During a recent speaking engagement in front of a large REIA in a Midwestern state, I asked the audience how many of them had set up a self-directed retirement account. Approximately 85% of the room raised their hands. After the presentation, I discussed the fact with a friend of mine who has been doing self-directed investing since the late 1970s. He made the comment that when that questions was asked just ten years ago, only five to ten hands would be raised in a room of over a hundred people. Clearly the awareness of self-directed investing is growing.
With that in mind I would like to share with you over the course of two articles what I consider to be the top ten recommendations for self-directed retirement account investors.
- If you do not understand the deal, do not do it!
This is one of the fundamental rules in all types of investing, whether inside or outside a retirement account. Understanding the deal means more than just being able to say you understand it. It means being able to explain it in a way that makes the complex sound simple. You should be able to explain the deal to an 8-year-old child. When a person is able to explain something complex in a way that even an 8-year-old child can understand, then you know they truly understand what they are doing. I have seen too many investors who made investments with a self-directed retirement account and later regretted it because the person with whom they invested or to whom they lent money was far more sophisticated than they were, and they felt like they had been taken advantage of. Ask me how I know!
Allow me to give you an example of a simple explanation. I am going to loan $50,000 from my retirement account to Fred. Fred is going to use that money and other money to buy a house, fix it up, and resell it. My loan to Fred will be secured by a mortgage against the house he is buying and fixing. There, in three simple sentences you can explain a deal that many people could take paragraphs to cover.
- Always fund your accounts every year.
Many real estate investors are struggling with ongoing monthly cash-flow needs, and they forget to discipline themselves to set up an automatic or systematic program for funding their retirement accounts, whether they are Roth IRAs, 401(k)s, HSAs or CESAs. Pick the two or three accounts that really matter to you and determine what your monthly budget needs to have to be in order to be able to put approximately $6,000 per year into those accounts. At a minimum, you should be funding approximately $6,000 into your IRA< your spouse’s IRA, and your HAS. If you do not fund your accounts, you will have very little to work with for investing purposes. The discipline of consistently funding your accounts creates the “seed” you will plant it.
- Know the things in which you cannot invest.
The list of things in which you cannot invest with a self-directed retirement account is very simple: collectibles, shares of sub-S corporations, and life insurance contracts. Once you understand what you cannot invest in, it means everything else is possible. The same theory also applies to the next rule.
- Know the prohibited transaction rules, or hire someone who does.
We all think we understand the rules; but when we are in a hurry and get into a deal with a lot of moving parts, we often don’t take the time to analyze the transaction in light of all the prohibited transaction rules, particularly rules regarding not providing a service to your account, as well as direct and indirect benefit rules. Many retirement account investors are unable to distinguish between what they believe is a service and/ or managing their investment, let alone explain whether they are using their retirement account in a way that either directly or indirectly benefits them now or in the near future.
It is prudent to at do at least an annual review of the rules regarding prohibited transactions and disqualified persons so you can keep current as to what you can do with your self-directed retirement account investments. There are many good resources from custodians, administrators and trustees, lawyers, and even some reasonably-priced books on the internet. These will give you a basic understanding of most of the rules for prohibited transactions and investments, and disqualified persons. If you are a fact junkie like I am, or if you suffer from chronic insomnia, you may want to take the time to carefully read26 U.S.C. 4975, as well as the Plan Asset Rules promulgated by the Department of Labor.
- Remember that it is a retirement account, and you need to treat it as such by doing longer-term, cash-flow-producing deals.
Many times an investor gets trapped in what I call “yield disease.” They are looking for a high rate of return and are willing to do short-term deals (such as hard money lending) in order to achieve those rates of return. While 3 points and 15% might sound impressive for a 6-month period of time, that deal pales in comparison to an investment that may last for four years consistently earning a 12% rate of return. Since the goal is to amass a good-sized retirement account, you need to work toward that goal. My suggestion is that you do it by focusing on longer-term deals. Consistency is important, because slow and steady wins the race.
Another benefit of doing longer term deals is that it is much easier to do the necessary due diligence and underwriting for one longer-term deal that for a series of shorter-term deals. There are fewer demands on your time and fewer opportunities to make mistakes.
The remaining five recommendations for self-directed retirement accountholders will be available in next month’s publication. Read Here
This was originally published in the RE Journal from National REIA Fall Issue 2015.