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USA Real Estate Blog

When a Roth IRA Meets Real Estate Investing

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Real estate is the most popular alternative asset The Entrust Group clients own in their Self-Directed IRAs. You have a lot of options when it comes to the type of account you can hold to invest in real estate, but today, we’ll discuss investing in real estate using Roth IRAs and show you the benefits, for both you and your beneficiaries.

The Benefits to You

Tax-free distributions.

The contributions to Roth IRAs have already been taxed when you make them. The benefits of the Roth IRA are that the earnings on the contributions are distributed tax-free if you:

  • Have held any Roth IRA for at least five years, and
  • Are at least 59 ½ years of age, die or become disabled.

The tax-free distributions apply to all Roth IRAs once those two criteria are met.  This includes any revenue stream generated by the real estate, such as rent, as well as the entire sale price, if you choose to sell the property. That’s right, including any increase in value gained on the assets!

No required minimum distributions (RMD).

With a Roth IRA, you do not have to start whittling away at your retirement nest egg just because you turn 70 ½. This is a big advantage over investors who own real estate in a Traditional IRA, who are required to take a small distribution yearly or face a hefty 50% penalty.

You will not face RMD issues such as asset liquidity issues to come up with the cash needed to distribute the RMD. In addition, because RMDs are calculated based on the value of the assets held in the Traditional IRA, at the very least, they will have to pay for a yearly appraisal of the real estate assets to determine the amount of RMD required.

None of this has to happen when you invest in real estate using a Roth IRA.

Ongoing contributions.

In addition to the absence of RMDs, you may continue to contribute to your Roth IRA even after age 70 ½. Unlike Traditional IRAs which forces you to stop making contributions upon attainment of age 70 ½, Roth IRA eligibility does not have a restriction. This arrangement suits the growing number of people who continue to work after the “usual” retirement age (which really doesn’t exist anymore anyway).

As an additional type of contribution to fund your Roth, you may also want to consider converting your Traditional IRA to a Roth IRA. A Roth IRA conversion is done by taking a distribution of your Traditional IRA and contributing the distributed amount to your Roth IRA. This transaction is not subject to the 10% premature distribution penalty regardless of your age.

You also have the option of converting a portion, or all, of your Traditional IRAs.  It’s your choice. You can work with your tax advisor on an amount you may be considering converting to know in advance the amount of tax liability the transaction would incur. You are also not limited to converting Traditional IRAs to a Roth IRA.

If you have accounts in a prior employer’s 401(k), 403(b) or governmental 457(b) plan, those assets can also be converted to a Roth IRA.

By putting more dollars into your Roth, you will have more purchasing power to acquire more real estate using a Roth IRA. Some are even purchasing their future retirement home in their Roth IRA.  By purchasing the property now, they can have their future retirement home already purchased at today’s cost. Later the property can be distributed tax-free to live in.

The Benefits to Your Beneficiaries

One of the many factors associated with passing on your hard-earned retirement assets to your heirs is taxation. Roth IRA distributions, if done at the appropriate time, is tax-free. These same benefits—are passed on to your beneficiaries. Roth IRAs can be used strategically in legacy planning.

Your beneficiary has choices on how to take the tax-free distributions from the Roth IRA you leave them after your die.

Your beneficiary can take a complete lump-sum tax-free distribution any time after your death as long as you have had a Roth IRA for at least five years. This can be a great strategy to pass on a real estate property to your heirs tax-free.

There is also the five-year-rules option. This option also allows your beneficiary to hold the assets in their inherited Roth account until the fifth anniversary of your death. Only then at that point will all the assets must be required to be distributed. However, any remaining assets not distributed will be subject to a 50% penalty.

The life-expectancy option allows your beneficiary to deplete the account by only having to take a small distribution annually. Distributions must begin no later than December 31 of the year following your death. The amount of the distributions is calculated using your beneficiary’s age and the life expectancy the IRS has set.

If the real estate generates enough rental income to fund the annual distribution, the asset may not have to be sold and can generate income for your beneficiary for the rest of their life. The law also allows for the beneficiary of your beneficiary to continue the life expectancy payments if by chance your beneficiary has not completely depleted the Roth IRA upon their death.

You can create separate Roth IRAs and name a different beneficiary for each Roth.

This avoids issues of having to separate the assets, in this case real estate, to each beneficiary if you have more than one named. This ensures that your wishes are carried appropriately. Speaking with your beneficiaries regarding what you are leaving them also allows the beneficiaries to know the steps they will need to take.

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