John
Schaub’s
Strategies and
Solutions
Our 26th year of providing quality information
to investors in single family homes and notes
Written for students of Making It Big On Little Deals
_____________________________________________________________________________________
#2103 March/April
ROTH
IRAs – YOUR MOST POWERFUL INVESTMENT TOOL
A
Roth IRA can help you as a real estate investor avoid taxes on much of your
profit. Understanding how to invest your Roth funds is a critical step in this
strategy. Encourage all of your friends and family members to open a Roth IRA. Copy this letter and give it to
your friends and relatives. It is that important!
Successful
real estate investors are used to tax sheltered income. A typical house bought
with leverage will produce tax-free cash flow for years, until you pay off the
debt and run out of depreciation. These
two events often occur about the same time, leaving you with income that is
taxable at rates up to 40%. $10,000 a month in rental income can be
reduced to $6000 by federal taxes. State and local taxes can add to your pain.
A
Roth IRA can produce tax-free income. It is tax free because the contributions that you make are not tax
deductible. You contribute with
after-tax dollars. Some underestimate the potential of a Roth IRA to which you
can contribute only $2000 (not including rollover contributions) a year. (This
amount may increase to $5000 per year this year.) If you simply invest this money in a bank account at 5%, you
can still accumulate more wealth than 90% of Americans have today.
As
a real estate investor, you are accustomed to making returns of 40% - 50% and
more on your invested capital. Remember my student Bob Allen’s book Nothing Down? When you buy
a house with high leverage, what is your rate of return?
You
can use your knowledge of how to make high returns and apply them to investing
your Roth funds. If you are 40 years old and begin making $2000 annual
contributions to your Roth, by the time you are 70 you will accumulate more than
$328,000 at just a 10% return. Throw in a couple of really good deals early and
you could have many times that amount.
I will show you how to invest your Roth funds wisely,
and strategies you can use to build your Roth up to $1,000,000 or more. Once you
have $1,000,000 in your Roth, you can conservatively take out 10% a year or
$100,000 for the rest of your life, tax-free. The Roth is a tool every investor
should use. Here are some reasons why:
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NO TAX NOW OR ON DEATH
All
the profits you earn on your Roth IRA and all distributions are tax-free. The
tax-free element is significant. If you started with $2000, and doubled it every
year you would have $1,012,000 in 9 years.
If you paid taxes on the profits as you made them, you would have less than half
as much money at the end of nine years.
The
big difference between a Roth and a traditional IRA or qualified retirement plan
is that the
Roth can distribute all profits tax-free. The profits and original
contributions of traditional retirement plans are taxable. If you already have a
traditional plan, keep it. You can use it with the Roth to develop your
retirement income.
At your death, this is significant. An estate of a
single individual would owe both income and estate taxes on the balance of funds
in a traditional retirement plan. Married people can make their spouse the
beneficiary and avoid this double tax.
You
can move your retirement funds from a regular IRA to a Roth, but you would owe
taxes on the amount transferred. You can move part
of your funds. If
you ever have a year where you will pay little or no taxes, move some funds over
and pay a low tax.
Once you qualify you can begin making tax free
distributions. First, you must meet two criteria: You must reach 59.5 years of
age and have had the Roth for five years. Let’s say you know how to make a
conservative return of 12% on first mortgage investments. How much would you
need in your Roth IRA to produce the income you now live on?
These
figures do not include the return of your principal. For example, your Roth with
$500,000 in assets earning 12% could pay you $5505 a month for 20 years. If you earned more than the 12%, you would have money left
over.
ORIGINAL CONTRIBUTIONS CAN BE WITHDRAWN AT ANY TIME
Think
of your Roth IRA like a savings account that is tax-free. If all you ever did
was deposit the allowable amount into a Roth interest bearing bank account, the
interest you earn would be tax-free. You can take your principal out at any time
without penalty.
NO REQUIREMENT TO TAKE
MONEY OUT
Another major advantage of the Roth is the
flexibility to take money out only when you need it. Unlike most retirement
plans that have mandatory, taxable distributions, the Roth distributions can be
taken when you need them.
If
you have another retirement plan that requires you to take distributions, you may want to take those taxable distributions when
you have operating losses from your real estate. Those losses could be used to
offset your taxable income.
