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Breaking Down IRAs And 401(k)s In The Note Investing Business With Brian Eastman

GDNI 108 | IRA And 401(k)

We can only know so much by ourselves in this business that it seems unfortunate that we can’t ever utilize all there is that would make our investing game better. Fortunately, with experts who are ever so willing to educate the rest of us about the complex world of investing, navigating different opportunities when they present themselves could become easier. One of the unfamiliar territories many note investors struggle with is the whole topic of IRAs and solo 401(k)s. In this episode, Chris Seveney invites over Brian Eastman of Safeguard Advisors, a boutique firm specializing in self-directed IRA and 401(k) plans, to share with us his knowledge about these accounts and how we can best leverage them in investing. He compares and contrasts IRAs and 401(k)s, talks about who can best benefit them, and explains the best strategies to use when dealing with your notes. Working towards a secure retirement in the future, Brian then gives out some of the things you need to be aware of with these accounts and advises you to always think for the benefit of the retirement plan.

Listen to the podcast here:

Breaking Down IRAs And 401(k)s In The Note Investing Business With Brian Eastman

I’ve got a special guest. He’s somebody I’ve known now for several years. Prior to my note investing, he’s of the people I reached out to because I was setting up a Solo 401(k) at the time. I’ve got Brian Eastman from Safeguard Advisors. Brian, how are you?

I’m doing great, Chris. It’s great to have the opportunity to chat with you.

I’ve been meaning to have you on for a while now because the whole topic of IRAs, Individual Retirement Accounts, Solo 401(k)s is such an unknown for people. It’s similar to note investing. People aren’t familiar with these products because everyone’s so used to investing with MassMutual or Fidelity or putting their things through those accounts. We’re going to talk about retirement account investing. Brian, why don’t you tell people a little more about yourself?

My name is Brian Eastman. I’m a Principal with Safeguard Advisors. We’re a boutique firm that specializes in what is referred to as self-directed IRA and 401(k) plans that provide checkbook control. The whole focus of that is retirement plans configured differently so they can invest differently beyond the stock market. We’ll certainly talk about that here. I’ve been doing this since 2008. I was part of a small team that acquired the company from the original owner in 2014. I enjoy working with clients and evangelizing about the benefits of these little-known structures that allow you to take tax-sheltered money and get great results for investing in what you know. We’re headquartered in Boulder, Colorado. We work with clients all across the country. It’s a very different type of financial service. It’s more of a consulting and educating business, helping people get their minds around these different things they can do. That’s always been challenging, interesting, and fun.

You hit a point there too when you mentioned the educational side of things. I know since I’ve had the Solo 401(k), when I’ve had a question now, it’s been so important to ask the questions. There’s so much we don’t know that we don’t know in this business, especially in this type of investing. Having somebody who’s sophisticated like yourself, be able to answer those questions is even more important.

As an investor, you’re not going to become a PhD in these topics in the Tax Code. It’s pretty wide-ranging, convoluted, and complex. Having an expert on your team who can help you navigate what you’re doing and the different opportunities and sometimes different approaches to various types of opportunities that are going to be more in line with IRS guidelines is a big part of what we do.GDNI 108 | IRA And 401(k)

 

Why don’t you tell us a little bit more about the whole IRA, Solo 401(k) realm as it pertains to note investing and some of the things are key benefits potentially that you see as part of investing with retirement funds versus your own cash if you had the option.

There’s nothing that says any particular one asset such as a note is better or worse or IRA or non-IRA or maybe both. Everybody looks at their own needs and portfolio and how they want to balance things. For an IRA, the whole nature of our business in the field that we serve is about broader diversification. Any good financial planner or advisor is going to tell you that you want to be diversified but in the common realm, that means which three different mutual funds. They’re the international, the small-cap, the large-cap. They’re all still stock market-based. They’re all still subject to the same new cycles and the same asset dimensions. If you are largely looking for appreciation, maybe there’s a dividend component.

It is what it is. It’s very good. There’s a reason to have money in that, but to have all your money in that one basket, especially in times like this, is not the best practice. With a self-directed retirement plan, we take that exact same retirement plan. Everything about our plans, contribution limits, timelines, tax treatment, and the fact that this is retirement savings meant for your future use, not your use now. It’s all the same. It’s no different than an IRA from either Schwab, Fidelity, Vanguard, or anybody like that. It’s more choices. You can invest in things like notes, real estate and stock of privately held companies, precious metals, and cryptocurrencies and all these ways to create true diversification. I’ll be honest, notes are probably number 1 or 2 on the list.

Between that and let’s say, maybe owning a rental property or investing in apartment syndication is one of the most popular things we’ve been serving for many years. Frankly, one of the best places to put IRA money in my opinion, for a lot of reasons relating to how IRAs work. That’s what it is. It is having a plan with more choices. It takes a different configuration to accomplish that. We have two approaches that we can use depending on who we’re working with and what their particular account type, employment status, and a few factors. You’d indicated there are both IRA and 401(k) solutions.

Let me give you a rundown on those two things. An IRA is an individual retirement account. Pretty much anybody can set that plan up and that’s a great vehicle for taking some existing savings and getting in a vehicle where you can invest differently. A Solo 401(k) is similar to an investment vehicle. It’s the same flexibility, choices, and control. What it brings to the table that the IRA does is it’s also a fantastic retirement plan for somebody who has their own business. A Solo 401(k) is a simplified iteration of a 401(k) retirement plan that’s designed for an owner-only business. They might have a partner or their spouse might be in their business, but there’s no non-owner rank and file employees.

Once you have that, you’re in a different realm and the administrative responsibilities are very complex. Those frankly don’t make very good self-directed vehicles. We work with a lot of people like yourself. You’ve got your own business. We’ve got real estate agents, independent tech consultants, people like that who, in addition to having the investment flexibility, want the high contribution limits. Maybe it’s as much as $57,000 a year, you can put in the plan and things like that. Those are the two plan formats that are out there. We’ll work with somebody to see what fits their needs and help build it.

