Taking the leap to establish a self-directed IRA or Solo 401(k) is a big move. While unlocking your retirement plan to enable a broader range of investment choices is appealing, there’s work involved in both moving your plan funds and planning for a different type of investing.
For many investors, this can create a catch-22 scenario: should I find the right investment first, or setup my plan first?
There are many reasons your first step should be setting up your self-directed retirement plan before you start investing. Keep reading to find out why.
Timing, Timing, Timing
It typically takes 3-4 weeks to have a Checkbook IRA or Solo 401(k) setup, funded, and ready to start investing. While it’s possible in some circumstances to shorten this timeframe, expediting the plan may or may not be available depending on several factors.
The state of LLC formation, the type of retirement plan funds are currently in, and even the institution that’s holding the funds can impact the amount of time it will take to setup a plan. To take any action on an investment opportunity, the plan really needs to be in place and funded first.
We commonly hear from investors who have the following plan:
• Find an opportunity and lock it up personally
• Assign the transaction to their IRA before closing
If you like having your entire retirement plan taxed and writing big checks to the IRS, this is a great strategy.
IRS rules prohibit any direct or indirect transactions or benefit between a retirement plan and a disqualified person. If you personally place a property under contract in your own name or an entity you control, that property can never be acquired by or transferred to your self-directed IRA. To do so would create a self-dealing transaction.
This limitation prevents you from personally providing any kind of deposit or earnest money on a contract, even if the contract itself is made in the name of your self-directed IRA or 401(k) plan. Your provision of capital to the plan would violate IRS rules.
The bottom line is, all investment activities must be conducted through the vehicle of the self-directed IRA. Offers must be written in the name of the plan entity and all funds for deposits, inspection, or purchase must come from the plan.
The Rules Workaround
The world is not always a neat and tidy place where everything goes according to plan — including retirement investments. We get that. Many investors with an interest in real property investments come to us wanting to setup a plan after they’ve already identified a good investment property.
In some cases, there is a workaround that can be applied.
The offer needs to be written in the name of the plan. With a Solo (k) plan, we can know the name immediately. With a checkbook IRA LLC, we can either make a good guess at a unique and acceptable LLC name with the state in question, or even have the LLC filing done in just a day or so.
Any pre-closing costs (like an earnest money deposit, inspections, etc.) may not be paid by you. Your plan will also not be in a position to pay for such expenses for several weeks.
However, the plan can, borrow funds from someone who is not a disqualified person per the IRS rules. This eliminates you or lineal family. The plan may borrow from a sibling, neighbor, or perhaps your real estate agent.
This type of loan will need to be on behalf of the plan, not you personally. The loan can typically then be paid back to the lender at the time of closing on the property.
Charging interest on such a short-term loan of typically under 30 days is not always beneficial. It’s better to just have a set fee of perhaps a few hundred dollars for this transaction (paid by the plan, of course).
The Partial Funding Strategy
For real estate investors, there is another strategy that can make sense and eliminate the need to divest your current portfolio without having a specific investment opportunity lined up.
You can establish a self-directed plan and fund it minimally at first. The amount would vary based on your investment goals, and would need to cover any expect costs in the period prior to closing — like an earnest money deposit, inspections, and appraisals if you’re using a non-recourse loan. This could be as little as $2,000 or as much as $30,000 depending on the price range of the properties you may be evaluating.
Once a contract has been executed, you can then easily move additional funds from a prior IRA or 401(k) plan into your self-directed vehicle. It will still take approximately 2-3 weeks to move additional funds, and may cost between $50 and $100 in processing and wire fees.
The benefit of this approach is that it takes off any pressure to hurry up and find an investment property. If you have a large sum sitting in cash waiting to be invested, that can create a certain impetus to put that money to work. Taking your time to identify the best possible investment property may be the better approach.
Writing Stronger Offers for Real Estate
When it comes to investing in real estate, being able to write an all-cash offer can allow you to seek a discount. This can be especially true if you pair the cash offer with a short closing period.
The certainty that a seller can have of the transaction completing and doing so more quickly can be worth a reduction in price as compared to an offer that is contingent on financing. If your intention is to make an all-cash purchase, there can be advantages to having your IRA or Solo 401(k) setup and fully funded before making offers.
Many Investments Require All Cash Funding
In a standard real estate transaction with a 30-day close, using techniques such as a 3rd party loan or smaller initial funding can work. But for many other types of investments, this is just not an option.
If your investment goals include participating in these types of assets, you will likely need to plan ahead and move the necessary amount of cash into your self-directed plan first.
Being Prepared Pays Off
There are many reasons to put your self-directed retirement plan in place before finding the right investment. There are cases where this may not be possible, but it’s important to consult with a professional before trying to hack together a plan transaction in a hurry — otherwise you might put your IRA’s tax-sheltered status at risk.