In all my prior jobs except the current one, I can now say in hindsight that my 401k sucked.
It only offered 10-15 fund options…which is like being forced to shop for weekly groceries in a gas station mini-mart when you know that Kroger is on the other side of the street.
Their fund expense ratios were mediocre, even for the passive funds. You couldn’t beef up pre-tax money with additional after-tax money. There was no mega-backdoor Roth conversion option.
These are really easy ways for companies to create value for employees via 401k plans. Why they are so often deficient when it comes to these things, I’m sure I don’t know.
Luckily, there is a way you can take greater control over your 401k money (or IRA for that matter) to invest more freely and build wealth.
It’s called a self-directed retirement account.
This week, I chat with Dmitriy Fomichenko, a financial planner who specializes in using self-directed retirement accounts “with checkbook control” to beef up your investing and retirement planning strategy.
What you’ll learn:
- What is a self-directed retirement account, the different types that exist, key risks, and how they differ from traditional retirement accounts
- The process for setting up a self-directed retirement account, and how to fund it
- Maintenance costs associated with self-directed accounts
- The role of the custodian / trustee / administrator for self-directed accounts
- How to access your self-directed account funds to invest (and key differences here between 401k vs. IRA versions)
- What kind of assets you can invest in with a self-directed account, and how income and expenses generated by those investments are treated
- Why mixing outside funds with self-directed account funds is such a big no-no, and the consequences if you do
Are you satisfied with your 401k? Why or why not? Does a self-directed account sound appealing? Why or why not? Let me know by leaving a comment when you’re done.
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Links mentioned in this episode:
- Sense Financial free consultation
- List of non-recourse lenders
- Everything you need to know about 401Ks (HYW003)
- IRAs, Roth IRAs, and how to get the tax benefits of BOTH (HYW004)
- 18 real estate investors share what they wish they knew at college graduation
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Dmitriy Fomichenko.
Dmitriy is the founder and president of Sense Financial, a boutique financial planning consultancy that specializes in self-directed retirement accounts.
He is an expert on using self-directed retirement accounts to complement your investing and retirement planning strategy.
He is a member of the Forbes Finance Council, where he writes frequently about self-directed accounts.
He is also a real estate investor himself and a licensed California real estate broker.
Dmitriy, thanks so much for joining us today to share insights and tips about self-directed retirement accounts.
Dmitriy Fomichenko 01:52
Andrew, you’re very welcome. It’s great to be on this show.
Andrew Chen 01:55
I’d love to first start by just learning a little bit more about your background, for our listeners anyway.
We connected a couple of years back now when you were one of the guest contributors to a blog post that I had written about real estate investors’ advice for new college graduates, which I’ll link in the show notes for folks who are interested.
But just tell us a little bit more about how did you get into becoming an expert on self-directed retirement accounts like 401(k)s, IRAs, etc.?
Dmitriy Fomichenko 02:29
Sure. I’ve got to go back into my background.
By education, I’m an electromechanical engineer. I went to college.
As you can hear or your listeners can hear from my accent, I’m not from here originally. I immigrated into this beautiful country back in 1996 from Russia and translated my degree, which was equivalent to BS in Electromechanical Engineering. And I did work in the field for several years.
And then I actually got laid off and was forced to look for something else. I got started in financial services, was recruited by a local firm, and been doing that for a few years, just dealing with traditional retirement accounts: IRAs, Roth IRAs, mutual funds, college education savings, and so forth.
In 1999, I was introduced to the concept of investing in real estate, been attending local real estate investment clubs, and purchased my first property in 2001. When I got started in financial services, I started investing as well in the market while I was investing in real estate.
So I could actually see the parallel and I could compare. And I figured out that investing in real estate, I have much more control and I have much more potential for the gain.
Just to give you an example, I purchased two properties. My first property was in 2001, and then the second in 2002. Both of these properties, in a period of four or five years, they more than doubled in value.
Now, I have to make a disclaimer. The market was crazy at that time. It was a good time, but nonetheless, you do have that potential.
I pretty much used equity in those properties to catapult my investment career.
But in 2004, I started working with a local real estate investment firm. I was invited as an advisor. I had been there for several years.
And then the market crashed in 2007 and people were looking to invest using their retirement funds. Because of my expertise and background in financial planning, I was asked to lead a department with this.