The more that you put in 401(k) and the earlier you do it, the cushy your life in retirement is going to be. Click To Tweet

From my experience, the common question that gets asked a lot because a lot of people are similar in my situation where we have a 9:00 to 5:00. We have a retirement plan through your company. It’s like, “Can I have another IRA or can I have another Solo 401(k).” For example, I have a noted business that generates revenue and income. From that perspective, I hear that question asked a lot. I answer it in a way, but I’m not the expert. I’d love to have you provide comments because people think that they can only contribute to their company’s 401(k) or whatnot.

It depends on somebody’s situation, but we have a lot of clients who are exactly in your situation. They have some day job, regular mainstream source of income, where they have access to a retirement plan, like a 401(k) or they are a police officer with a 457 or a doctor, nurse with a 403. There are lots of different employer plans out there. Separately on the side, they have something that creates some legitimate self-employment income. That separate business can’t have its own 401(k) and they can contribute to that. There are some limitations. There are two types of contributions. There are employee contributions and employer profit-sharing contributions. Employee contributions are limited and capped across all plans that you participate in.

If you’re under age 50, that’s $19,500. You get one $19,500 chunk that you can put the plans that you participated in. Plan A and Plan B combination of the two hinging on income. You’ve got the main job that pays you $100,000 a year and you’ve got some side business that’s small and does your $10,000 a year. You can’t put $19,000 in your own plan where the business only made $10,000. You can put a good chunk of that $10,000. Any of that minus self-employment taxes could go into the plan as long as you weren’t exceeding your overall $19,000. Where the independent plan for somebody like yourself works well is the profit sharing.

Your own business, even if you’re maxing out in your regular work plan and maybe getting a match from that employer. You always want to take advantage of however much match you can get. That’s free money or instant 100% ROI, as I like to call it. If you have your own business, you can do a profit share and that’s completely independent of any other plan that you might be participating in. You can max out that feature of the plan out of your own business. The number would vary a little bit depending on your business format and sole proprietors see one set of numbers.

People who have their own corporation pay themselves their own W-2. I see a different set of numbers, but it’s roughly 20%, 25% of business income up to the cap of $37,000 that could go with the profit sharing. A lot of clients are putting 35%, 40% in their work plan between themselves and their employer. They’re putting another 20%, 25% in their own separate Solo 401(k) and that keeps you in a lower tax bracket. It builds you up a lot of nice tax-sheltered savings that you can use in your plans. The more that you put in, the earlier you do it, the cushier your life in retirement is going to be.

This past year was the first year I’ve been able to contribute a significant amount to the profit-sharing plan. My wife and I are both working. We’re paying taxes and then seeing how much we’re saving in taxes by putting that in there. Again, similar that it’s going to grow tax-deferred for a period of time. If I can do that for 4 or 5 years, when you look at it, that’s some serious money that can get in there over those years. You mentioned another nail on the head, which is diversification. Diversifying your portfolios to make sure you’re not all in one basket, whether it’s stocks, notes and rentals. That’s one thing I see some people do is if they have $100,000, they’ll buy a note for $100,000. I’m like, “To me if I had $100,000, I’d rather buy three notes at $33,000 or four at $25,000 and to try and diversify. For me, I’m more about mitigating risk.

That’s one of the things I like about notes, it is the ability to get the same amount of capital, much more diversified than say in a rental property or things like that. If you have either for smaller notes or fractional interest in five notes or whatnot, you’ve got five notes and one goes south for a little while. Maybe there’s a little late payment or something, a little blip where your income stream is being shut off. It’s being cut by 10%, 20% and the other 80% is still happening. That makes a big difference in your overall long-term returns and risk exposure.

One question I wanted to ask too is, because here’s a common question that people ask me, and honestly, I don’t know the answer. You’ve got companies out there who are custodians that you give them their money, they hold it for you essentially. If you want to invest in real estate, you fill out the paperwork and send it to them. They make sure it’s good and they send the money off. There’s the checkbook control, which is a little different where you’re the one writing the checks and so forth, but you still have a custodian. Can you explain the difference between the two because that’s always confusing?

There’s a good distinction to understand and something that a lot of people unless you start diving into this that you won’t know. It’s a different service. We focus on the checkbook plans for a lot of investors. It’s the best plan. It’s not the best plan for 100% of investors. If we’re talking to somebody and they’re going to be better suited with a custodian, we’ll certainly let them know that. It’s two different paradigms. In an IRA, you have to have what’s called a custodian. They’re the record keeper. They’re the administrative layer and there’s a handful, maybe 3, 4 dozen. Mostly, they have the word trust in their name. Kingdom Trust is a company we use at the backend of our services. There’s PENSCO Trust. In your part of the world, there’s Mid Atlantic Trust.

I’d like to say about 3 or 4 dozens. What they are is they trade with different paperwork. Everything about the IRA account is the same. It could be a traditional IRA, Roth IRA, SEP IRA. They do all the tax handling and reporting, your contribution rules and beneficiaries, and reporting. All that is the same. What’s different is their service model. Instead of being plugged into the stock exchange and computers doing trading, stocks and funds, which is pretty simplified and automated, the self-directed custodians have people and paperwork to document. The more individualized types of transactions that happen in what we call nontraditional assets.

Buying a note, buying into a private placement, like a note fund, buying a piece of real property. The custodian business model is out there. It’s been around for a long time. It can be functional for very limited and static investments. You’re going to buy something relatively low dollar and you’re going to sit on it. That service works okay. You’re going to start being more active. It’s going to fall. I’ll talk about the alternative with the checkbook control that we do. With the custodian, you have a processor and that’s it. They don’t provide a lot of meaningful guidance or advisement. They’re not providing compliance oversight to a large degree. They see something that’s a red flag. They’re going to stop and ask questions, but they’re there to say, “You’re telling us that your IRA wants to do X.”

