Take advantage of this unfair tax break being offered now to the self employed.

Prohibited transactions is a chief topic when exploring self-directed IRA & Solo 401(k) investing. When a person first discovers that his retirement accounts have been chained to Wall Street brokerages without necessity, his mind starts to imagine the possibilities.

Real Estate? Yes.
Private Businesses? Sure.
Precious Metals? Absolutely.
Getting my hands on my retirement money now? Slow down there.

There are two types of limitations on the average retirement account. One is an unnecessary restriction of investment options to securities products. That can be eliminated through restructuring your accounts and funds. The second limitation is legal and cannot be removed.

Setting up a self-directed IRA or 401(k) is about removing limitations. Once you have it setup outside the nearly monopolistic network of securities dealers, you can invest in almost anything… but you must fully understand the legal limitations.

The general premise behind prohibited transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make “losing investments” that actually put their retirement funds into their own hands.

For example, imagine you grow your IRA to $1 million and now you’re ready to get that money into your own hands so you can spend it. You could distribute it to yourself and pay ordinary income taxes on the distributions. Or you could invest it into your business that you personally own and operate. The latter could be an “investment” from the IRA. Once the money is in your business you could do whatever you want with it. And maybe your business doesn’t pay anything back to your IRA. Maybe it was a “losing investment” for your IRA. Taxes avoided. Woo hoo!

The only problem with the above scenario is that the real loser isn’t your IRA–it’s the government who didn’t collect distribution taxes because your IRA “lost” all its money. For this reason, the prohibited transaction rules make the above scenario illegal. The government made the PT rules to ensure that you don’t end up “losing” your retirement money. There are six PT rules. Four of the rules are commonly quoted, written about, and understood easily. The remaining two rules seem to elude or mystify most people, so let me bring clarity to the matter.

In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives. Let’s go ahead and knock out the most common strategies that are wrongly believed to successfully “get around” the rules:

Benefit Swapping

Joe & Frank are friends and each of them setup a self-directed IRA. Joe’s IRA loans $50,000 to Frank and Frank’s IRA loans $50,000 to Joe. This doesn’t break the 4 rules that are most focused on, but it does break the usually-ignored rules. For each loan transaction the borrower is not a “disqualified person” for the IRA to transact with, but the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction.

Another example would be if Joe’s IRA and Frank’s IRA each bought a vacation condo, and each IRA let the other person stay in the condo. Real estate is a popular investment for self-directed IRAs, but if an IRA owns real estate its owner (and his relatives) are not allowed to make personal use of the property, regardless of whether fair market rent is paid. If Joe vacationed in property owned by Frank’s IRA and Frank vacationed in property owned by Joe’s IRA, it would be a prohibited transaction. Just like the loan swapping, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit as a result of the transaction. This applies to direct benefis and indirect benefits that come about as an expected chain of events.

Strawperson

Joe wants to sell his house, but he can’t find a buyer. His IRA has enough money in it to buy the house from Joe, but that would be a prohibited transaction because Joe is a disqualified person. So Joe arranges for his friend Frank to buy the house from him who will later sell the house to Joe’s IRA. Joe thinks he didn’t break any rules because Frank is not related to Joe and thus is not a disqualified person. In this scenario, in the eyes of the law Frank is a “strawperson”… a person who is not involved in the transaction for genuine reasons. Frank doesn’t really want to buy and then own Joe’s house. He is just entering into the transaction to add separation to the real transaction. The law removes the strawperson to examine the real transacting parties. In this case the real parties are Joe and his IRA. Effectively, Joe sold his house to his IRA. That is a prohibited transaction and it remains a prohibited transaction even with Frank the strawperson inserted into the chain of transactions.

The same strawperson strategy fails the test no matter how it is constructed. If Joe’s IRA loaned money to Frank and Frank subsequently loaned money to Joe, it would violate the PT rules.

The lesson

Setting up a self-directed IRA or Solo 401(k) brings your retirement funds to an unlimited investment platform in the sense that you can invest in virtually any type of asset. You will save yourself a lot of time and headache (and possibly tons of money) if you clearly understand the remaining limitation: you must invest solely to grow your retirement account without engaging in conflicts of interest.