I started that, and about a year later, I transitioned on my own and started Sense Financial Services. So that’s the answer.
Andrew Chen 05:30
What caused you to specialize in self-directed accounts?
Dmitriy Fomichenko 05:37
As I mentioned, I worked with a local real estate investment company here in Southern California, and they actually attempted working with several self-directed companies.
None of them really worked out long term because they couldn’t perform to our satisfaction. So I had been given a task to start a department. I did that in 2009.
I did that for about a year. And then a year later, in 2010, I started Sense Financial, transitioned on my own.
That’s pretty much all we do. We specialize in creating self-directed retirement accounts that give our clients “checkbook control.”
Andrew Chen 06:21
I definitely want to dive into that in more detail here in a moment.
It sounds like you purchased real estate properties yourself using self-directed accounts.
How many doors do you currently own? How many did you acquire using self-directed accounts up until now?
Dmitriy Fomichenko 06:37
I actually acquired one property that I had purchased. It was a good deal. I ended up buying that in a retirement account.
And then I own another property that I own involuntarily. It was a loan. I did a private loan which was defaulted and I received the property as a deed in lieu of foreclosure.
So I currently own two properties in my retirement account. The rest of my retirement assets are invested in private loans. I own a number of notes in my retirement account.
Actually, my investment strategy just overall, whether it’s retirement accounts or not, evolved over time.
At one point, I owned over 20 properties approximately, 20 rentals. When I started this business, I basically transitioned. I sold a portion of my portfolio and I started doing private lending.
And the reason for that is private lending is passive.
Rentals, they do require management. They still take time from you. And I want to dedicate my time completely to my business.
Also, the risk is significantly lower with being a private lender, investing in a note.
You actually act as a bank. You collect the payments, pretty much contractually guaranteed by the note.
And returns are pretty nice as well. I average over 10%, so you get double digit returns.
So majority of my portfolio in my retirement account is private notes, but I do own a couple of rentals as well.
Andrew Chen 08:35
Let’s dive in a little bit more detail now into self-directed accounts. First, to level set, help us understand, what is a self-directed retirement account?
Dmitriy Fomichenko 08:47
Sure. It’s very important for your listeners to understand, because some people think they have an account with Schwab, an IRA, and it’s a self-directed IRA.
Well, it’s not a truly self-directed IRA because if you have an IRA with Schwab, you can only pick from the investments that Schwab allows you to do. And all of those investments are tied to the stock market. They are confined to the stock market.
A truly self-directed IRA allows you to invest into virtually anything, including real estate which is very popular. Majority of my clients invest in real estate.
So a truly self-directed retirement account is an account with a custodian that does not place limitations on the investments that you can make. You can virtually invest in anything, any alternative investment, not just the stock market.
That’s what the self-directed IRA is. You have freedom to choose investments.
Andrew Chen 09:53
Got it. There are a bunch of qualified retirement plans that I think folks are familiar with: IRAs, 401(k)s, even solo 401(k)s.
Help us understand. Can you have self-directed for all these?
And what is the difference? Why would you go with one or the other?
Dmitriy Fomichenko 10:09
You can have a 401(k) with your employer, if you work for a company and they offer a 401(k) or any other employer-sponsored plan, such as 457 or 403(b).
You can have those employer-sponsored plans and you can have a self-directed IRA on the side.
IRA is an individual retirement account. You can have that in addition.
And if you are self-employed or you work for yourself, then you can have a solo 401(k). Solo 401(k) can also be self-directed.
Andrew Chen 10:48
How does the self-directed version differ from their more traditional siblings that folks are more familiar with? What are things that you can do with a self-directed version of an IRA or a solo 401(k) that you cannot do with a traditional version of those accounts?
Dmitriy Fomichenko 11:07
The main distinction is the investments that are available.
If you have an IRA with a well-known custodian (Schwab, TD Ameritrade, Fidelity), you can only pick from the investments that are available by that custodian.
Because custodians basically are in business to sell investments, mutual funds, maybe some stocks. So you’re always limited to the investments that custodians offer.
Some custodians, when they set up an account, they have the power to dictate or limit your investment options. It’s always limited to investments tied to the stock market. That’s how they make money.
