only allow you to invest in assets you can purchase through a standard brokerage account. This includes stocks, bonds, ETFs, mutual funds, etc. If you want to use your money in these plans to buy and flip a property, you will be out of luck. They let you self-direct, but only with traditional assets.

Non-Traditional Custodian

There are particular types of custodians out there that specialize in helping investors set up self-directed plans that specialize in purchasing alternative assets. These custodians understand this business, which is why they formed, to give investors more control and the ability to go into these alternative investments. Here is a partial list of custodians. These custodians are not in any order. In full disclosure, I use Advanta IRA and Equity Trust. Please investigate the fees and capabilities of each company to choose the one(s) best suited to your needs.

• Advanta IRA
• Quest IRA
• Equity Trust
• American IRA
• Directed IRA

I am sure I am missing some that might be out there, but I am familiar with the above mentioned companies. While many of them have IRA in their name, most can also set up a Solo K plan and other self-directed accounts such as CESA and HSA plans.

The one catch I have found with the non-traditional custodians is that they don’t have a brokerage service. That means they will help you with alternative investments but will not allow you to buy stocks, bonds, etc. The traditional custodians are just the opposite. In other words, you will need more than one plan if you want both traditional and alternative investments.

I mix and match. I have both traditional plans with brokerage access and non-traditional custodians where I can do the alternative investments. I don’t want to be limited by my investment choices, so I needed to create more than one plan. You can have multiple plans, but your annual contribution limits apply to all plans combined. In other words, you can still only contribute a total of $6,000 per year ($7,000 if you are over 50) to your IRA as I write this, if you have one or three accounts. You can’t deposit $6,000 to each account per year.

As I discussed above, my Solo K has both a deferred bucket that I use for traditional investments with a brokerage account at TD Ameritrade, and my Roth bucket is managed by Advanta IRA, which allows me to do alternative investments. I had to create two solo K plans, one deferred with TD Ameritrade and one Roth with Advanta. This probably isn’t the optimal way to do it, but it works. I would recommend that you speak with financial and legal specialists in this area to see how you should set it up based on your goals.

Conclusion

Self-directed retirement plans combined with alternative investments, proper tax planning, and creative investing will add plutonium to your wealth-building efforts. This vast investing area requires you to have some skills, knowledge, and a team of professionals you can call on.

The flexibility having these plans gives you is incredible. When you combine the use of these plans with the two other legs of my trifecta, alternative investments, and entrepreneurship so you to set up your own Solo K, you have some incredible tools at your disposal. Those tools require some education and special care to follow the rules.

These plans will turn some people off because of the work involved in learning the rules and avoiding the potential pitfalls. That is unfortunate because these same people will not appreciate the incredible flexibility and investment returns that can be achieved if you take the time to learn and implement these plans.

In future pieces, I will outline additional strategies and tools for self-directed investing. I believe strongly in the concept and find the education I need to be a fair trade. I hope you do as well. Happy investing!

Resources

Books

1. The Self-Directed IRA Handbook by Mat Sorensen
2. The Solo 401(k) by Dyches Boddiford, Dorsie Boddiford Kuni, and John Hyre
3. IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment by Patrick W. Rice
4. Self-Directed IRAs: Building Retirement Wealth Through Alternative Investing by Richard Desich Sr.
5. How to Buy Real Estate (and Other Cool Stuff) in Your IRA by William Bronchick

Seminars

• Dyches Boddiford & Pete Fortunato – Self Directed Investing. If this seminar is offered again you should sign up for it. Check out their website for when it will be offered again. https://assets101.com/
• Self-Directed IRA Summit by KKOS Lawyers. https://kkoslawyers.com/events/

Podcast

• Directed IRA Podcast: https://directedira.com/podcast/