CREDITOR PROOF
Your
state law will determine if creditors can get to the assets in your Roth IRA.
Florida and many other states have enacted laws, which protect the assets in
your Roth IRA from claims of creditors. Once you have considerable assets in
your Roth, you will be in a much better negotiating position should you ever be
sued.
Although
the assets in your Roth may be protected from claims against you, you need to
make sure that the assets inside your Roth do not invite lawsuits because of
their nature. If you own real estate in your Roth, and someone falls off the
roof of that real estate, the owner (your Roth IRA) may have some liability. The
claimants would be after the property that was involved in the incident. For
this reason, I prefer not to own property or any investment that may attract
lawsuits in my Roth.
If
I was going to invest in anything with higher risk in a Roth, I would start a
separate Roth for just that investment. I would not mix safe investments with
high-risk investments.
NO AGE LIMITATIONS
Many
traditional retirement plans have age limitations on making contributions. The
Roth has none. Your two-year-old can open a Roth as can your ninety-year-old
grandmother. Although the two-year-old would have to wait a while before they
took profits out tax free, they could withdraw their contributions at any time
without penalty.
EARNED INCOME REQUIREMENT
You
must have earned
income in order to qualify for a Roth. If you want to contribute $2,000, then
you must earn $2,000. This cannot be investment income. However, if your
teenager has earned and spent their $2000, you could gift them another $2000 to
deposit to their Roth. Your twelve year old may earn money babysitting or being
a computer consultant. Your teenagers could help clean and paint houses and earn
their $2000.
Even
a two-year-old can earn $2,000 by posing for a picture that might be used in an
advertisement. The $2000 would be deductible to the entity that paid the two
year old to pose. If that was the only money the two year old earned, the taxes
would be nominal. Of course the two year old would have to have a social
security number.
TOO MUCH INCOME
Some
people have too much income to qualify. The maximum adjusted gross income limits
today are $110,000 for a single person and $160,000 for a married person filing
jointly. If you have too much
income to qualify, I suggest that you try to arrange you life to have one lower
income year when you can qualify. You can defer the sale of a property, increase
your rental expenses by doing preventiative maintenance, or if you normally earn
a big salary, you might ask your employer if they would mind paying part next
year, rather than this year.
By
having just one year where your income is below the threshold, you can start
your Roth.
After it is started and you make that first contribution, then you can grow that
contribution into a tax-free income-producing asset. If you cannot reduce your
income, perhaps your spouse can qualify by filing a separate return one year.
INVESTMENT STRATEGIES
#1.
Don’t lose money – As
the Roth pays no taxes, a taxable loss would be of no benefit. If you are going
to speculate on a deal that may not be a winner, do it in an entity that can use
the loss to offset another gain. At least you get some benefit.
#2. Don’t buy
property with depreciation or capital gains benefits - The Roth is the ultimate tax shelter. Don’t buy other
tax-sheltered investments in a tax shelter. Buy investments with high, otherwise
taxable profits. Then you keep the profit without any tax liability.
#3. Buy low
liability investments – Certain investments have low liability by nature. Stock
in a publicly held corporation has no risk to the holder. Notes secured by mortgages
and deeds of trust have little or no risk to the holder. When there is a claim
against the property, they don’t sue the lender. Options
to purchase either securities or real estate are safe investments from the
standpoint that they have no liability.
Buying
notes or options are strategies that only should be used by those who know how
to make money using these strategies. (Review rule #1) If you
buy a note or an option and don’t make money, it’s a bad strategy.
I have recorded excellent courses on buying options and notes and suggest
that you learn these techniques before you invest your Roth funds. See www.Johnschaub.com
for details, or call Dottie at 800-237-9222.
USING LEVERAGE IN YOUR ROTH
Borrowing
money to buy an investment in your Roth exposes you to a tax liability,
which will be based on the amount of leverage that you use. For example,
if you bought a property for $100,000 and borrowed $90,000, then your profits
would be taxed based on that ratio 90/100 or 90%. If you make $20,000, then 90%
of that profit will be taxable.
Borrowing
money in a Roth is not good strategy. You can get the effect of leverage without
borrowing money when you buy an option or a partial interest in a note.