A truly self-directed IRA does not have those limitations. A custodian that offers truly self-directed IRA, they charge fees for you to make the investments, but they don’t offer investments.
You can invest in things like real estate. You can own a physical real estate inside of your retirement account. You can also own commercial real estate.
You can own a promissory note. Like I said, with my retirement account, that’s what I do. You can be a private lender, so you can be the bank essentially.
You can invest in real estate outside of the U.S. I have clients who have done it as well.
You name it. There is no limit here. You can pretty much invest into anything you want.
Andrew Chen 12:42
Can you have a self-directed account and an employer-sponsored plan? And do contribution limits apply across these accounts in aggregate or individually?
Dmitriy Fomichenko 12:52
It depends on the type of account.
If you have a 401(k) at your employer, you can contribute to that 401(k). If you have an IRA which is a self-directed IRA on the side, you can contribute independently.
So a 401(k) and an IRA, those are two separate retirement accounts you can contribute. Each one of them has a separate contribution limit.
Andrew Chen 13:17
Is there anything preventing me from having an employer 401(k) with my company and a self-directed solo 401(k)?
Maybe I have a side hustle, etc. Does the annual contribution limit apply to both those accounts individually or together?
Dmitriy Fomichenko 13:36
When it comes to solo 401(k), it’s a little bit different because, first of all, solo 401(k) is a qualified retirement plan designed for those people who are either self-employed or own a small business. If you are in that situation, you can open this plan.
And it has some tremendous benefits, one of which is a large contribution limit. With a solo 401(k), you can contribute up to $63,500 for this year. In an IRA, that limit is $7000.
As you can see, nearly 10 times. So it’s a great tax shelter.
If you work for yourself and if you’re making good income, then you are dealing with a problem for you, which is taxes. And the solution to that is set up a solo 401(k) and shelter.
But the contribution limit if you have an employer-sponsored 401(k) and a solo 401(k), the employee portion that you contribute, which is $19,500, that is subject to limit for all of the plans. You cannot put more than $19,500 in a given year or for this year (that’s the limit) across all of the plans that you participate in.
But on top of that, solo 401(k) has profit sharing, which allows you to actually bump up your contributions up to $63,500.
Andrew Chen 15:10
Gotcha. There’s nothing that prevents me from having both, right? Maybe I have a business on the side and I work at a company?
Dmitriy Fomichenko 15:17
Correct. You can have both.
You can have an employer-sponsored plan. And if you’re eligible, meaning you work for yourself or you have a side gig, then you can set up a solo 401(k) as well. You can have both.
Andrew Chen 15:31
Who is a self-directed retirement account, in your mind, best suited for? What are the types of people for whom self-directed is a good option versus the types of people for whom it’s not so good of an option?
Dmitriy Fomichenko 15:48
First and foremost, it’s for those people who don’t want to be limited when it comes to their investments. As we talked in the very beginning, the conventional retirement account, you have a custodian who limits your investment options.
I’m sure your listeners have seen what happened with the market in the beginning of the year when the pandemic hit. I don’t have much invested in the market, but I was looking at my portfolio and it dropped 30%.
Now, back in 2007 when the previous market crash was, I had seen some people lost 50% of their portfolio. Think about if you’re approaching retirement and you lose half of your portfolio. That can be devastating.
So more and more people are uncomfortable with this idea of investing in something that they cannot truly control.
You and I and your listeners, we cannot control the stock market. Now, we can do certain things to minimize the risk, but ultimately, we don’t have the control over the stock market.
But there are other investments such as real estate that you have much greater control over.
In my case, being a private lender, I have a bunch of notes out there which I own in my retirement account and personally. And my note portfolio has not been affected at all.
Maybe I had one payment that was late. It didn’t default or anything like that. So almost no effect, whereas the stock market dropped 30%.
That’s the whole point behind self-directed is that you can invest into something that you understand more and that you can control, most importantly, and minimize the risk.
Andrew Chen 17:47
Are there important risks that folks should be aware of when it comes to investing with a self-directed account?
Dmitriy Fomichenko 17:54
There is always a risk when you make the investment. But actually, even if you don’t make an investment, if you put your money into a CD, you’re still running a risk. And the risk of that is your money is losing a purchasing power to inflation.
