An increasingly popular way for individuals to invest in real estate is by leveraging their retirement accounts to do so. Many people will convert their traditional or Roth IRA to a “self-directed IRA” or SDIRA. This allows them to invest their principal contributions in an array of alternative asset classes.
Using an SDIRA, investors can diversify beyond traditional stocks and bonds. They can also invest in real estate funds or syndications, hedge funds, private equity investments, cryptocurrency, precious metals, and more.
This specific approach requires someone to have significant funds in a traditional or Roth IRA to convert to an SDIRA. Those who have a 401k or other retirement accounts through their employer are ineligible for contributing to a traditional IRA.
Those who have a modified adjusted gross income over $140,000 (or $208,000 if married and filing jointly) are unable to contribute to a Roth IRA.
The vast majority of real estate investors either a) have an employer-sponsored retirement account or b) earn too much to contribute to a Roth IRA.
Using an SDIRA, investors can
diversify beyond traditional stocks and bonds.
Yet, many investors still use a Roth IRA to invest in real estate. But how? It’s through what’s known as a “Backdoor” Roth IRA. This is something Congress has recently proposed eliminating as part of the “Build Back Better” legislation.
What is a “Backdoor” Roth IRA?
A “Backdoor” Roth IRA is not an actual account type. It is a process that investors use to otherwise skirt IRS limitations on investing in a Roth IRA.
To use a Backdoor Roth IRA, an investor must either:
- Contribute and then convert money in a traditional IRA into a Roth IRA; or
- Roll a 401k plan over to a Roth IRA (which only some companies allow).
Investments in both a traditional IRA and 401k help to lower an investors’ taxable income in the year those contributions were made. Since these are pre-taxed dollars being invested. Once the funds are converted to a Roth IRA, the funds (both initial contributions and any subsequent earnings) will be taxed at that time.
Once the funds are converted to a Roth IRA, those funds will begin to grow income-tax-free.
In some cases, high-income earners are precluded from making deductible contributions to a traditional IRA. However, they can continue to make nondeductible contributions, in which they invest using after-tax dollars.
To avoid future taxation, many high-net-worth individuals will make non-deductible contributions to a traditional IRA. Then immediately convert that account to a Backdoor Roth IRA.
This limits the amount of time the funds have to grow. In cases where there are no earnings on the contribution, the funds being rolled over will avoid being taxed when converted using the Backdoor Roth IRA process. This is something that can result in major tax savings for investors.
How to Use Backdoor Roth IRA to Invest in Real Estate
Once other retirement accounts have been converted to a Roth IRA. An investor who wants to leverage their Roth IRA to invest in real estate essentially has two options.
The first option is to convert the Roth IRA to a self-directed IRA, or SDIRA. Doing so gives the investors more control over how investments can be made. Using an SDIRA, individuals can elect to invest in a range of alternative investments. Including but not limited to real estate.
Many people will use an SDIRA to invest in a real estate syndication or fund. This allows them to be hands-off, passive investors. More conservative investors may decide to invest a portion of their SDIRA into real estate investment trusts (REITs) as well as directly into real estate deals.
With a standard Roth IRA, individuals can
withdraw their principal contributions
at any point tax- and penalty-free
A second, less frequently used option is to withdraw funds from a Roth IRA to invest in real estate directly. However, this approach has many limitations when using a Backdoor Roth IRA vs. a standard Roth IRA. With a standard Roth IRA, individuals can withdraw their principal contributions at any point tax- and penalty-free (earnings must remain in the account until a person hits a certain age, otherwise those will be heavily taxed).
With a Backdoor Roth IRA, the funds converted from a traditional IRA, 401k or similar plan are considered “converted funds,” not contributions. Therefore, they must be held in the Roth IRA for at least five years before they can be withdrawn penalty-free.
For investors with a long-term mindset, this second option might be viable. However, most investors will generally use the Backdoor Roth IRA process to transfer funds into an SDIRA that can be reinvested into alternative assets accordingly (and sooner than the latter option allows).