We’re going to execute and document that process in the way that the compliance rules require. You’ve got to send in paperwork. You’ve got to give them a couple of days to get it through their queue. They’re looking to give us all the paperwork that we can properly record this and they’ll execute documents and fund transactions. You’ve got to do that for every step of the way. With properties, for example, when you buy the property, pay the property taxes, pay a plumber, when you receive your rent checks, it’s all got to go through the custodian. It’s the same with notes. You start up your note, you fund it out of the account and you receive your payments back into that account with the custodian. That’s the custodian model. That’s only in the IRA space.

With the checkbook plans, the format we provide and also with our Solo 401(k), it’s a big shift. We’re putting the cash in the hands of the client where they can directly execute a transaction, fund expenses and receive income without that third-party layer that’s a lot of delay and bureaucracy and a lot of fees. Every time you make a move with that structure. The custodians charge a combination of maybe some base fee. They’ll have some formula, some combination per transaction, number of assets held, the dollar asset, the dollar value of the account and some formula like that. It quickly adds up.

You’re doing one $40,000, five-year sit on investment. That’s going to be the right model. It’s going to work. It’s not going to be too complicated. It’s not going to be too expensive. What we do to create checkbook control in an IRA is we start with that IRA. We have to have that but we push the IRA to the backend and we haven’t made a single investment into a specialty formed usually limited liability company. Every once in a while, we use a trust format depending on the state. A few states that have LLCs are a pain in the neck. For the most part, an LLC and I like to describe it as we’re creating for the client their own private fund. The IRA owns the LLC. The client can be the signer, the non-owner manager for the LLC.

We would roll over money from an old plan first into the IRA with the custodian. We use a company called Cane Trust. We build the LLC. The client goes and sets up a bank account at their local favorite bank for the LLC. With your 401(k), it’s a little trickier. We’ve got a better solution for that now than when you initially set up. In the IRA, it’s super easy. It’s an LLC. You can open an account anywhere. Anyways, they open a bank account. The IRA invest in the LLC, it’s buying shares of a private fund and the monies are then sent out to that LLC account. Now, the client can put those funds to work as part of our services. We help them know what they can and can’t do and how to go about staying within the IRS rules.

That’s what it is. They have the checkbook. When they want to do, say a note investment, it’s that LLC, that’s the lender. They as the manager get to execute the contracts. They can wire funds to have that recorded and funded and receive the income straight into their LLC checking account. It eliminates the bureaucratic layer, the delays and the per-transaction fees that come with the other structure. It doesn’t take a whole lot of transactional activity for that to start producing a payoff. It costs a little more to set up because of all the legal work and whatnot.

Also, you’re getting access to us for advisement, which is something you don’t get from the custodian. There is a value layer. It’s a little more high-value frontend set up, but your annual operating costs are going to be a lot less because you’re eliminating the per-transaction fees and the asset-based fees that the custodians normally charged. In our case, the custodian annual fees are $125 in our structure. Whereas if you were at $150,000 and we’re doing 3, 4 note transactions and with that, you probably spent $500, $600 a year if you stopped with the custodian and didn’t build the LLC.

It’s a nice model. The 401(k) provides checkbook control right out of the box, the plans or trust. You’re the trustee. You set up a trust bank account. There are a few banks that have stepped in and decided they want to specialize that because any bank can open the account but most bankers don’t have a checklist that says, “Here’s this custom 401(k). How do I open an account for it?” It can be sometimes you’re happy to educate your banker. A couple of bankers that have come in the last few years and decided to specialize in it and it makes that process a lot smoother.GDNI 108 | IRA And 401(k)

 

I do have to admit though, when I did set it up, you had mentioned that sometimes it’s challenging and I got mine set up at Wells Fargo. You gave me a checklist and said, “Hand this to them.” When I brought that in and handed it to them, the first person was like, “Let me bring this to my manager.” The manager was like, “I understand.” Businesses in LLC that has an account and I wanted to open one up like this, and they were confused thinking it was the same. I’m like, “No, they’re not the same.”

It’s always a little fun. We’re always happy to chat with a client’s banker and speak a little bank queries. It’s not something that most bankers are most accustomed to. It is what it is. A custom 401(k) plan. It has been around for many years. Most custom 401(k)s go to a Schwab or Fidelity or someplace like that. Those guys totally know how to work with these things, but the banks don’t see it that often. The idea of a custom 401(k) focused on alternative assets is out there. They have been around for a long time and we’ve been doing it since 2005. There are a lot of them out there, but it’s still such a small little specialty thing that most bankers haven’t seen. The other thing you’ve got to keep in mind is if you go into your local bank who’s there six months ago. Those people do shop a lot.

One of the things that I love about having that checkbook control also is I’ve had deals where somebody would call me and be like, “I’ve got this deal but it needs to close tomorrow.” There’s language in there that protects me if there were title issues on the property. It was a fund that needed to close it out and the price was so good. I’m like, “I’m going to roll the dice. I have language protecting me from a title perspective if there were issues.” I had the ability where I could cut that check or wire the money that day. I knew it was getting there. I know with the custodians, that’s almost impossible. I dealt with many of them. Some are much better than others, but if somebody called you up at 4:00 in the afternoon and said you had to wire money tomorrow, I don’t think you’d find any custodian that would get that all the paperwork process and done for you. If they did, you’d probably have to pay a hefty fee.