So there is a risk no matter what. But obviously, you do need to understand the risk that is related to the particular investment that you’re making.
In my case, I did mention earlier, I own one property in my retirement account in which I actually was a lender. And the risk when you do private lending is that the borrower may default, so they might stop making payments.
I can make this into a case study. I’ll just go over the numbers for you.
But I lent $28,000 on a property in Pennsylvania. I was in the first position. I held up for about three years and then they defaulted.
It was actually loaned to a company. They owned the portfolio.
So they mismanaged that and they eventually defaulted. After the negotiation, I agreed to do a deed in lieu, so they signed the deed over to me. And now I own a property that is worth about $65,000.
My interest payment that I was receiving on that note (it was a 9% note) was $350 a month. My rental income is $675 now.
As you can see, the worst case scenario actually ended up pretty good for me.
So those are the risks.
But if you don’t do your due diligence and you lend on a piece of crap, then you can lose money. Obviously, you have to do your due diligence and look at the particular investment that you’re making.
Andrew Chen 19:49
That’s good advice.
What is the process for actually setting up a self-directed account? Can I just walk into Vanguard, Fidelity, Schwab, and open one of these up?
Dmitriy Fomichenko 20:02
Unfortunately, these traditional financial institutions, they don’t offer a truly self-directed retirement account, so you do need a specialized custodian.
If you’re talking about an IRA, there are two options, as we did mention earlier. There is a self-directed IRA and there is a truly self-directed solo 401(k). I can explain the process for both.
But for an IRA, you do need a specialized custodian that specifically offers self-directed accounts without placing limitations on the investments.
You open the account just like you would with any other custodian. You move the funds from your existing IRA, and then you’re ready to start making investments.
Now, with the self-directed solo 401(k), the process will be a little bit different. You actually don’t need a custodian for that. A custodian is not required for a solo 401(k).
Instead, the plan is set up with the trust being the vehicle to hold the plan asset. For that, you do need a specialized company that offers the documents for that.
A company like ours, that’s what we do. We are a document provider for solo 401(k) and we set up these types of accounts for our clients.
But you do need a specialized company that can help you set up a truly self-directed retirement account.
Andrew Chen 21:29
I see. It sounds like I can’t go into any normal brokerage. You need a specialized company.
Two questions. What does this custodian do other than provide the documentation? Do they provide any other value add services?
Let me just first start there.
Dmitriy Fomichenko 21:53
The role of a custodian is they have custody of the funds. Custodians typically have thousands or more customers, and they hold assets for those clients’ IRAs.
If you have an IRA with ABC custodian, then they hold the assets. Now, you control it, so you tell them you would like to invest in this particular asset.
Or let’s say you want to buy this particular property. You obviously have to do your own due diligence, find the property, and then submit an offer.
Now, this offer has to be signed by the custodian. Both of you will sign the offer.
And then when you’re ready to make that purchase, you have to submit the paperwork to the custodian and direct them to transfer the funds because they’re actually in possession of your funds. They have custody.
They transfer the funds to escrow or wire the funds to escrow. You buy the property.
And then when you have to make certain payments or expenses, you have to go through the custodian for each transaction and direct them to send the funds.
Andrew Chen 23:15
Interesting. This was one of the things I wanted to ask about.
It sounds like when I have an investment opportunity or I need to make a related transaction or purchase, in terms of the mechanics of actually accessing the money from the self-directed account, I think what you call “checkbook control,” right?
I can’t actually self-withdraw the money myself. I need the custodian to sign off. They’re going to send it through escrow.
The money never passes through the account holder’s hands. Is that correct?
Dmitriy Fomichenko 23:49
That’s correct. Yes.
As an account holder, you don’t touch the money. You always have to go through a middleman, which is a custodian.
That’s for an IRA. For an IRA, you have to have a custodian.
But the “checkbook control” that you mentioned, that is available with the solo 401(k) because a solo 401(k) does not require a custodian. And with a solo 401(k), the funds are in the 401(k) trust.
And the client actually is the trustee of that trust. So as the trustee, you control it. You physically have a “checkbook control.”
You will have a checking account attached to your 401(k). The funds are there, and you can literally write the check. You don’t have to go through a middleman, wait for the approval, lose the time, pay the fees.
