Real Estate & Retirement

Most stock brokers talk about being secure and diversified using a 3-legged stool analogy. This analogy represents diversification between stocks, bonds and cash. At UbidProperties.com we like to take it a step further and let you know that a 4-legged chair is more stable than a 3-legged stool. Advocates of stock market investing never talk about the 4th asset class, which is by far the best investment you can make. Why is that? Two reasons, the first is they don’t get paid if you buy real estate so they have no need to talk about it. Second, most of them don’t have a clue about investment real estate and what a good deal is or is not.

All we do at UbidProperties.com is real estate. We talk about it, buy it, rehab it, invest in it, sell it, educate clients about it, and much more. We walk the walk and talk the talk. We don’t talk about stocks and bonds, we’ll leave that up to your stock broker. However, were are here to educate you and to let you know that whatever you do outside your retirement fund with real estate can be done inside your retirement fund, you just need to know how to do it and where to go to get the information.

The biggest complaint we have with the investment community is that they don’t talk about buying real estate in your retirement plans. Only 2% of the American population owns a real estate retirement account. This is a problem as most investors don’t realize that they can buy, sell, rent, flip and lease investment real estate within a retirement fund. Very few people know about it because no one sells real estate administered retirement plans and then gives you the ability to buy the real estate as well. You can find an administrator that will handle the retirement account but then it is up to the individual to find the real estate to put into the account.

Let’s start out by talking about the different types of retirement funds and what the differences are. Again, don’t forget that you can use any of these vehicles to fund your real estate transaction. The key is to have an administrator that is set up to handle real estate transaction. The different types of retirement vehicles include;

Traditional IRA - A Traditional IRA plan offers pre-tax advantages for individuals to set money aside for retirement. Contributions are made using pre-tax dollars. The profits as well as the contributions in the IRA can be compounded tax free until the funds are withdrawn. At that time they are taxed at the individual’s marginal income tax rate. There are several guidelines that the IRS set which must be adhered to or stiff penalties will be applied. These guidelines include contribution limits, income ceilings to participants, withdrawal penalties prior to age 59½, and required distributions at age 70 ½.

Roth IRA - This IRA offers after tax advantages for individuals to set money aside for retirement. Contributions are made with after-tax dollars. The profits as well as the contributions in the IRA can be compounded tax free and the funds withdrawn are also tax-free. There are several guidelines for this IRA as well that include all the above guidelines for a traditional IRA plus the account must be at least five years old.

Simplified Employee Pension Plan (SEP) – This retirement fund enables individuals to make IRA contributions of up to $44,000 toward their own and their employees' retirement account. SEPs are owned and controlled by the employee but the employer makes the contributions to all accounts. There can be no discrimination and the contribution percentage must be the same for all employees including the owner. The maximum contribution is 25% of the employee’s salary. The contribution is based off of salary only and can not include income from profits. Eligible employees are those who have reached the age of 21, have worked for the company 3 of the last 5 years, and have earned at least $450 that year.

Savings Incentive Match Plan for Employees (SIMPLE) – The SIMPLE plan is a retirement plan designed for small businesses with 100 or fewer employees. It allows the business to offer a company sponsored tax deferred retirement plan to their employees. Under this plan, employees can choose to make a tax deferred contribution from their salary, payable directly to their retirement plan, rather than receiving the amount as current taxable income. Employer contributions are required as a matching contribution only and limited to 3% of the employee’s annual income but no more than $10,000. Eligible employees include those that earned more than $5,000 in the previous year and expect to do the same in the current year. An employee can defer up to 100% of their income into the retirement plan but no more than $10,000 total.

Individual 401(k) - The Individual(k) retirement plan, also known as the Solo(k), offers business owners the same benefits as a traditional 401(k) plan. This plan is only designed for businesses in which there are no employees other than the owner and spouse (partners are acceptable). It must be the only plan the business maintains and cannot be considered part of a controlled group under tax law. Employees (owners paid as employees) are eligible to contribute up to $15,000 annually as long as their income exceeds that amount. The employer is then allowed to contribute up to 25% (20% if sole-proprietor) of the employees wages into the retirement plan with a contribution maximum of $44,000 for both husband and wife.

A common question we get asked is can we convert our Traditional IRA to a Roth IRA? The answer is yes you can but here’s how it works. For the tax year that you choose to transfer the funds, you will be making a withdrawal from your Traditional IRA, paying taxes based on your marginal income rate on those funds, then rolling the funds into your newly acquired Roth IRA. You can certainly do it unfortunately it’s a taxable event. The IRS will get “their” money one way or another.

Now that you know about the different retirement plans and the fact that you can invest in real estate in all of them let’s talk about some of the advantages and disadvantages. First of all, depending on your real estate activities not all plans are ideal for real estate investments. We need to look a little more in depth about taxes and how the retirement plans work in conjunction with taxes.

Not all income is treated the same by the Internal Revenue Service (IRS). I’m sure that’s not a big surprise to anyone but for this discussion it’s very important. There are basically 3 types of income; earned income, portfolio income, and passive income. Earned income is what you earn from your job or occupation. It is the most common income made, the highest income taxed and taxed by the most authorities. If you get a salary, take a look at your next paycheck and you will notice that your gross pay is reduced (substantially) by Social Security, Medicare, Federal Tax, and State Tax. Portfolio income is income you earn from interest and dividends. It is the second most taxed of the three incomes. You will pay Federal and State Tax but there is no Social Security or Medicare tax. Passive income is the least tax income in which you will pay federal and state taxes, no social security or Medicare. Income from real estate and royalties are the most common in this category.

Now that you have a good idea of the three types of income, let’s talk about how it relates to the retirement funds. In all cases except the Roth IRA, your income is tax deferred. If you were going to purchase a piece of real estate and hold it long term for the monthly cash flow, you would not want to buy the property in any retirement account other than your Roth IRA. The reason behind this is even though you are deferring the tax until you withdraw the funds, you would be taking passive income and converting it to earned income. You actually changed the tax structure of the income to a higher taxed income. Something we absolutely do not want to do. Now if you have a Roth IRA, then by all means you can buy a property and hold it long term in your retirement account because you are taking passive income (which is taxable) and converting it to a non-taxable event. That’s always a good thing.

Let’s say you are in the business of real estate. You decide to buy a piece of real estate that you are only going to hold only a few months. Just enough to buy it, complete the rehab, and sell it to a homeowner. The whole process will take less than 6 months. In this case you can certainly buy this property in any of your retirement plans and either defer the tax or eliminate it. If you buy in any of the plans other than the Roth IRA, then the tax will be deferred. If you buy the property in your Roth IRA then the transaction will be tax free.

The main idea is to make sure you have an exit strategy prior to purchasing your investment property. This way you know which retirement plan to buy the property in order to maximize the tax benefits.