It’s usually the same day, 24 hours, about an extra $150 to get that done. It’s the nature of the beast. It’s people pushing paper. They’re usually trying to be efficient so they can be cost-effective. They are, I wouldn’t say short-staffed but there aren’t people sitting around twiddling their thumbs waiting to do your paperwork. Let’s put it that way. It can be challenging in other formats to get stuff done. It also depends on what you’re investing in. People who are directly investing in rental property, they are well better to have checkbook control. You get a call from your tenant and the water heater is broken. You need to get a plumber out on a Saturday. You need to be able to call the plumber and say, “Go out to the property. I’ll get you my debit card.” You don’t want me to say, “Fix my property and I’ll get you a check for my custodian in seven days.” Which plumber are you going to get? It solves a lot of issues and creates a lot of efficiency having the checkbook control.

Some people prefer not to have it because there are many reasons also why you may not want to have it if you’re not disciplined and so forth and so on. Sometimes, it’s better to have some checks and balances there. It’s an option that’s out there for people. People don’t know what they don’t know and I’m one that I can admit, I don’t know what I don’t know. What are some of the things that people should be aware of with these retirement accounts?

Everything has to be done exclusively through the vehicle of the retirement plan and exclusively for the benefit of the plan. Click To Tweet

There are three main things. We always talk about this with the client in the initial consultation and then on an ongoing basis as people are looking at different types of deals. They’re welcome to check with us and make sure they’re on the right path. Number one is this isn’t, “I want to invest in X and here’s some tax-sheltered money I can use to do so.” It’s, “I’m diversifying my retirement plan.” Everything has to be done exclusively through the vehicle of the plan and exclusively for the benefit of the plan. You have to avoid any direct or indirect benefit between the plan and what’s called a disqualified person, which is you, your spouse, lineal family, and family-owned businesses.

If you own a business, a co-owner of the business, financial entanglements but mostly it’s lineal family. The main thing is avoiding. You don’t want to co-fund a note personally and planned funds and non-planned funds. Lend money to one of those disqualified persons like your son, your father, or your own business and things like that. You’ve got to keep these all investments like what you’re used to in the stock market now. “I’m going to invest in Apple, Boeing or whatever as a way to produce more savings.” That’s the main thing and navigating that is critical.

There are two other things that are a little lesser-known. They don’t apply in the note space too much. In your world, they’re simplified, but in other types of investments, one is these IRA and 401(k) retirement plans are designed for what’s called passive income and notes are passive income. They produce interests so they fit very nicely. There are other things that are allowable with an IRA like investing in a stock of a privately held company or certain types of real estate transactions, self-storage or flipping, things like that where it’s not passive income, it’s services income. It’s what a trader business income by the IRS and those are not as well-suited. When you have a tax-exempt like a 401(k) operating as a business and competing with tax-paying businesses, there are some taxes. It’s what’s called the Unrelated Business Taxable Income or UBTI that’s generated and that can be pretty steep taxes.

It could be detrimental to certain types of venture capital or equity positions and operating businesses and things like that. Again, you see in the note space. It’s a nice thing there. What’s passive, what’s well-suited to these plans is interest. Notes, dividends, royalties and what we’re used to in the main stock market. Rent from real property and the future sale of an asset they’ve held over time within the plan. Things like flipping houses and new home construction can be viewed as a business. Things we like to call real estate, but they’re services businesses like hotels, self-storage, and adult care. Those are businesses that create business taxable income.

One that comes up a lot and I hear varying opinions is people who flip notes whereas they buy a note for $2,000 and they turn around and sell it for $5,000 and that’s their business model. They’re buying these and turning these around. Another thing I’ve heard people talk about is doing like an option on a contract, which is I have the option to buy this note for $10,000. I’ll put $1,000 down and then they’ll turn around and sell it for $15,000 and then pay the $10,000 with the $15,000. That’s walking that fine line and you might be crossing it because it’s more service-related than passive. What is your opinion on that?

It was a pretty clear opinion. It becomes a service. That’s what’s viewed as a dealer activity. You’re not investing in the passive interest-bearing aspect of the note. The note is inventory that you’re buying and selling. It’s the same with flipping houses. There’s no difference or flipping airplanes. I’ve had people call me and want to do that, and I say, “You can do it, but it’s going to create some taxation.” The rules if tax-exempt IRA or 401(k) or church, hospital, whatever, but a tax-exempt is engaging in a trader business on a regular or repeated basis and it’s going to have this tax exposure. Somebody who has an opportunistic deal, they’re doing a bunch of regular note investing and then this one falls in their lap where they can quickly flip it and make a few extra bucks, there is no worry. If that’s their focus, if they’re running a note dealer business through their retirement plan, then they’re going to be creating taxable income.

How would that apply with people who do like fractionals or partials where I originated a note? My business model is I originate notes. I collect on them for a year and so forth and then I sell the next 50 payments and then I take that money that I get in. Originate another note and then I’ll sell off a partial of that. The next 50 payments and keep stacking that where you’re keeping the backend. Is that still considered passive or are you starting to get into the dealer phase?

That’s a little bit gray and it might be that it’s 50/50. It might be that the selling off is looked at as a dealer piece, but the piece that you’re holding is looked at as passive and only the dealer piece of the income. There are two challenges with that. One is where does that fall on the regular repeated and viewed as a dealer activity or not. I’d say if you’re doing a lot of that on a focused basis, it is. The bigger challenge with that is the hustle that you, as the account holder, would have to put into creating those types of deals in a retirement plan and that may not be appropriate.

You’re allowed to administer investments, but you can’t benefit from the plan such as paying yourself a fee for your services. You also can’t inject value through the provision of goods or services of selecting and choosing an investment here and there and negotiating contracts, whatnot. That’s all fine. If you’re going out and running marketing, activity, and running a business to go out and find and deal these notes through your retirement plan, you’re probably putting in more effort than the IRS rules allow for. While it’s a great strategy and something people like yourself engage in, it’s probably better to be on your personal non-retirement side of the ledger than inside the retirement plan. I got a lot of retirement investors who will buy that fractional that you’re selling and that makes a lot more sense for the retirement plan.