You literally have “checkbook control” over your retirement funds with the truly self-directed solo 401(k).
Andrew Chen 24:47
That sounds better. Why don’t people just always do that?
Dmitriy Fomichenko 24:58
Number one, not everyone is aware of this.
And number two, solo 401(k) is not for everyone. As we mentioned, it’s designed for those people who are self-employed or own a small business.
You basically have to meet the two criteria.
Number one, you have to have a legitimate business or self-employment activity in place that generates earned income.
Know that it cannot be a passive income. Some people, let’s say the given example, they may say, “I’m in a real estate business. I own a portfolio of five or ten properties.”
From the IRS’ standpoint, that’s not really a business. This is an investment portfolio because the rental income is considered passive income.
So that’s not considered a business. You have to have earned income. You have to have to do something to generate.
And the range is pretty wide. It can be anything.
You can do some consulting. I have many clients who are real estate agents. As a real estate agent, you’re actually self-employed.
You can provide some services. You name it.
As long as you receive some 1099 miscellaneous income that you report on a Schedule C or if you own an entity (S corp, C corp, LLC) that you file a separate tax return for, you’re eligible.
And then criteria number two, you cannot have any full time employees working for you.
Because if you have employees working more than 1000 hours for your business, then the law requires you to offer the same retirement benefits to your employees. A solo 401(k) cannot accommodate that.
Andrew Chen 27:03
How do I tell what’s the difference between passive versus earned income for those who aren’t aware?
Real estate makes sense. That seems like passive income.
But let’s say I’m a YouTube influencer or a blogger and I make money using passive affiliate links. I create content but I don’t actively sell anything. Or maybe I do, but it’s all passive in the background.
I’m assuming it would still be considered earned income. So how do folks tell the difference between the two?
Dmitriy Fomichenko 27:47
You have to look at the source of income, where the money is coming from.
Let me use the example of affiliate, creating those links, of writing those blogs, and compare that with being a rental property owner.
Here’s an example. If you have to take a couple of months off and go out of the country for two months, when the first of the month comes, you still get that rental check coming in. The next month, you still get that rental check coming in.
You don’t have to do anything to earn it. It’s coming to you passively.
Now, with writing blogs or creating those affiliates, you always have to maintain that. You have to create those links. You have to create those relationships.
Once you set that up, it might be somewhat passive, but you have to do something to earn that.
And again, you have to look at the source of the income. If it is a 1099 miscellaneous (because those affiliates will report that income on a 1099), if that’s going to go on a Schedule C, that’s earned income.
Your CPA can help you clarify that as well.
Andrew Chen 29:19
Cool. We talked a little bit about custodians, which are required for IRAs but not solo 401(k)s on the self-directed side.
How do people find a custodian? Do they just do Google searches?
More importantly, how do they compare custodians to find the one that’s right for them? What are the things that they should be evaluating?
Dmitriy Fomichenko 29:49
Obviously, you can do Google search and you can search for self-directed custodians. Some people put together lists. You may find that.
But how to compare? You have to do your own due diligence. You have to do your own research.
First and foremost, look at the clients’ feedback. Look at the testimonials from their existing and past clients.
Go online and search Better Business Bureau or look at their profile.
Go on Google. Google has a bunch of reviews just on Google. You can find a company on Google Maps and just look at their reviews there.
See if you can connect with other clients who are actually using their services.
There are sites. One site that is specifically geared to real estate investors, which I’m actually actively participating almost on a daily basis, is called Bigger Pockets. This is a social networking site for real estate investors.
It has a lot of resources. You can connect with other investors. You can ask questions.
You can research things like that. But ultimately, you have to do your due diligence.
Andrew Chen 31:10
Let me ask this way. If you were going to search for a custodian, what are the things that you would be looking for to determine whether they’re good or not? What are the markers of a good custodian?
Dmitriy Fomichenko 31:22
Well, I’m going to be a little bit biased because we specialize in creating retirement accounts with “checkbook control.”
And I hear from clients that they have sometimes trouble working with the custodian. They need to make an investment and they have to wait a few days, and they lost a deal because they dealt with a custodian.
So looking at the speed, how quickly they can process the transaction.
But looking also at their fees because each custodian has a separate fee structure. Some charge based on the transactions.