The Benefits of Investing in Real Estate Using a Backdoor Roth IRA
There are many benefits associated with using a Backdoor Roth IRA to invest in real estate. These benefits include:
More Income to Invest
Those who are eligible to invest in a standard Roth IRA are limited to how much they can invest each year. For both 2021 and 2022, individuals can only contribute up to $6,000 per year (or $7,000 if aged 50 or older). The contribution limits to a traditional 401k and other retirement plans are significantly higher.
For example, someone who is self-employed might be contributing to a Solo 401k plan, which allowed individuals to contribute up to $58,000 per year in 2021 (and will increase to $61,000 in 2022, with an additional $6,500 “catch-up” contribution for those aged 50 or older).
No Income Limits
Unlike a standard Roth IRA, which prohibits people earning above a certain amount from investing, there are no income limits when investing in a Backdoor Roth IRA. This makes the Backdoor Roth IRA a great option for high-income earners.
Income Earned Tax-Free
Because the funds converted to a Backdoor Roth IRA have already been taxed by the IRS, any earnings will grow at a tax-free rate. When an investor eventually decides to take distributions, these distributions will be made tax-free as well.
No Required Minimum Distribution
Unlike other retirement plans, Roth IRAs do not have required minimum distributions once a person reaches a certain age. Therefore, someone can continue to grow their tax-deferred retirement savings for as long as they’d like without being forced to make mandatory withdrawals.
For these reasons, those who want to invest in real estate will find using a Backdoor Roth IRA very appealing. They will have more money available to invest than if they were investing through a standard IRA, any proceeds from the real estate transaction will grow at a tax-free rate, and investors—regardless of how much money they earn each year—can use this process to invest in real estate.
Moreover, an often overlooked benefit is that using a Backdoor Roth IRA to invest in real estate, through an SDIRA or otherwise, is an excellent way for high-net-worth individuals to diversify their retirement accounts.
Those who invest in traditional retirement accounts, be it a 401k or otherwise, are usually limited to what types of investments they can make (usually centered around stocks and bonds). Using a Backdoor Roth IRA, people will have the opportunity to invest a greater share of their retirement savings into alternative assets like real estate.
The Proposed Elimination of Backdoor Roth IRAs
In November, the U.S. House of Representatives passed a version of President Biden’s “Build Back Better” bill that would eliminate Backdoor Roth IRA conversions. According to the House-passed bill, all taxpayers would be prohibited from converting their after-tax contributions using this “backdoor” process.
This proposed change is part of a larger effort to curtail what are perceived to be tax-avoidance strategies for the wealthy. For example, an investigative report found that Paypal founder Peter Theil reportedly has a Roth IRA valued at more than $5 billion – something that would be nearly impossible to achieve without using this “backdoor” strategy.
What’s more, the Build Back Better legislation contemplates adding more stringent requirements for those who have more than $10 million or more across any defined contribution retirement account, such as IRAs and 401ks. These requirements pertain to withdrawals. Any single tax filer earning more than $400,000 per year would be required to withdraw 50% of any amount above the $10 million threshold.
The Build Back Better legislation is now with the U.S. Senate for consideration. The Senate is anticipated to take action, one way or another, by year-end. Whether the Backdoor Roth IRA survives past the Senate remains to be seen.
Those who have funds in a
traditional IRA, 401k or other retirement account have a narrow window left
to convert to a Roth IRA before year-end.
Those who have funds in a traditional IRA, 401k or other retirement account have a narrow window left to convert to a Roth IRA before year-end. Those who do so now will be best positioned to take advantage of the Backdoor Roth IRA before it is potentially eliminated by Congress.
As always, investors will want to consult with their retirement or tax advisor before making any dramatic changes to their investment plans. However, those who elect to convert funds now into a Roth IRA will be well-positioned to invest in real estate through an SDIRA in the months and years to come.
Contact us today to learn how you can leverage your retirement accounts to invest in institutional-quality real estate assets through the Smartland platform.