Obama is going to take my IRA! The sky is falling!

I heard this from several people who stopped by our booth last weekend in Chicago at the coin/gold convention.  This is the follow up to “the government is going to take all my gold if I don’t store it under my bed”.  As an IRA administrator I am interested in anything that affects IRA law but, really, only when it becomes law.  I perused the internet and came upon a number of histrionic articles that talked about the government taking our retirement plans and at least one used the example of the country of Cypress.  As in “if it can happen to the Cypriots it can happen to us”.  I have not yet found the connection between Cypress and US policy that allows this claim.  Some of the confusion is that what is currently in the works does NOT involve actually "taking" money away from the IRA or individual.  What is proposed is removing the tax deferred status on some IRA money thus forcing the individual to take a taxable distribution. Besides this, I also found theses additional items of interest (note: if you have less than /$3.4 million in your retirement account(s) skip items 1 through 4 and jump to item 5):

1. This is still in the negotiation stage and is not yet a law.
2. If you have $3.4 million in your IRA/401k you would be affected.
3. If you are fortunate enough to have $3.4 million in your account, you would:

• not be allowed to make further contributions to the account
• have to distribute that amount necessary to bring it to the $3.4 million level (to yourself, not the US government) and,  
• have to pay taxes on the amount distributed.

4. The $3.4 million threshold would change annually in proportion to the cost of annuities
5. If you have less than the $3.4 million threshold you can be affected by:

• Company 401k plans could be disbanded if the Plan can no longer shelter the retirement savings of the more successful retirement investors.  
• As a sub “$3.4” individual you may end up in an individual retirement plan with smaller contribution limits.

6. The current 3.4 cap would affect only 0.1% of those 60 or over.
7. On the bright side, one proposal would exempt IRA accounts worth less than $75K from the required minimum distribution at 70 ½ which is currently in place.  This is a good thing.

Why IRAs and retirement plans?  Why not your personal non-sheltered savings?

The reason is taxes.  You have not yet paid taxes on your Traditional IRA and Traditional 401k money and won’t be taxed you take the money out.  If anything illustrates the value of tax advantaged plans like IRAs and 401ks it’s this: the IRS is willing to allow special tax treatment on these accounts so that earnings inside the accounts can grow, untaxed, until withdrawn; but in the future they not be willing to allow this non-taxed money to stay in unlimited balances, untaxed for years.

At New Direction IRA we have very very few accounts that would be affected by the proposed law, if it actually becomes a law.  I don’t think very many people realize and utilize the power of a tax sheltered account yet.  I can only hope that this latest proposal to limit IRAs, will make people realize how precious and powerful the IRA (and 401k) can be.  Especially the money is self-directed into investments that the IRA holder understands.

Can I Live in a Property Owned by my IRA?

You have seen this on the Internet and wonder – is it possible to use your IRA to purchase real estate that you can actually live in?  We get this question all the time at New Direction IRA.  The answer to that question is NOT a simple “yes.”  There are many ways to buy real estate with your IRA, here are two of them:

#1    Purchasing as personal property but paid for with your account
The advertising that states you can buy real estate with your IRA and live in it is not actually referring to the purchase of real estate within the IRA.  What it is talking about is a little known rule for IRAs whereby you can take distributions from your Plan before reaching the age of 59 ½ years without penalty.  This type of transaction is called a “72(t) distribution.”

In IRS Publication 590, included in the list of allowed distributions without penalty, is one in which you establish an agreement with the IRS for you to take equal payments from your IRA account.  The IRS states:

Annuity: You can receive distributions from your traditional IRA that are part of a series of substantially equal payments over your life (or your life expectancy), or over the lives (or the joint life expediencies)  of you and your beneficiary, without having to pay the 10% additional tax, even if you receive such distributions before you are age 59 ½  You must use an IRS-approved distribution method and you must take at least one distribution annually for this exception to apply.

The payments under this exception must generally continue until at least 5 years after the date of the first payment, or until you reach age 59 ½  whichever is later. If a change from an approved distribution method is made before the end of the appropriate period, any payments you receive before you reach age 59 ½ will be subject to the 10% additional tax.