Some charge based on the number of assets that you hold. Some charge based on the total account balance, which to me doesn’t make any sense.
Andrew Chen 32:21
Yeah, because how would you value an illiquid asset?
Dmitriy Fomichenko 32:25
Well, you still can value it. There is a value to an asset. If it’s a property, for example, there are property values.
But what doesn’t make sense to me in this, if they charge based on the total assets, they’re not your partner. They’re providing a certain service, so why should they get the percentage? That doesn’t make any sense to me.
But the bottom line is that I don’t want to have somebody control my retirement account. I want to be in control.
That’s why I will go for the checkbook. That’s why we offer a “checkbook control.”
But custodians, they do work. There are millions of people who are using custodians. It does work for them for various reasons.
Maybe they’re not aware of the “checkbook control.” Or maybe they do passive investments where there is very little interaction with the custodian.
If you’re doing passive investment, an example is with a note. Once you make a loan, once you invest in a note, you obviously have to do your due diligence upfront.
But then after that, it’s completely passive. You’re pretty much not involved, especially if you have a servicing company, which I do use.
Some people call it “mailbox money” because they just receive a check in the mailbox every month.
In my case, I don’t even use a mailbox. My servicer, the broker that I use, they simply deposit the funds directly into my bank account.
So it’s completely passive. And that can work with a self-directed IRA as well.
Andrew Chen 34:14
Do the costs of opening and maintaining an account differ for self-directed accounts compared to regular qualified retirement accounts?
Dmitriy Fomichenko 34:24
Yeah, because with just the traditional retirement accounts, if you go with Schwab or Merrill Lynch, they usually offer you a free IRA or maybe they charge you $20 or something like that.
But how they make money is by selling investments. When you invest with TD Ameritrade or Schwab, they make a little bit of money every time you make the investment. They make money off of your investments.
With the self-directed IRA, the custodian does not sell the investments. They basically provide a service. They process transactions and they charge fees per transaction.
Different custodians have different fee schedules.
Some charge per each transaction. Some might give you free transactions a year.
Some charge based on the assets. Every asset, you’ll pay them a fee.
And some charge based on the total account balance.
Andrew Chen 35:23
Can you roll money into and out of a self-directed account the same way you can between other retirement accounts like 401(k)s and IRAs?
Dmitriy Fomichenko 35:36
Yes, you definitely can. The self-directed IRA can accept rollovers from other IRAs or 401(k)s. So is a solo 401(k).
A solo 401(k) can accommodate rollovers from any other qualified retirement plan, with one exception, and that is a Roth IRA. IRS does not allow Roth IRA to go into a 401(k).
But all other accounts can be moved.
One other comment I need to make is that if you have an employer-sponsored retirement plan, if you work for a company and you have a 401(k) there, most likely you’re not going to be able to transfer that 401(k) value employed.
But if you leave the company, if it’s a past employer, you can move that. Or if you reach retirement age, you can also move that account, but not while you’re employed and before retirement age.
Andrew Chen 36:33
Let’s say you have a self-directed account and you wanted to roll out to an employer plan, for example, and you have investments. Would you be required to liquidate your potentially illiquid assets into cash in order to roll that money out of the self-directed account back into a traditional 401(k)?
Dmitriy Fomichenko 36:56
You’re not going to be able to do that. If you have assets in your IRA, you’re not going to be able to move that into an employer-sponsored plan because your employer-sponsored plan does not allow those kinds of investments.
Andrew Chen 37:09
So you’d have to sell it?
Dmitriy Fomichenko 37:10
Yeah, if you have to. I don’t know why you would do that. It doesn’t actually make any sense.
I understand you may decide you don’t want to deal with the alternative investments. You just want to get back into mutual funds, so you set up an IRA.
But usually it doesn’t ever make sense to move money into employer 401(k). If you start a new job and you get a 401(k) there, it’s never a good idea to bring any money in there.
You may want to still have just a normal IRA because you have a lot more options with an IRA than your employer-sponsored plan. Options are very limited there.
So I can’t think of an instance why it will make sense to do so.
Andrew Chen 38:00
With a 401(k), for example, you’re allowed to take out a loan from your 401(k) under special circumstances, and there are other things that you can do.
With a self-directed account, does it basically work the exact same way as its qualified traditional sibling? Could I take a loan out of my self-directed 401(k) and things like that?
