Bad news for borrowers can be good news for lenders. After a very long dry spell, interest rates are starting to nose up out of the cellar. Which means it’s getting more profitable to lend money, as opposed to borrowing it.
At the same time, many folks have been looking at taking some profits in the real estate world, capitalizing on a broad housing recovery over the past several years. Essentially, this reflects a ‘risk-off’ strategy, including potentially de-leveraging retirement portfolios by converting them – wholly or partially – from net borrowers to net lenders.
Outlook for Private Lending in IRAs
The rising interest rate trend is likely to continue for some time. It took a while for interest rates to get as low as they did, and it will take time for them to move back up to healthier and more sustainable rates for net savers.
With that in mind, it’s time to take a look at the potential of using self-directed retirement accounts, such as IRAs, Roth IRAs, SEPs and solo 401(k)s to engage in Private Lending.
Advantages of self-directed IRAs and Private Lending
Normally, interest income is taxed at ordinary income rates. But by lending money from an IRA or other retirement account, you can defer any income taxes due on this interest income. All interest received goes back into your retirement account, where it can be reinvested, instead of going to the IRS and taken out of action, as far as you’re concerned.
The general tax rules concerning traditional versus Roth IRAs apply: Interest income in tradition IRAs as well as 401(k)s, SIMPLEs and SEPs is normally tax-deferred. Interest in Roth IRAs and designated Roth 401(k) accounts grows tax-free, subject to the same 5-year rule that applies to stocks, bonds and mutual funds within Roth accounts.
Penalties for Early Withdrawal
Further, you will have to pay a 10 percent excise tax on amounts you withdraw from an IRA or 401(k) prior to age 59 ½, unless you are over 55 and have left the work force, in which case you can begin taking penalty-free 401(k) distributions once you are older than 55.
A few rules concerning lending from within retirement accounts that most other lenders don’t think about: You can’t take a current tax write-off on bad debts. There was no current income tax due if they paid you, and there’s nothing to deduct against if someone defaults on a loan. Ultimately, you’ll just have less money available for eventual distributions in retirement than you would if the borrower(s) had not defaulted.
Furthermore, traditional IRAs, 401(k)s and SEPs have required minimum distributions (RMDs). You must begin taking income out of these accounts by April 1 of the year after the year in which you turn age 70½.
That means you can’t have your entire portfolio lent out when the deadline comes! If you don’t make your RMDs as required, the IRS can and almost always will levy a 50 percent penalty on any amounts you should have taken as RMDs and didn’t. Ouch.
It’s always tempting to lend to oneself or to family members. That’s not allowed in IRA accounts, though. Here are the rules:
- Disqualified persons include the IRA owner’s fiduciary and members of his or her family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
- The following are examples of prohibited transactions with a traditional IRA.
- Borrowing money from it
- Selling property to it
- Receiving unreasonable compensation for managing it
- Using it as security for a loan
- Buying property for personal use (present or future) with IRA funds
To open an account with American IRA, or simply to learn more about the flexibility and benefits of self-directed IRA accounts, including real estate IRAs and IRA partnerships, call us today at 866-7500-IRA(472).