Now that’s not so bad is it? The merits of whether the income tax is good for our country in the first place is a topic for another discussion. But within our current system, it’s not so much to ask that you avoid all conflicts of interest. Use your retirement account for its intended purpose–to grow massive wealth. There is a whole world of opportunities out there that don’t involve a potential conflict of interest!

Mature investors close to retirement age are likely kicking themselves wishing they had pulled their money out of the market while they had the chance.

But too often these investors were told to “stay the course” and that “the market will come back.”  Truth be told, no one knows for sure what the market will do.

But we do know is that you still have time to recover your losses – as long as you don’t just sit back and “hope” the stock market will recover.  You have to do something about it.

Real estate can be a wonderful option for someone nearing retirement. With depressed housing prices, you may be able to find a home that offers positive cash-flow so that it provides a healthy monthly income.  When the market recovers, you can consider selling the property only if the numbers add up and you will benefit from appreciation.  If not, you can continue to cash-flow the property and create income for yourself for a long time.

So the point is that you’re never too old to consider alternative investments. A diversified investor is a smart investor at any age.

This is my favorite excerpt taken from the interview between Steve Kroft of 60 Minutes and Brooks Hamilton, who Kroft interviewed in his expose on 401(k)s.  Hamilton is an expert in designing retirement plans for large corporations.

“The fact is that the typical 401(k) investor is a financial novice. They don’t know a stock from a bond. And we give ‘em a list of 20 or 30 mutual funds with really, really powerful names, you know, they sound like, ‘Gee, that’s where I want to have my money,’” Hamilton said.

“What are the, generally, the quality of the mutual funds in 401(k) plans?” Kroft asked.

“Mediocre,” Hamilton replied. “I’m being real honest with you, with half the funds on the list really dogs, what people would characterize as dogs shouldn’t be on the list to start with.”

So many Americans believed that the 401(k) would be the sure-fire way to safely save for retirement.  In fact, it has been reported that 401(k) plans that have become the primary source of retirement income for 60 million Americans. Companies would match our contributions making it irresistible to sock away money in these mutual funds.  But the truth is, as exposed by 60 Minutes a few weeks ago, that companies turned to 401(k)s as a cheap alternative to offering costly pension plans.  This decision created millions of new employee investors in Wall Street – creating a boom on Wall Street and putting trillions of dollars of investable cash into the hands of unsophisticated investors.

In the 60 Minutes piece, however, experts in the field say that Wall Street more than cashed-in on this phenomenon by offering employees what is categorized as “dog” mutual funds that shouldn’t have been offered in the first place.

So now that Americans know the flaws in the 401(k) system, how can they go about breaking their 401(k) addictions?

Here are some ideas:

Look Elsewhere: Look for alternative places for your money. With most companies are backing away from offering company matches (which incentivized people to sock away even more money in their 401(k)s), it has never been a better time to seek alternative advice and alternative strategies.

Read and Learn: Just by reading a few good books on the topic of investing outside of Wall Street, you can learn so much. Jeff Nabers is coming out with his first book to address this topic called, “Unlimited Investing:  Break-Free from Wall Street to Build Real Wealth with Alternative Investments,” (I know this is a little self-promotional, but this book is amazing!)

Explore Outside Investment Vehicles: While companies make it convenient to save for retirement through direct deposit of savings into a 401(k) account, an investor can easily set up an automatic bill pay to make regular contributions to another savings vehicle that gives them more options.  If you want to continue to invest in securities, look into other IRA options where you have more control over the funds you can invest in.

Bonus for the Self-Employed: If you have any sort of self-employment income (which many of us do from side jobs), you are eligible to set up a Self-Directed Solo 401(k), which allows you to invest your retirement funds in real estate, gold, private companies and without taking a distribution.  Plus, all the income made on these alternative assets is tax-deferred too.  Imagine having your retirement money free to invest outside of Wall Street – it’ll make you wonder why you were restricted to investing in only securities in the first place.

Ask Your Friends: Chances are you have some friends who are doing well. Ask them their secret and how they’re doing it.  In the book, “Rich Dad Poor Dad,” the author Robert Kiyosaki says that friends of the rich only ask for a loan or a job – but no one ventures to ask how that person got rich in the first place.  You may find your friends are willing to share their investment strategies with you if you took an interest in learning.

I hope these tips helps you on your journey to break your addiction from your company’s 401(k) and take control of your finances.