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Real Estate Investment – The best way to generate income inside of your IRA

Real Estate Investment – The best way to generate income inside of your IRA

Real estate is one of the very best investments you can make within your IRA. It will diversify your overall holdings, protect you from inflation and provide a steady stream of income that you will utilize in your old age. Real estate tends to appreciate over time so holding it within your IRA, which naturally has a longer timeline, makes perfect sense. The safety and security of real estate also makes it ideal for your IRA as no one wants to take high risk into their retirement. The nature of the IRA means your investments will grow on a tax deferred or tax-free basis which will set you up to live well in your golden years.

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What is an IRA?

An IRA, or Individual Retirement Account, is an investing tool that works in a tax advantaged way so that individuals can earmark savings for retirement. This tool set up by the government and governed by the IRS is offered through a variety of financial institutions and is available for individuals and small businesses.

You add money to your IRA and then invest those funds in stocks, bonds, ETFs, CDs and mutual funds. There are some special IRAs where you can hold alternative investments like real estate and we’ll get to those below. There are also limits to how much you can contribute and penalties for early withdrawals. Let’s take a quick review of the several different types of IRAs.

What is an IRA?

  • Traditional: When you make a contribution to a traditional IRA your contribution can be used to reduce your taxable income. This is called a tax deduction and will save you money in the year you make your contribution. Any investments within your IRA will grow without having to pay tax on them. Upon withdrawal of those funds is when the IRS gets its money, but when you retire you might be in a lower tax bracket and end up having to pay less tax overall.
  • Roth: With this type of IRA you can only contribute with after tax dollars and do not get to take a deduction on your income tax. However, all the investment gains within a Roth IRA are completely tax free. Once again there are restrictions on how much you can contribute and also an income limit on even having a Roth IRA. Unlike a traditional, there are no minimum withdrawal amounts once you reach age 72.
  • SEP: This stands for Simplified Employee Pension and is used by those of us who are self-employed. SEPs have similar taxation rules as traditional IRAs but the contributions must come from the business and not the individual. It is the business that can take the tax deduction – but the individual pays the tax upon withdrawal. The contribution limits are much higher on this type of IRA.
  • SIMPLE: The Savings Incentive Match Plan for Employees is very similar to the SEP except that employees are allowed to make contributions. The employer must match those contributions and both get to take a tax deduction to help reduce their taxes owing. Just like the SEP the contribution limits are much higher than with a traditional or Roth IRA.

All of these IRAs only allow you to hold standard financial instruments within them – mutual funds, stocks, bonds, CDs and ETFs. You can hold alternative investments within your IRA but it has to be a special kind of IRA and is usually only offered by certain companies. They all offer different services for different fees so be sure to shop around. You will be glad you did.

What’s a SDIRA? A Self-Directed Individual Retirement Account is a special type of IRA that allows you to hold alternative investments like tax liens, private placements and real estate. The companies that offer SDIRAs are called custodians and although they administer the accounts it is you the account holder that directly manages the IRA.

Benefits of buying real estate in your Self Directed IRA

This means that you make the investment decisions (the custodians are not allowed to give advice) and manage all the risks. Usually these types of accounts are suitable only for experienced sophisticated investors and there are certain rules that must be followed.

Benefits of buying real estate in your SDIRA: There are a number of reasons why you would want to purchase real estate inside your SDIRA.

  • Tax advantages:This refers to the inherent tax advantages of all IRA accounts. Namely that your investment will grow tax free and you won’t have to pay that tax at all if you have a Roth IRA even when you do withdraw it. (With a traditional IRA your taxed only on withdrawal which, during your retirement will hopefully put you in a lower tax bracket. This is why a traditional IRA is called tax differed, or tax-free if it is a Roth).
  • High yield:Compared to traditional investments such as stocks, mutual funds and ETFs it is difficult to create a fair comparison. It is easy to calculate the return on investment for stocks, since everything hinges on the price at which you sell versus the price at which you bought. Real estate is a little different. You need to calculate the income earned from the real estate (ie the rent you charged your tenants), as well as the appreciation.
    One way to compare returns of real estate vs the stock market is to look at the performance of REITs (Real Estate Investment Trusts). These are companies that invest in real estate and their stock is freely available on the stock market as well. Let’s look at some historical numbers between the S&P 500 vs the Vanguard Real Estate ETF total return.

You can clearly see that real estate returns easily stack up to the stock market and in the case of the longer time lines they far exceed the S&P 500 returns. While this is not a perfect comparison between holding real estate and holding stocks it does give us some good rough numbers to consider.

  • Diversification: Holding alternative investments in your SDIRA allows you to diversify away from traditional financial markets. Real estate does not move in the same cycles as do stocks and bonds. In this way you are afforded a measure of protection should some calamity hit the stock market.
  • Tangible assets: When you purchase real estate, you are getting a real asset that you can see, touch and smell. It will rise and fall in value like other assets but it will never collapse to zero as has happened with stocks. If your investing plan goes south and you need to make a change you can always sell the real estate and receive something back.
  • Control over your property: One thing that is very nice about the SDIRA is that you are in control. If you have done your homework you can be rewarded for your efforts. You can set the price, make any changes to the property, decide to rent or sell and your asset will grow under your influence.
  • Protection against inflation: When you decide to rent out the property and receive that steady income stream you can protect that income against inflation by raising the rent each year.
  • Generation of income: There are two main ways to generate income with your real estate. Create a passive income stream by renting your property to tenants. You can control how much to set the rent and if you can also control your costs this can provide a very steady and secure income stream that will ideally last for years.

The other way to generate income is to sell your property once it has appreciated in value. This is dependent upon the location (has the neighborhood improved, a new employer moved into the area or a transit stop been added nearby), development of the property (build a house on raw land) or any improvements that you have made.

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