To date, the stuff I have in my plan has been primarily performing stuff. I’ll go out and buy the performing notes and stuff. I keep it passive and live off the cashflow.

Passive is good and simple is good and low-risk is good. There are things you can do that are more aggressive, which might produce a little bit higher rate of return, but they also come with higher levels of risk. Maybe do that personally and put the more bread and butter coupon clippings type of stuff, which notes can be so effective in the retirement plan.

GDNI 108 | IRA And 401(k)
IRA And 401(k): There are things you can do that are more aggressive and might produce a bit higher rate of return, but they also come with higher levels of risk.

 

One question that I had is and this is one thing that popped up in the past for me is, you talked about the plans and the plans are somewhat protected. The plan is almost like a separate entity and you’re the person. It came up because I’ve seen agreements in the past where servicers and some other companies request personal guarantees on things. For example, I was buying a performing note. I went to go to a servicer and they sent me the contract. They had all this personal guarantee language in there. I asked you a question. I’m like, “I can’t do a personal guarantee, can I?” You can give the response, which I’m guessing is the same one you gave me a few years ago.

The reality is, no, you can’t. I’ve talked about a little bit of the self-dealing prohibitions and avoiding disqualified parties, whether you’re a disqualified party. That provision against any benefit is two ways. You can’t benefit from your plan, nor can you provide a benefit to your plan and pledging your own assets on behalf of your plan would be you providing a benefit to the plan. The plan has to stand on its own two feet. In a situation like that, the plan could say, “I’ve got $50,000 in plan reserves that are sitting in a brokerage account.” If there’s a shortfall or whatever, the plan can make that up but you can’t put in any personal guarantee on that.

That was one that I was like, “Wait a second.” It’s the little nuances like that you can’t take a contract that someone sends you and sign it.

You shouldn’t in any framework. In your retirement plan, there are a few other things that you need to be looking at. That’s something I like to stress. For the most part, when you’re working with one of these self-directed retirement plans, you might need to do deals the way deals are done. You look at the diligence, proper record-keeping, and proper contracts that protect you and your counterparties and whatnot. It’s like any other investment activity. It’s a handful of people you can’t deal with a handful of things that might not be the right flavor of income. It wouldn’t be the right fit in a plan but when it comes to transacting the plans, a party to a transaction, it’s pretty much anybody else.

Are there any other items that you see, the don’t know what you don’t knows? You mentioned a few already.

There are three main ones. We talked about two, the keeping things at arm’s length, the potential of certain business income to create some tax implications. The last against and something we don’t commonly see in the note space, but there are a few formations where it could come up is there can be another type of tax on income that’s derived from leverage from debt financing. It applies to IRAs. It applies to 401(k)s. The 401(k)s do have an exemption when the underlying debt is secured by real property. If you were doing leverage notes like you’re going to buy into a note fund, the note fund uses a combination of investor capital as well as a line of credit. It is producing debt-financed income and a certain of the income. The percentage that’s derived from that debt financing could be generating some taxes that would apply to both an IRA and a 401(k).

If you’re going out, buying a rental house and instead of making 100% all-cash purchase with your plan, or you’re going out and getting what’s called a non-recourse mortgage note, where the property is the security and there’s no personal guarantee from you leveraging up what we talked about. You can do that in an IRA or 401(k). IRA pays a little bit of tax on the percentage of the income that’s derived from the borrowed money. 401(k) in that case, the direct ownership of real estate or the real estate is the debt instrument wouldn’t have that same tax implication. It’s not a huge tax. It’s not a deal killer. You’re getting the benefits of leverage inside your plan.

It’s not something you do in a lot of investments, certainly not in the stock market that could boost your returns. The tax on what’s called unrelated debt-financed income, there is a little bit of friction on that return. It’s not a big number. People see the tax rates and they see numbers and they see stuff where you can have tax rates at 37% but the reality is for most investors, you’re paying 10% or 15% on some 5% of your gross income that’s fractionalized down after deductions and depreciation and things like that. The tax impact is nominal but you do need to be aware that bringing leverage into the picture does have the administrative obligations to go along with that.

That’s one thing I’ve heard. I’ve launched several funds and the main question I get a lot from people is, “Are you going to be getting any debt or are you borrowing any money?” Even on the note space, sometimes people will have a note that goes nonperforming. They take the property back. They’ll turn around and turn it into a rental and maybe then finance it to get that money back or leverage. Those are things that need to be considered. I’ve heard from many investors who’ve invested in the funds say, “I should have asked because I ended up having to pay it.” It’s not the number. It’s the fact that everyone thinks, “It’s tax-deferred. I don’t need to pay any taxes for the next X amount of years.” All of a sudden, they get their K1 and they’ve got to pay taxes. It throws people for a curveball.

You can't deal with a handful of things that might not be the right flavor of income. Click To Tweet

We want to know about it in advance and plan around it. In terms of dollars and percentages of reduction in income, it is nominal. It’s not a big deal.

Isn’t even the UBIT component, which is a little different? Even the rates on that, when you’re looking at the amounts that it makes, it can get up there high in taxes but for most people, it’s still probably pretty low, isn’t it?

The thing that makes unrelated debt-financed income very workable is that you get a lot of deductions and offsets. A simple example is let’s say we’re going to buy $100,000 property, put 40 down and borrow 60. That property is 60% debt-financed. Sixty percent of the gross income is looked at as taxable. You then get to use 60% of your normal deductions. Real estate is so tax-favored. You get 60% of your depreciation, 60% of your interest on your note, 60% of your other allowable expenses like property taxes and insurance and whatnot. That’s going to take your 60% of your gross income and shave it down to next to nothing. You also get $1,000 exemption right off the top, which for somebody with $100,000, $300,000 deployed makes a difference.

