What is a retirement plan? Most people would say, “A retirement plan is an investment,” and they’d say it with confidence. Most people would be wrong. A retirement plan isn’t an investment, it’s a vehicle into which you place investments. That’s a key difference and deserves repeating. A retirement plan is a financial vehicle.
Whether your investments are mutual funds, money market accounts, a limited liability company, a business loan to a friend or your brother-in-law, a private placement, or real estate, the investments are placed into the vehicle.
The Two Types of Retirement Plans
A retirement plan is governed by a written instrument creating a trust and there are two types of plans:
• A Defined Benefit Plan (DB plan)
• A Defined Contribution Plan (DC plan)
The Defined Benefit Plan
In a Defined Benefit Plan, a company (or an individual) funds a retirement plan for a specific benefit. The employee states the desired benefit he or she wants out of the plan upon retirement and then puts in as much money as is required to earn that benefit.
Here’s a basic example: let’s say a company offers a pension plan that pays 50 percent of the highest annual salaries averaged over the last ten years of employment by someone who has worked there 40 years. Let’s assume for the purposes of this hypothetical example that the individual’s salary for those ten years averaged $200,000 a year. The company would need to invest enough money in the plan to purchase an annuity for the employee so that when they retired, the plan would produce (the annuity would pay out) $100,000 per year until that employee died (again, you arrive at that figure by dividing the $200,000 average income over ten years by 50 percent to get $100,000).
In many cases, the company may offer the employee the option of taking either the $100,000 a year (or whatever the figure is for the individual at hand) or taking the funds in a lump-sum payment. If you were the employee, you could take the cash necessary to buy the annuity and use it in a self-directed retirement plan. To create that type of benefit, a dollar amount of $1.5 million is required.
An amortization calculator is provided in your workbook. According to a life expectancy chart (see Appendix) you could expect to live another 30.9 years beyond your current age. For the purposes of this example, we’ll say you’re 60 years old. The annuity would have to fund payments for the next 30.9 years. That’s $100,000 a year for the next 30.9 years.
Deferred Benefit Plans work much better for older workers than for younger workers. That’s because the younger wage earners have a longer period of time to put money into the plan to get the same benefit. The dollar volumes just don’t work as well for younger employees.
Let’s look at it from the standpoint of an older worker. The DB plan would be the type in which you would take a very large tax deduction each year and put it into a retirement plan. Again, that’s putting your investment into the vehicle. For example, if you’re that 60 year old employee mentioned in the previous paragraph and a high wage earner who wants to retire at age 65, you might be in a position to put as much as $$265,000 a year into the plan.
In general, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of: 100% of the participant’s average compensation for his or her highest 3 consecutive calendar years, or $265,000 for 2023 You can also self-direct that money and the $265,000 is tax deferred.
The Defined Contribution Plan
Most of us are more familiar with the Defined Contribution Plan, such as an IRA or a Roth IRA. A DC plan defines the contribution and not the benefit. The defined contribution for an IRA is $6,000 unless you’re 50 years old or older. In that case you can put $6,500 a year in to your IRA or Roth IRA.
A Simplified Employee Pension, or SEP IRA, allows you to put 25 percent of your income up to $66,000 a year into the plan. This plan doesn’t designate how much money the investor would get out of the plan at retirement. That’s an unknown because the amount is determined by the rate of return and the number of contributions made.
A profit-sharing plan, such as 401K plan, works the same way. You’re permitted withholdings from your payroll check placed into the plan. Profit sharing plans have the same limits as the SEP IRA. Your contributions are limited to 25 percent of your income up to $66,000 a year and up to $75,000 if you need to “catch up” meaning you are above age 55. Thrift savings plans and stock bonus plans are defined contribution plans.
The Self-Directed Plan
A self-directed retirement plan is exactly what it says it is – self-directed. The person making the contributions is in control. It’s any plan where the primary beneficiary has discretionary authority over what investments are placed into the plan. You choose the investment. You choose the degree of risk. You structure the investment with the advice of professionals. You track the investment. You determine the outcome.