Those who sell annuities market primarily the 72(t) distribution concept.   The IRA is actually investing in an annuity that guarantees a series of payments, which are taken as distributions.  This is how it is used for real estate purchases:

• Sellers of annuity contracts will have the individual transfer their IRA into an IRA account, which in turn will purchase an annuity contract that guarantees a fixed payment in order to meet the required payment agreed to with the IRS
• The individual will find a piece of real estate and buy it using a mortgage guaranteed by their personal assets, with payments from the annuity used to pay the mortgage on the property.

How is this different from real estate held in your IRA?  The substantial differences are:

1. You must have enough wealth to guarantee the mortgage on the property to begin with.  
2. This is not an IRA investment.  The real estate is outside of your IRA.  Sale of the property, unless it is your primary residence, will follow all the rules of any investment sale.
3. The IRA is being liquidated to make the distribution payment.  You may not put those funds back into the IRA after taking them out.
4. There is generally little flexibility on the rate of return or how you invest the IRA after the annuity is purchased and the 72(t) distribution election is made.
5. You will be taxed on the distributions at your current tax rate rather than at your tax rate at retirement.
6. You have a mortgage on your credit rating as well as the need to come up with a down payment.

#2   Purchasing real estate as an investment within your self-directed account
Using a “Self-Directed” custodian, you may, if you choose, buy and sell real estate within your IRA. The proceeds of each sale go back into your account, tax-free, to be used for the next purchase.  There is no time limit on how long real estate is held, nor is there any requirement for “like kind” purchases with the proceeds as there is in a Section 1031 Exchange.  Taxes occur when you take distributions from the IRA at age 59 ½ or later, at which time they are taxed at your income tax rate at that time.  With this type of investment, however, there is a requirement that this be an investment and that the IRA owner cannot use it personally while it is still in the IRA.

Which method or real estate purchase is right for you?
If your intent is to use your IRA now for the purchase of, most likely, a second home to use now, the 72(t) option could be for you.  If your attraction to real estate is for building wealth within a tax-deferred account by buying and selling for a profit and growing your IRA, then a 72(t) is probably not what you want.  The tax-deferred status of IRAs is specifically designed for the purpose of tax-free growth.  You lose this status when the real estate is purchased outside the IRA and funded with taxable distributions from an annuity.

Are there other options available?
Must you purchase an annuity contract in order to take a 72(t) distribution?  The answer is no.  It is possible to do a 72(t) distribution from any IRA, regardless of the assets held.  For ease of distribution, the investments in the IRA should have sufficient liquidity available to make the mandatory distributions.  You need only to be able, or to have an adviser able, to make the calculation of the required annual distribution amount.   It is a relatively simple calculation, and most tax advisers can advise you.  Your self-directed custodian can hold any investment of your choosing for the purposes of the 72(t) distribution.  Purchasing mortgages, income property, or any cash-producing asset can be used.  Consider that the purchase of an appreciating asset that also produces cash flow sufficient for your distributions may allow the account to grow for your future retirement needs while still funding the 72(t) distribution.   Making your investments inside a self-directed account allows you to keep maximum flexibility rather than locking you into the purchase of annuity contract..  As an example, consider the following for your IRA:

1. Purchase a condo for cash within your IRA for $150,000
2. Your IRA rents the condo for $800 per month, which nets $700 per month cash flow into the IRA.
3. You determine that the required monthly distribution for a 72(t) will involve taking $700 per month from your IRA account.
4. You use the $700 to make payments on your “second home” mortgage.
5. The condo appreciates at a rate of 5% per year, making your IRA worth $190,000 in five years even while paying out the required distributions.
6. Your IRA is going up in value because it contains real estate.
7. You have your second home to use now.

Conclusion
Choosing the right option is important when one of the choices is electing a 72(t) distribution which involves a commitment to the IRS to take mandatory distributions.  Seek input from your tax and financial advisers before embarking on investments either inside or outside of your IRA in order to quantify the tax consequences of the various options.  For information on self-directed IRAs and the IRS rules applicable to those types of investments contact your local self-directed IRA administrator.