You’ll start getting $500,000 deployed and that $1,000 reduction in income doesn’t mean much but for most investors in the common range, it makes a nice bite there. Let’s say that $100,000 property is producing a 10% return, by the time you apply for your exemptions and your deductions on your rental income, your leftover net taxable income is like $1,500 or $2,000. That’s debt finance that the IRA is receiving as a benefit of the non-IRA money. That’s why it’s being taxed. Your tax bill ends up being like $150, $200. It’s not a big deal. You spend maybe another $250, $300 having a CPA do the return for you. It’s a pretty discrete return. CPAs aren’t cheap. Maybe you have a $400, $500 expense to bring in leverage and boost your return by four points on the overall deal. It’s a win-win.

Go checkbook control and then you’re saving the money for having to pay on the fees. It’s the same cost as the fees you paid us in the check.

Those are the three things. It’s keeping things at arm’s length, understanding the difference between active and passive and then knowing what debt financing does. There’s some granularity into any specific situation and a lot of details but those are the main big three things I would like to introduce people to. It’s the framework of what you want to be aware of.

It’s important because as we mentioned, this is still somewhat of an unknown. A lot of people don’t understand that you can do this. I try and spread the word for people like notes. I’ve had calls with four different people on a certain topic. They’re like, “What do you do?” When they saw my website and what I did, they’re like, “I didn’t even know that existed.” It’s the same thing with self-directing your IRA or your retirement funds because everyone’s locked into the Fidelity’s of the world and some of these other firms. That’s where your retirement plan is. Most people that have 9:00 to 5:00 don’t even realize that you can control this.

We can spend an hour on that topic alone, which is short. It’s the whole paradigm and people show up at their job. The HR department says, “Sign here to participate in the 401(k). Here are the three different mutual funds you can choose or six different mutual funds you can choose from.” That’s the way most people address their retirement savings. They don’t have a lot of choices. They don’t give it a lot of thought. Once you learn, “I can have more choices and choose where this money is going to go.” I can’t tell you how many times I have people say, “I’ve had a retirement plan through my own business. I haven’t been throwing any money at it because I’m not happy with what I can put it in.”

When they realized they can invest in something that they know and where they can control the risk profile and the returns, they’re like, “I’m going to be throwing money at this and start saving for my future.” They get a lot more excited about the prospects of building that future well. It is very much unknown due to the nature of the structure. When you go to your Fidelity, they can’t even handle this stuff. It’s such a different realm of services. Most of them don’t even know it exists in those places. A few do, but it’s not something they serve. They say, “That’s specialized. We’re leaving that to the guys who specialize in it. We do what we do and make money hand over fist.” Most people have no exposure to it.

The last two questions that I have and the second one could be a whole other topic, but I want a short explanation. It’s my understanding to invest in IRA, you need to have income. You can’t set up an IRA for your kids. The second question is the difference with a Roth versus a regular.

The second one, we could have a whole conversation on that. That’s a very good topic. In order to have an IRA, you have to be breathing. Anybody, you can even be a foreign citizen, but as long as you’ve got money that can be placed in IRA. If you work for a company and had a 401(k) and then you quit that job or retire, we’d move money into an IRA. Having an IRA is pretty broad, but contributing requires earned income. You have to have earned income in order. You’ll have a lot of situations where maybe there’s a breadwinner and a homemaker. There are certain limitations to where they can. The breadwinners got some of the earned income, they can make contributions on behalf of their spouse. There are some provisions there. You mentioned children, the child has to have income.

They have to be filing a tax return and saying, “I made X dollars.” Here’s the kicker. They don’t have to make the IRA contribution. I’ve got to deal with my son. He goes out and he works. He’s seventeen and he’s a competitive athlete. He’s got very little time. He’ll be lucky to make $2,000, $3,000. He can keep that $2,000, $3,000. Put it into savings and do the occasional go out for ice cream with his buddies or bowling or whatever but he’s got the income. He goes in and files his return and says, “I’m eligible. From my $3,000, I can put $2,800 of that in my retirement plan.” I can put the 2,800 in on his behalf. As long as you’ve got the earnings that show that he has the capacity, he doesn’t necessarily have to make the contribution.

A lot of parents or grandparents will do that, but they have to have legitimate income. I work in a job. I get a lot of people and this is a CPA question. You’ve got your own business. You want to employ your kids in your business. There are lots of restrictions about doing that the right way. You don’t just set up a sham and funnel the money in. Segueing over to your next question, set up for a young person, a Roth IRA, you are setting them up for huge success. We’ve gone a lot though that in this conversation. We figured if we can get him, $20,000, $25,000, even that amount by the time he’s done with college and he doesn’t add another penny, it will be worth something like $800,000 by the time he’s 60.

It’s sick, the amount of compounding and when you’ve got that amount of time that you can work with. The Roth IRA is a great conversation. The basic principle is with a normal tax-deferred IRA, you don’t pay taxes on the money in and you put it in your retirement plan. You can say, “I can put more money in. If I made $10,000 and I’m in the 30% tax bracket, I can put $10,000 in my retirement plan. If I took it personally, I’d get $7,000 after paying $3,000 to taxes. You boosted and started to put your basis that you can put into an investment vehicle through that tax deferral. Your growth overtime is not taxed. You get to mushroom those tax savings. It accelerates your growth exponentially, which is you get $20,000 by the time you’re twenty.

