I was recently interviewed and asked, “what has caused so many investors to self-direct their retirement plan?” As many people know, self-directed retirement plan investors use their self-directed IRA and 401(k)s to invest into real estate, private companies, precious metals and other “non-wall street” investments. I’ve worked with thousands of self-directed IRA and 401(k) investors and as I reflected on the question I realized that there are three primary categories of self-directed investors.
I. COMPETITIVE ADVANTAGE INVESTORS USING ROTH ACCOUNTS
These investors like to invest in what they know. They avoid mutual funds and the stock market because they have a competitive advantage over other investors and usually have a special expertise over other investors. Because they have a special expertise, they often expect to make significant returns and therefore will frequently use Roth IRA or 401(k) accounts for their investments. Let me offer a few examples from actual un-named clients of mine that all resulted in 7 figure returns.
- Software Engineer. Software Engineer who used Roth IRA funds along with some other technology savvy investors and funded an LLC. This LLC then engaged and paid some un-related developers to develop new programming that the Roth IRA investors knew would have value. The LLC owned by the Roth IRAs then in turn negotiated a royalty agreement with an un-related company who wanted the technology to be used in a specific software program that it would sell commercially. The LLC receives royalties on the use/sales of the product. The income goes back to the Roth IRAs tax free.
- Real Estate Developer. Real estate developer and investor personally develops millions of dollars of real estate a year and decides to use his Roth IRA to fund a specific real estate investment. Real estate developer converted a couple hundred thousand dollars of traditional IRA funds to Roth IRA funds so that he could acquire a specific piece of real estate which was to be held and later sold. The developer know the land would have significant value over the next few years as a result of zoning law changes and planned development from neighboring property. The Roth IRA paid for some paper development zoning changes upon acquisition and then held the property as an investment for a few years. The property later increased nearly 10 times in value as neighboring development took off.
- Bio-Tech Start-Up Entrepreneur. An experienced bio-tech investor had an opportunity to invest at early stages in a patent that was going to be the basis for a new bio-tech start-up. The investor used Roth IRA funds and funded additional research costs in exchange for an interest in the patent that was being developed by un-related researchers for commercial purposes. The patent was the basis of value for a start-up venture and the Roth IRA received a significant share of the company in exchange for the patent interest.
This group would also include former Republican Party Nominee Mitt Romney and famous Venture Capitalist Peter Theil whose large self-directed IRAs have been reported on extensively.
Keep in mind, the rules for these investments are complex and careful planning must be taken to avoid prohibited transactions and unrelated business income tax (UBIT). However, when properly executed with the right investment, this group can sock away significant returns in tax-free roth accounts. There’s no better deal in the tax code that this.
II. SEEKING INCREASED RETRUNS AND TIRED OF POOR FUND OR STOCK PERFORMANCE
This is the largest group of self directed IRA investors. These investors have seen stagnant performance, losses, or ridiculous fees eat away at their retirement account. They are generally tired of the ups and downs of the stock market and want stable investments they can actually understand. This group usually invests in real estate, in its various forms, because it can offer more stable returns and because the investor can actually understand the investment (something they can’t do from a 100 page mutual fund prospectus). Here are a couple of actual client examples.
- Retired Corporate Manager Becomes a Real Estate Investor. A retired real estate investor client of mine rolled over former employer 401(k) funds to a traditional self-directed IRA. This investor is in their early 60’s and uses the income from her retirement account to live on. She invested her traditional IRA into a modest 3 bd 2 bth single family rental. The property has no debt and the cash-flow goes back into her IRA. She routinely takes distributions of the cash-flow to supplement her retirement income. Since this is a traditional IRA she is taxed on the distributions (as she would with any traditional IRA) but she is not reducing the actual investment value of the IRA as she only distributes the cash-flow. This client has had an increase in confidence as the rental income has proven to be consistent over time and she still knows that her IRA owns the property so she doesn’t feel like she’s depleting her retirement account when she takes distributions of the cash-flow. Frankly, I’ve talked to hundreds if not thousands of clients in a scenario similar to this.
- Real Estate Broker Loans Solo 401(k) Funds to Other Investors. This real estate broker uses his self-directed 401(k) to loan money to real estate investors buying investment properties. Some people refer to these loans as hard money loans or as trust deed loans. The 401(k) will loan funds to other real estate investors in situations where banks are typically un-willing to lend. The real estate broker lends to properties in markets that he knows and receives a first or second place deed of trust (mortgage) securing his loan. The typical loan terms are 10% annual interest with 2 points. This self-directed investor knows real estate and has been able to receive annual returns far in excess of the stock market.
III. HARD ASSETS OVER PAPER ASSETS
These investors value hard assets over paper assets. They are generally disillusioned by the stock market and feel that price to earnings ratios of publically traded companies have sky-rocketed without regard to company performance. They tend to believe that stock prices have nothing to do with actual value but instead are propped up by the Wall Street money machine. They’ve usually had retirement accounts for years and have seen their account go through the dot-com bubble and the financial crisis. They have little faith in paper assets and desire to move to a self-directed account at a time when they believe the market is going to collapse. Most of these investors will invest in precious metals or real estate.
- Retired Corporate 401(k). A retired corporate employee rolls over a portion of his prior employer’s 401(k) to a self-directed IRA and buys actual precious metals that are stored at a depository for his IRA. The precious metals are not an ETF or a fund but are actual physical gold bullion that meets the retirement plan rules for ownership by an IRA. Common precious metals would be gold or silver bullion as well as specifically approved American Eagle coins.
- Working Corporate Employee with Prior Employer 401(k). A 50 year old corporate employee uses her present employer retirement plan for standard mutual fund investments based on risk factors and tolerances for investors her age. Her current employer’s plan cannot be self-directed but she rolls over a prior employer’s 401(k) to a self-directed IRA and uses that self-directed IRA to invest in real estate investments with other like-minded investors. The investors use their self directed IRAs and each invest into the newly created IRA/LLC (and LLC owned by IRAs). The LLC then uses the combined funds to purchase a multi-family property. In the end, her IRA owns a 20% interest in an LLC that owns an apartment building.
There are many other characteristics of self-directed investors and there are even more examples of these groups. However, the three groups above seem to capture 90% of the growing self-directed retirement plan market. Additionally, many investors have cross over and identify in two or all three of these groups. Because self-directed IRAs and 401(k)s give investors options for greater control and because they provide for better access to investment opportunities, we will only continue to see growth in the self-directed retirement plan market.
By: Mat Sorensen, Attorney and best-selling Author of The Self Directed IRA Handbook