One of the real benefits of self-directed retirement plans is that the types of investments you can put in them are unlimited. That means you have unlimited opportunity. Here are just a few to give you an idea of the variety available:
• Stocks
• Bonds
• Mutual funds
• Annuities
• Non-publicly traded stocks
• Commercial real estate
• Rental properties
• Raw land
• Loan the money to a friend or relative
• Invest in a limited liability company
• Form a partnership
• Invest in a business
• Short sales
• Real estate options
• Other types of options on other types of properties
• Development loans
• Construction loans
• Real estate flips
• Tax liens
• The list could go on and on and on…
If someone can invest in something, chances are that person can invest through a self-directed retirement plan.
How Do I Do It?
The first step in setting up a self-directed IRA, or any retirement plan, is filling out an application called an adoption agreement. It’s a written government instrument that creates a trust. An accompanying document carries all the fine print that is related to the agreement.
Rollovers and Transfers
You need to become familiar with two terms:
• Rollover
• Transfer
A rollover is removing money from your IRA or retirement plan, taking possession of it, and depositing those funds in your bank account, using it for personal investments, or for personal loans. If you do not return the principle, amount back to the account within 60 days, that money becomes a taxable distribution. If you return a portion of the amount, only the amount remaining out of the IRA is considered a taxable distribution. You aren’t permitted to put more back in than you took out. A rollover is a terrific vehicle for short term investments.
Here’s an interesting example of how someone uses a rollover:
Every November a man takes funds from his IRA and puts it to use for the allotted 60 days. When asked why he did this every year, he replied, “I use it for a short-term investment and then I take the earned interest and use it for Christmas money.” What a great idea, but you can do more than that. Use your knowledge to teach people about the power of a rollover. A group of people who have IRAs could pull their money out, pool it, and make an investment that could earn a lot more than just Christmas money. All rollovers must be reported to the IRS, which keeps pretty close tabs on these things. When you remove the money from your IRA, the custodian will file a tax form 1099- R at the end of the year. When you replace the funds, the custodian will file a tax form 5498 to record the transaction. The IRS checks both forms to make sure that the money you took out was put back in or that you pay the appropriate amount of tax on funds that you did not replace.
A transfer is an entirely different matter. You can fill out a transfer form and the money is taken from your account and sent to a custodian. You never actually touch the money so there is no taxable event and therefore no tax reporting. You can do a transfer as many times as you want during the year.
If you have a 401K from a previous employer and you want to roll it over into a self-directed IRA, that employer will usually have some form for you to fill out. Once the money has been transferred into your IRA, you are in a position to invest in real estate, or any investment of your choice.
Another term you will need to understand is “investment letter.” This is a form in which you state the specific investment directions for the custodian who has possession of your transferred IRA funds. You’ll need to provide detailed instructions so the custodian can properly close on the piece of property you want, or to perform the transaction you desire. The custodian will need enough specifics to wire the money or write the check and do whatever is necessary to accomplish your goals.
There are two other definitions you’ll need to understand:
• Custodian
• Trustee
These terms are frequently used interchangeably, but when working with self-directed IRAs, the term custodian is proper because this person takes possession of your money and your investment documentation.
A trustee has more authority. In addition to taking possession of the funds, the trustee is empowered to make business decisions for the retirement plan. Self-directed IRAs use custodians because the IRA holder is the one who calls the shots. But there is a better way where YOU can control your investments utilizing Check Book Control…
Checkbook Control
This is a key factor in becoming a successful investor using retirement plans. Despite what many of the financial planners say, the laws, rules, and regulations applying to retirement plans state clearly that you can have checkbook control over your retirement plan. The way to do this is move your 401K, IRA, or Roth IRA into a self-directed IRA. You can then have the custodian make your investment. For example, let’s assume your funds are invested in a limited liability company. Is this a taxable distribution? The answer is ‘no,’ because the funds were transformed from cash into membership in the LLC. Let’s see how that works:
Self-directed 401ks are probably the most valuable investment tool you can use today. Here’s an example of how an investor, we’ll call him Brian, parlayed a small investment into a terrific payout:
• Brian rolled over $300,000 from his employers 401k to his own Solo k that is now self-directed.
• He then rolled that $300,000 and completed his rollover and used those funds as earnest money on the purchase of an apartment building. He’d been researching the market carefully and had located a buyer looking for an apartment building that met certain criteria. The building he’d just tied up met those criteria.
• He called the potential buyer who toured the building and agreed to make the purchase.
• Within 30 days Brian received a check for $400,000 on a double closed escrow or a flip. If he does this through the Solo k the return on investment is tax deferred.