By the time you’re 60, it’s seven figures potentially depending on your returns. That’s great. You build a big pile of savings by eliminating the taxes. In a tax-deferred account, you will then pay taxes on the amount you take out in retirement each year. You take out $10,000. You added $10,000 to your taxable income for that year, and it gets tacked onto your other income. It’s taxed as whatever you would be taxed at. You’re still going to end up, in theory, saving some taxes but what you’re doing is you’re building more money. You’re ultimately going to pay more raw taxes, but you’ll also still get more spendable money in your pocket too with that tax deferral. A Roth IRA, by comparison, you pay taxes on the seat, you pay on the frontend.

Especially for somebody who’s young, somebody who’s got a long-time horizon, it can be beneficial to be in that Roth program. You don’t get the benefit of writing off your pants. You’ve got your $10,000 of income. You want to put $7,000 in a retirement plan, which you’d have to do in a 401(k). You can only put $6,000 in a Roth IRA, but we’ll use our rough number. You put $7,000 in while you’re going to pay $3,000 in taxes. You’re starting with a little lower number to get into your investing pile. Everything that you grow with that becomes tax-free in the future. You pay tax on the seed and the crop that you eventually harvest is completely tax-free. With a certain amount of time and based on the rate of return, there’s a trajectory point several years down the road where you’re going to come out ahead. The tax-deferred is a win for a while because you started with more money. The Roth will catch up and surpass that over time because of the fact that you’re not going to pay taxes on the exit side.

It’s a pretty complex calculation. My wife and I both work. We live in Washington, DC. It’s an expensive market. You have a good salary. When you retire at 65, for example, I’m probably being a lower tax bracket. It’s something you’ve got to analyze to see if it is beneficial. Everyone thinks like, “You should go Roth.” You need to analyze it thoroughly in regards to what is your income stream when you’re going to be retired. If it’s mostly off the rental property and that’s passive, tax at one bracket, it’s not simple.

It’s not. It’s something to sit down and chat with a licensed financial planner, a CPA or a CFP, either of those would have the horsepower to do that. There are a lot of variables. There are some crystal balls. Nobody knows what tax rates are going to be twenty years from now. They’re probably going to be higher than they are now. I hear the comment, “My tax bracket is going to be lower when I’m in retirement.” I’ve been working hard to ensure that’s not going to be the case. You’ve got to look at it. You’ve also got to figure in your opportunity costs.

There’s another we talked about going tax-deferred versus going Roth on the get-go. You can also do what’s called a Roth conversion. That’s where you take money that you’ve accumulated previously on a tax-deferred basis. Pay the taxes on it now and switch it over into the Roth account. You’ve got to look at the payback and the timeline for that. I’ve talked to a guy who had been talking to some independent financial advisor. The guy told him he should do a Roth conversion. The guy is 70 years old. He’ll never see a payback for that. It makes no sense.

Is there a typical time for it?

There isn’t, but I would say after about 60, 62, when you start looking at a Roth conversion, it’s because you don’t need this money and you’re passing it onto your kids or grandkids and you want to save them from paying taxes on it. You’re not going to see a net spendable benefit in your pocket from a conversion now in older age. There are some scenarios where there may be other offsetting reasons. It might be like, “The numbers end up about the same, but I changed the timing of when I have to pull money out.” You’re required to take money out of a tax-deferred account at 72 now. In Roth, you’re not required. Some people might say, “I’ve got plenty of income to live on. If I switch this to Roth, I can leave more of it in the plan. I can pass more of that onto my heirs,” and stuff like that. There are some other factors other than straight dollars and cents, but usually the older you are, the less benefit you’ll see.

GDNI 108 | IRA And 401(k)
IRA And 401(k): When working with self-directed retirement plans, you might need to do deals the way deals are done—look at diligence, proper record keeping, and proper contracts that protect you and your counterparties.

 

I have a question for you. I’m going to use me as a case study. I’ve got a Solo 401(k) that is not Roth. If I wanted to convert that to a Roth, one, could I? Secondly, say I have $100,000 cash in it and I have $100,000 invested in a note, for example. Can you convert the note? Do you have to break it up? One, can I convert a Solo 401(k) to a Roth? Secondly, what happens when you have investments already out the door and then cash?

There are two pieces to that. Yes, 401(k) does allow for what is called Roth conversions. With a 401(k), you can have two different buckets of funds. You can have a tax-deferred portion. You can have a Roth portion. It’s a great horsepower. You have two bank accounts inside of your 401(k), one that holds tax-deferred money, one that holds Roth money. You need to know at any given point in time the value of each. Sometimes, when you go to invest, you’ve got to be a little careful. Am I investing in this pile? Am I combining? You’ve got to track and you’ve got to allocate things. There are some good strategies to do that. It’s very manageable. It’s very doable. There’s that horsepower of Roth and you can contribute on a Roth basis very generously without income limits or as you pass, you can do a conversion.

When you’re doing a conversion, it’s all about valuation. If you’ve got cash or stocks that are very easy to value. You’ve got to balance. You say, “I’ve got $100,000 liquid before I deploy that into my next investment. I’m going to go ahead and convert that to Roth.” You take that $100,000. You move from bank account A to bank account B. It’s some pretty simple tax filings that you do and that shows up on your personal tax return. You added $100,000 of income to whatever it is you’re doing for that year. That’s simple. It’s easiest to convert to cash. If you add a note, for example, you have to value that note. What’s that note worth? That’s what I’m converting. I know it is worth its open principle balance. There’s some fudging you can do in other situations. There are some people who get out and specialize in valuation services and maybe discounting that value.

It’s good. I’m probably going to email you because I have my daughter who assists me. She’s sixteen and does some work for me and makes a few bucks from our note business. I’d like to get her set up. I’d like to talk to you about converting my 401(k) to a Roth.

Schedule a time with me. As far as your daughter, there’s no reason to self-direct for her. Work with your CPA and figure out what she can do and put it in Fidelity. I want you to get some gas in the tank. If you want to move that in so you can put it into some notes, great.

Final thoughts, I want to talk about your company, some of the services you provide and a few other things.

