What is a real estate IRA? Retire with comfort, security and sustainable income

A real estate IRA (Individual Retirement Account) is a self-directed IRA with a heavy focus on real estate investments. Sounds simple – but there is a bit more to it. What is an IRA? What is a self-directed IRA? What are real estate investments? Let’s look into these questions in a bit more depth so we can find our answers.

Individual Retirement Accounts:

There are four types of IRAs each with their own set of rules and regulations. Traditional, Roth, SEP and Simple. Each type of IRA is designed to help individuals in different situations save for their retirement.

Traditional: Allows you to direct pre-tax income towards investments that can grow tax-differed. This means that you get to make a tax deduction in the year you make your contribution but you will have to pay those taxes in the year you make your withdrawal. If you are not covered with a SEP IRA at your place of employment and your income falls within certain limits, you may open up a traditional IRA. The contribution limit is $6,000 per year ($7,000 if you are over 50 years old). You must make minimum withdrawals after age 72. A traditional IRA makes sense if you expect to be in a lower tax bracket upon retirement.

Roth: Very similar to a traditional IRA except that your contributions are made with after-tax money. This means that you are not allowed to take a tax deduction for your contributions. But it also means that any earnings in your Roth IRA and your withdrawals are tax free. This is ideal if you expect to be in a higher tax bracket upon retirement than you are currently. There are no minimum withdrawals required.

Simplified Employee Pension (or SEP IRA): This is a retirement plan that an employer or self-employed person can establish. Like a traditional IRA they are funded with pre-tax contributions and grow any earnings on a tax differed basis. An advantage of a SEP is that there are much higher contribution limits – 25% of your income or $57,000 (in 2020) whichever is less. The employer is allowed to make the tax deduction on any contribution.

Simple IRAs: These retirement plans can be used by most small businesses with 100 or fewer employees. Employees can contribute up to $13,500 per year and Employers can choose to contribute 2% or can match an employee’s contributions up to 3%.

The types of investments allowed in each of these IRAs include annuities, mutual funds, exchange traded funds, stocks, bonds, cash and cash investments and DRIPs. You will notice that real estate was not mentioned above. For that type of investment, we need to look at self-directed IRAs

Self-Directed IRAs: Investopedia defines a self-directed IRA as follows.

A self-directed individual retirement account (SDIRA) is a type of  individual retirement account (IRA)  that can hold a variety of alternative investments normally prohibited from regular IRAs. Although the account is administered by a custodian or trustee, it's directly managed by the account holder—the reason it's called "self-directed."

That last point is key. The custodian is not allowed to give you any financial advice, so you must do your research before making any purchases.

The main advantage of the self-directed IRA is that you can hold a much broader set of investments with them. Commodities, precious metals, limited partnerships, private placements, tax lien certificates and real estate are all allowed within a self-directed IRA.

Real Estate Investments: If you think about it, you might already be a real estate investor. If you own your own home then you are already invested in real estate. Beyond that however there are vacation properties, home rentals, commercial properties such as office towers and hotels and many others.

Conclusion: Earning a passive income from a property that you own is a fantastic way to get rich. If you can build a luxury hotel on a piece of real estate and charge handsome fees for the use of the hotel rooms – not to mention any restaurant revenue, spa bookings, gift shop, etc – then your property will be earning far more than any expenses you may have to manage that property. In this case, it is a perfect vehicle for growing your retirement accounts. This is particularly true if you do this within a self-directed IRA since you can also capture significant tax advantages as well.