4 Strategies to Produce Income in Your IRA
One of the biggest concerns when it comes to planning for retirement is ensuring that you will have enough income to support the type of lifestyle that you envision. Longer life expectancies, increased living costs and today's low interest rate environment make it tough to fund a prolonged, comfortable retirement period.
When planning for retirement, many investors focus on building large taxable investing accounts, while assuming they will also collect Social Security and withdrawal funds from their IRAs. But many investors are unaware of the unique ways that self-directed IRAs can be used to generate retirement income.
At PENSCO, where we custody assets for our clients' IRAs, we help investors hold real estate, private equity and other alternative assets in their IRAs. This gives account owners more choice and control over their tax-advantaged funds, and a way to broadly diversify beyond stocks and bonds. Alternative assets also tend to have low correlations to both equities and fixed income, making them a compelling diversifier in a portfolio.
There are a number of different ways that our clients position their self-directed IRAs to generate income during their retirement years. But keep in mind that penalties can occur for making withdrawals from a traditional or Roth IRA before the age of 59½. That means these income producing strategies are often developed with the intent of taking advantage of them once the IRA owner is older than 59½.
Here are four potential strategies for generating income in your self-directed IRA:
- Purchase a rental property in your IRA:
In this direct investing approach, an investor purchases a property in their IRA and then rents out the property, with the IRA receiving a rent check each month. Before turning 59½, investors can accumulate the rent in their IRA to boost their account balance. Starting after 59½, you can begin taking money out of your retirement accounts without penalty, although federal or state taxes may be due if you own a traditional IRA. That means that the cash balance in your IRA -- which has been growing by collecting rent checks -- can start to be distributed to you to support your retirement.
But remember to follow IRS rules to avoid penalties or losing the tax-advantaged status of your account. The property must be treated as an investment and cannot be used for personal reasons or the immediate benefit of you, your business or your family. Maintenance and repair must be handled by a third party, with expenses, like property taxes, being paid by funds in the IRA.
- Become a different kind of landlord:
Instead of buying a house with IRA funds, have you considered owning timberland, farmland or mineral rights? These assets can be thought of in a similar manner as owning a house in your IRA and collecting rent checks.
Let's take the example of owning working farmland in your IRA. The value of land will generally rise with an uptick in the economy, building your IRA balance. Another benefit to owning farmland in your IRA is the steady stream of income that could be paid to your account if a farmer pays rent to your IRA to use the land to grow crops.
In the case of timber, the land can be leased to harvest trees for paper or furniture. Tenant rent payments are then paid directly to the IRA. These payments can grow tax-deferred in the case of a traditional IRA or tax-free in the case of a Roth until the account owner starts taking withdrawals upon retirement.
Your IRA can also own mineral rights. You could lease those rights to a drilling company that has an interest in extracting minerals from the land, creating a flow of payments into your IRA. Or a company could pay your IRA royalties for minerals they find through their drilling activity.
- Become a mortgage holder:
Another way to create a real-estate related income stream in your self-directed IRA is with a mortgage-backed note. Following this strategy, your IRA essentially acts like a bank by loaning money to a borrower and, in return, your IRA receives a note and deed of trust to a property. This effectively puts a lien on the property in the name of your IRA for the amount of principal it is owed.
The borrower then pays back the principal and/or interest to the IRA each month until the loan is satisfied, creating income for the IRA. Once the loan is satisfied the IRA releases its lien on the property, giving the borrower clear title to the property (assuming no other liens exist against the property).
As with owning a rental property in your IRA, it's important you follow the rules if your IRA holds a mortgage note. Your IRA custodian will need to review the paperwork to ensure there are no prohibited transactions that could jeopardize your account. For example, an IRA cannot loan money via a mortgage to a disqualified party, such as a parent or child.
- Hold unsecured notes:
Depending on your appetite for risk, you could hold unsecured notes in your IRA. With an unsecured note or loan there is no posted collateral -- like a house -- that can be turned over to the IRA in the event of borrower default. But in return for that increased risk, these loans -- which include bridge loans, construction loans and personal loans -- command higher interest rates.
To see how an income stream would be produced, let's look at the example of a personal loan. Say your cousin wants to start a new tech venture, but needs $100,000 to get the business running. Your IRA could lend your cousin $100,000 by drafting a promissory note outlining terms of a loan. Let's say the note terms required your cousin to pay your IRA 8.5% interest over the 5-year life of the loan, and it was structured as an interest-only loan with a balloon payment at the end. This means your IRA would receive 60 interest payments of $708 each over the life of the loan, and your retirement account would receive a principal payment of $100,000 at the note's maturity.
When it comes to loans, you must be sure your IRA is not lending to any disqualified parties.
When considering which income strategy might make the most sense for you, it's always best to consult with a financial professional who can help you determine the best arrangements given your investment profile and goals.