It’s a consulting business at the end of the day. There are some legal work and some moving money around and compliance environments that we do. It’s about educating clients. Anybody who’s interested in this should reach out and have a quick conversation. We’ll chat and see what works, what doesn’t, whether there is good stuff, and never heavy sales like, “Here are these tools. If they make sense to you, great, we can help you out with that.” I would encourage people that have the interest to reach out. People can reach us. We have a special deal for the shared marketing efforts here. People can come to visit our website. It’s IRA123.com. Go to the special page for 70 investments. It’s IRA123.com/7e. As part of that, people will receive a $200 discount if they come in as a result of working with you or reading the blog. It’s savings pass on people and whatnot, but I’m happy to chat with people.

Another place also, I see you are very active is on BiggerPockets is another location. Brian’s also pretty active on BiggerPockets. Anything that touches defer retirement accounts, I usually see your posts. I’m surprised you have a full head of hair still because some of the posts on there could cause you to rip your hair out. I do have one question for you because this has been bothering me a little bit and I’d love to get your opinion on this. With the whole COVID crisis and you’re allowed to withdraw monies, if you were impacted, I see a lot of people talking about withdrawing money to buy real estate and to me, they may qualify in being able to withdraw the money, but I wouldn’t consider that a need. I can’t fathom people would be allowed to withdraw money as a hardship to buy real estate.

That’s pretty suspect. There are no hard and fast rules. There’s probably no reason. The issue is that you’re required to exhibit that you’ve been impacted by COVID. There are two things. You could take a more generous loan or you can take a distribution without a penalty for early distribution. You still pay taxes on it. There’s a lot that goes into the COVID, but there are a couple of ways you could tap about $100,000 out of a 401(k) retirement plan and not get hit too hard for doing so. In this environment or in most other environments, that is stupid. You’re sacrificing the tax-sheltered benefits of the vehicle. I get people who are like, “I hate 401(k)s. I hate being in the stock market. I’m going to get this in real estate and I’m going to make better money. I’m going to make up for the taxes that I’m going to pay.”

I have never heard Warren Buffett say, “Take a 30% hit before you start in a new venture.” Why would you do that? It makes no sense. There is some real trepidation there, but if you legitimately qualify to pull money out, the IRS probably wouldn’t fry you for using that to invest it and get different results. You’d be much better off getting it into a self-directed vehicle and using the self-directed vehicle to invest in real estate. I have seen and here’s a one little tricky back door and a few people that take advantage of this, somebody who qualifies to take a distribution from some hardship, but overall, they’re fine. They don’t need it, but they use it as an escape valve.

You need to be aware that bringing leverage into the picture does have the administrative obligations to go along with that. Click To Tweet

One of the challenges we have in the self-directed world is you can’t move a current employer plan. If you work for IBM now and you participate in the IBM 401(k) plan, your money is stuck in the IBM 401(k) plan until you either retire or change jobs or whatever. What you could do is a workaround that by saying, “I have this eligibility to take a COVID-related distribution. I’m going to do that.” The COVID provisions, the CARES Act that came out in March, gives you the ability to put that money back. If you do so within three years, you don’t pay taxes at all. Some people are taking a distribution from their current plan and then using that to do a rollover into another plan and that’s totally allowable and legitimate. It works. They liberated from that limited option plan into a plan where they can invest differently and that makes some sense.

To do that, you still have to be impacted?

You have to demonstrate impact and I’m doing this off the top of my head. We wrote an article about it on our blog when the rules came out. I have to either have been diagnosed, have a spouse diagnosed, have a loss of a job, severely reduced work hours, income or loss of childcare as a result of the pandemic. There are some pretty broad interpretations of what would qualify you. With something like that where you’re taking it out a plan A and moving into plan B, it’s back in a retirement plan. The only thing you’ve done is get it out of a plan that might not have an exit path now, but you put it back into the plan. You haven’t changed the tax structure. Even if you were a little suspect on your rationale, I don’t think that would be a problem if you were suspecting a rationale and taking it out to use it in your own personal pocket to invest in real estate. I could see where the IRS is going to find some people who maybe they disagree with their capacity of taking those distributions in the first place.

I would love the ability to take it from my regular employer to put it into my Solo 401(k) because I must be doing something right. I’ve pretty much beat the returns that they’ve provided me every year so I can’t complain. If you want more information, Brian mentioned the website IRA123.com/7e if you’re interested in getting his services at a $200 discount. That’s a nice offer that you’re offering out there. Thanks for offering the audience here and again, if you’re interested in more information, I strongly recommend you go to the website, sign up for a call with Brian because it’s a wealth of information that I’ve gotten ever since I’ve opened the account there. With custodians, they can’t give investment advice, which you don’t provide either, but you provide a lot of plans, rules and regulations, which sometimes is more difficult to get from some of these larger corporations. I feel like with your business being in a boutique, it’s like a one-on-one relationship where I’m always dealing with you and not with somebody else. Thank you for everything you’ve done for me in the last few years. It’s been very helpful in putting all this together.

I’m glad to hear you like it. I’m glad to hear you’re getting good results as that’s what makes it worth showing up to the office every day. Thanks, Chris. It’s great having me. I’m glad to be here and look forward to continuing the conversations.

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About Brian Eastman

GDNI 108 | IRA And 401(k)

Brian Eastman, one of expert Self Directed IRA & 401(k) Advisors will be happy to speak with you about your investment goals, determine which of our self directed plans will be the best fit and provide you with detailed information about the plan and our services.

Initial consultations may range from 10 to 30 minutes depending on the investment strategies you wish to pursue, your funding situation, and how knowledgeable you are about self-directed plans in general. We’ll certainly work to make the best use of your valuable time. Our goal is to educate and inform so that you can make the best decisions for your retirement future.

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