No one tells you that converting an Individual Retirement Account (IRA) into a Self-Directed IRA (SDIRA), to invest in real estate is easy, but it is! You just need to be careful to follow the rules and understand how money can flow in and out of the investment vehicle. Investors often use SDIRAs when they’re seeking to raise their returns and diversify their investment portfolio with real estate. Typically, brand name financial institutions don’t offer SDIRAs, they offer Self-Managed IRAs (SMIRAs), which are quite different, and the names are often used interchangeably, which is wrong.
The goal of this article is to define a SDIRA and show you how money can move in and out of it.
Self-Directed IRA Defined
A SDIRA is a type of IRA you can use to invest in alternative investments; it’s controlled by you, the investor, and it allows more freedom to choose where your money is invested. Investing with a SDIRA requires you to place your capital with a third-party custodian who is responsible for putting the capital where the investor wants it to go. Real estate is the most common asset class for SDIRAs, but other asset classes such as precious metals and speculative business ventures can be invested in as well.
SDIRA gets confused with SMIRA. SMIRA has limited investment options. Although, the investor may choose where they want their capital to be placed, they’re limited to traditional IRA categories such has stocks, bonds, mutual funds, etc.
Below you’ll see an infographic; its purpose is to help you visualize how a SDIRA works, and how the money flows within it.
Think of a SDIRA as a town. You’re the architect, you design it to be self-sustaining by initially funding it in exactly the way you want and elect a Mayor who oversees the town as the third-party custodian. Then you leave and let the town grow! There are a series of one-way roads, in and out of town:
One-Way Streets into Town
Rollover Avenue: This is a one-way street into town, where money can come in by rolling over an old 401K or other retirement account.
Income Deferral Boulevard: This street, like a 401k or IRA, allows personal income to flow one-way into the town, tax deferred.
Two-Way Street in and Out of Town
Income Property Circle: This road is the only two-way street. When you built the town, you initially funded it from Rollover Ave. With these funds, you can direct Mayor Custodian to purchase your desired real estate investment, like a share in a real estate syndication or a variety of other properties, which come back to town in the form of your newly purchased asset.
One-Way Streets Out of Town
Rental Income Road: This is my favorite road; rental income comes into the town one-way and stays! Tax deferred.
Rental Expense Way: It’s important to know, that since you’ve left the town, you cannot use any money outside it to directly pay for rental property expenses. In the event you have to add funds to the town, due to unexpected expenses, you have to use Income Property Rd (could you use income deferral boulevard?). Once Mayor Custodian has the cash, they’ll use Rental Expense Way, to pay the contractors or other relevant party.
Distribution Lane (Sometimes called Required Minimum Distribution Lane): Think of this road being under construction until you turn 59 ½.Once you do, you can start reaping the rewards of your