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Self Directed IRA Benefits: Tax Savings
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Self Directed IRA Benefits: Tax Savings – Video
John Hyre: Lot of material to cover. This is the part I enjoy the most, the IRAs. There’s nothing comparable in terms of saving your tax money. What are we going to talk about now? IRAs. Why do I love them? Because what we talked about earlier were a bunch of pinpoint deduction type things and they each have their use. I’d like to say, one of the older proverbs, “It’s not death by a thousand cuts, it’s death by a thousand pricks.” With the IRS, that’s an especially apt term, I would say.
It’s a lot of little details that make for lowering your taxes. If there’s such a thing as a silver bullet, it’s running things through self-directed IRA accounts. Now, first, when I say IRA, unless I mentioned otherwise, I really mean IRA, 401k, Health Savings Account, or Coverdell Education Savings Account. I’ll briefly describe the differences, but I don’t want to have to say over and over like a dole lawyer. “If you invest in your self-directed IRA, 401k, HSA, CESA–” I’ll just say IRA, but the rules are the same unless I say otherwise. There are some differences and I’ll highlight them, but the default rules that apply to the IRAs really apply to all for account types.
For example, can I buy rental properties inside a Coverdell Education Savings Account and use that to pay not just for college, but private K through 12 tuition tax-free? Yes, a Coverdell Education Savings Account is essentially a Roth IRA that instead of retirement, is used to pay educational costs. A lot of people don’t realize it can be used for K through 12.
Let’s go to the PowerPoint. This is going to be very quick. The basics, you’re probably familiar with. Traditional IRA, you make a contribution, the contribution is tax-free, in other words, you get a deduction, the growth is tax-free, and then the money comes out taxable. It is a tax-deferred account. You pay money on what comes out, you get a deduction on what goes in.
A Roth flips the equation. With a Roth, you don’t get a deduction for the contribution. The contribution is after-tax money. It grows tax-free and it comes out tax-free. The question becomes, would you rather pay tax on the acorn today or the oak tree in X number of years? For most of you, you want to pay the tax on the acorn, but it does depend.
For those of you in a very high bracket who have single digit return rates within the IRA, and I hope you do better than that, but if you have single digit return rates on the IRA and you’re contributing large amounts and you’re in a very high tax bracket, the net present value may actually favor a traditional arrangement.
Once again, if you have high income, you’re contributing a lot to one of these accounts. Not just the $5,000 or so a year you can put into an IRA, but let’s say closer to $50,000, $60,000, maybe $100,000 a year. If you’re contributing large amounts and you’re in a high bracket and your return rate inside the account is single digit, the net present value may favor a traditional account.
In most other cases, a Roth is the favorite way to do it. We do have to adjust for risk, but the government shall betray us. We’ll get into that. They will double cross us. Let’s talk about when and how, I think they’re going to do it, and how we anticipate it and what we do with it. Because if you know the enemy is coming, you can use their momentum against them. Judo, right? I love that. “I’m tired. I’m lazy. Could you punch at me?” “Okay. Whoops. Sorry. That must’ve hurt. By the way, that was your energy.”
What does a self-directed account do? Here’s the most important part, the part that you underestimate. Tax free growth. I’m going to demonstrate why the tax-free growth is more than you think it is. I want to give you an example of what tax-free means. Most of you know it’s good. Most of you don’t realize how good. It’s important that I give you a context, a value of just how much these accounts are worth so that you actually take action and stop fiddling about.
Furthermore, the action will require a certain amount of time, effort, energy, expense. I want to demonstrate to you that it’s worth it. If this is one rehab and retail property. I’m going to use these numbers. You put 100 in, you make 30 on your rehab and retail. You rehab the property, you sell it to a retail customer, you make 30 grand. That’s a totally realistic number. I have clients who do way better than that.
I’m not saying this is necessarily what you will or won’t do, it’s an example. They make 30 grand on their $100,000. Their tax rate is 35%, which if it includes social security tax, I’d be shocked if anyone in this room weren’t in that bracket. $10,500 in this case, tax on my $30,000 profit, that leaves me with $19,500.
We reinvest the whole amount in year two, so we buy a little bit nicer property, continue to reinvest it. Out here to the right, same thing except no tax. $100,000, we make our $30,000, we have $130,000. We go into year two with $130,000 instead of $119,500. Guys, this is raw mathematics. When you get the PowerPoint from me, you can go through it and tell me if you object. Its math. It’s not subjective.
Now, you can question, I guess the premise of, “Can I make 30% forever?” I know people who do it. In order to balance this out, I only went over 10 years. You want to have some fun? Take a look at the difference after 40, take a look at the difference after 120, because can we make your IRA live for 120 years? Can your IRA outlive you? It can and it should, especially if it’s a Roth. We’re going to talk about that.
I’m going modest. Did I put 120 years? No, just 10. At the end of 10 years on this model, taxable, you have $594,000. Tax-free, almost 1.4 mil. The amount paid in taxes, $265,000. Total lost growth, $518,000. That’s where they get you. All that money that went to the government no longer grows for you. That’s where they get you.
Total direct cost of thieving government, $785 grand over just 10 years. For those of you who are, “I don’t really want to think ahead 40 year”, 10 years. Tax-free is way better, especially if you don’t need the income. That’s my position. I make great money as a lawyer. I don’t want cash flow hitting my tax return from my rentals. That’s why I want to invest and do invest through a 401k in my case.
Next example, and I’ll be verily brief about it. One rehab and retail per year, seven years, then lend it 12% for 13 years. 12% isn’t even hard money, I know people who use their IRAs to lend at 5 points and 15% consistently and the loans turnover in about 3 months. Now, there’s a method to the madness of how to do it, but I have a lot of clients who do that. 12%, I thought was kind of modest.
At the end of 20 years, $923,000 versus 2.7 million. If that doesn’t get your attention, you’re wasting your time here. This is what we’re going to discuss over the next hour and a half. Amount paid in taxes, $443,000. Total loss growth, 1.3 million. Total direct cost of thieving government, 1.8 million.
Bearing in mind that over 20 years at a 10% return, that 1.8 you lost, by not investing in an IRA, or a 401k, or an HSA, 10% a year on that would be 181 grand a year. For most people, that’s enough for retirement on its own. This is real money. When I talk to you about the steps we have to go through, please keep in perspective the greater cause, for it is a large cause indeed.