For
example, If my Roth pays $2000 for an option to purchase a house at a price of
$100,000, then the Roth will benefit from the appreciation of a $100,000 asset
with a small investment.
Likewise,
if your Roth would buy a partial interest in a second mortgage or TD well
secured by a good house, then the rate of return on that investment may be 30%
or more due to the leverage you get when buying only a partial interest in a
note. Your knowledge of the business allows you to offset the higher risk of
this investment.
OPERATING A BUSINESS IN YOUR ROTH
A
Roth IRA is penalized like other pensions plans if they have business income.
The business income is taxable as UBTI (Unrelated Business Taxable Income). You
cannot run a business, like building homes or remodeling houses in your Roth and
avoid paying taxes on the profits. You need to invest, not be in business.
You
can get lucky with your investments. Remember Hillary Clinton's investment in
the futures market? As I recall, Hillary
made about $100,000 in a short time on a small investment. If you can invest
$2000 and have it grow to $100,000, that was a great investment. Because of your
knowledge of real estate, you may find opportunities to do just that.
A
business requires you or someone to do work to make the money. An investment
does not require a lot of effort on your part. If you buy a house, fix it up and
sell it, you contributed a lot of effort. That could be considered a business
operation.
Suppose
your Roth bought an option on a house, then that house was bought by a third
party, giving the Roth a profit on the option. The option would clearly be an
investment to the Roth, as no work was done by you.
OTHER PROHIBITED TRANSACTIONS
As with other retirement plans, self-dealing is
prohibited. You cannot buy from or sell to your Roth. Neither can your close
relatives, your parents, and children. Some try to circumvent this rule; but, if
you are caught, you may jeopardize the tax-free status of your Roth. If after
thirty years of investing you had to pay taxes on all of the profits in your
Roth, that would be a terrible penalty to pay.
Another reason not to engage in self-dealing is that
when you self deal, you are not making a profit. If you sell a house that you
own to your Roth at a discount, then you are getting less profit.
It
is far better strategy to buy from a third party at a discount. When your Roth
buys from an unrelated party at a discount, it is really making a profit and you
cannot be accused of self-dealing.
LONG TERM STRATEGY
First,
set a goal for your Roth. How much do you want to accumulate over what period of
time. Next, calculate how many deals you have to make and how much profit per
deal to reach your goals. Now, make a plan that you are confident can be
implemented, that has the fewest possible investments. It would be better to
make ten good investments and reach your goal than 100 investments.
Suppose
you were starting a Roth today with an initial deposit of $2,000, and your goal
was to have $500,000 or more in ten years. You could take the first $2000 and
buy a ten year option on a house in an area that you thought would double in
value over the 10 years. If the house is worth $125,000 today, it may produce a
$100,000 net profit during that ten-year period. If all you did was to make a $2000 contribution each year and
then buy an option on one house a year, the chances are good that you would
exceed your goal. Probably not all of your houses would double in value.
However, as your skills increase and you are able to identify and buy in the
best areas in your town, your profits will increase.
Typically,
not all ten-year options will last ten years. Many of these homeowners will sell
in less than ten years and pay off the option early. You would make a smaller
profit on these options, but then could reinvest in others.
Once
you are on track to reach your goals, you may switch to investing more of your
Roth funds in notes that would produce an income stream. If you could invest
$500,000 in notes that gave you a 12% average return, you could take out $60,000
a year tax free without eating into your principal.
Buy
a few good options and a few good notes. Look for those that might pay off early
to increase your capital. Look for notes in default that you can buy at deep
discounts and then find a third party buyer to buy the house and pay off your
note.
ENCOURAGE EVERYONE, PARENTS, CHILDREN, SPOUSES, FRIENDS, TO START A ROTH
I have often said that I teach and
write so that all my friends can be rich. Help your family and friends to set up
Roth accounts. If you need more money than you have on hand to make a deal,
combine the assets of several Roth accounts to buy and share the profits.
Encourage your friends and family to learn how to invest their own funds. Act
now and you can contribute for both 2000 until April 15th and 2001.
For more information on Roth’s and IRA’s visit Mid Ohio Security’s web page
at www.midoh.com. Give everyone a copy of
this newsletter. Invite them to join you and attend the one time only event:
Upcoming
Seminars