Dmitriy Fomichenko 38:36
You can take a loan from the self-directed 401(k), assuming that the plan documents have the loan provision.
Typically, the plans that we set up, yes, there is a provision in the plan allowing you to take a participant loan. You can take up to $50,000 or 50% of the balance, just like with your employer 401(k).
But with an IRA, it’s different. You cannot take a loan from an IRA. That’s not possible.
Andrew Chen 39:05
So it sounds like on the 401(k) side, the rules for borrowing and payback tend to be the same. Is that right?
Dmitriy Fomichenko 39:12
Pretty much. Yes.
Andrew Chen 39:14
Let’s talk a little bit about how you can invest with a self-directed 401(k) or IRA.
A lot of people use their self-directed accounts to buy physical real estate. That’s one of the most popular investment asset classes that people use a self-directed account for.
How is rental income treated if you invest in real estate using a self-directed account? Is that just like a dividend? It just goes right back in?
Dmitriy Fomichenko 39:40
Yeah. If you own a rental property, that’s going to be rental income.
If you own a paper asset, for example, if you own a note, you don’t own the property, but you’re actually a lender in the property, so you still have income. That’s interest income coming in.
Or if you invest into some kind of a fund that maybe owns a number of properties or owns one large multifamily property, there is income coming in.
All the income must go back to the retirement account because the retirement account owns the asset.
The concept you mentioned in your question, the concept is the same. It’s treated just like dividends you receive from your mutual funds or stocks. Everything must go back into the retirement account.
Andrew Chen 40:39
What about operating costs, capital expenditures?
Let’s say you’re investing in real estate. Do those have to be funded entirely from self-directed account monies? Are you not allowed to use any outside personal money?
Let’s say there’s a big rehab project you have to do at the beginning, but you don’t have enough money in your self-directed account. Are you not allowed to mix that money?
And if so, what happens if you mix? Are there tax consequences, etc.?
Dmitriy Fomichenko 41:08
You absolutely cannot mix.
If your IRA owns a property and you’re doing a rehab on that property, first of all, you personally cannot participate in any work. You cannot do any work on the property because you’re a disqualified person to your IRA or 401(k).
So everything has to be done by an unrelated third party. You can oversee it, you can manage the projects, but you cannot personally be physically involved in any of the work that is done in the property.
But all of the expenses must be paid from an IRA or a 401(k). You cannot use personal funds because it’s not your property. Your IRA owns this.
That’s why you need to plan accordingly. If you’re starting or considering a certain investment, you have to estimate what the rehab cost is going to be. You want to make sure you have enough funds in your IRA.
Now, you can also borrow money. Your IRA or 401(k) can take a loan to buy the property and potentially take a loan to rehab the property.
Andrew Chen 42:19
Take a loan from a bank?
Dmitriy Fomichenko 42:21
If you can find a bank, there’s going to be limitations there. To buy the property, there are a number of lenders that specialize in that.
The loan must be non-recourse. Non-recourse means that there is no personal guarantee.
Because as a disqualified person to your IRA or 401(k), you’re prohibited from providing a personal guarantee for that loan.
You can’t go to just any bank and get a conventional loan because a conventional loan will require a personal guarantee. And that’s a no-no with a retirement account.
So it must be a non-recourse loan. We actually have a list of non-recourse lenders who specialize in this. There is a handful of lenders who do that.
Andrew Chen 43:05
Can you send me a link to that? I’ll link to that in the show notes.
Dmitriy Fomichenko 43:08
Sure. Now, if you need money for the rehab, those lenders are probably not going to lend you money for the rehab.
But you can still find a loan. You probably have to go a private lending route. Maybe talk to your friends or extended relatives.
It cannot be immediate family members like your parents or grandparents or your kids. But you can still possibly finance.
The bottom line is you need to think about all of that before taking on the project. You need to cover all those bases.
Andrew Chen 43:51
Do you typically find that real estate investors who are using self-directed accounts are taking on leverage, like they’re buying it with debt? Or do they tend to buy in all cash?
Dmitriy Fomichenko 44:12
I see both. You can do both. You can invest using leverage and you can invest just using cash.
Andrew Chen 44:20
Because obviously one of the big benefits of using leverage is that you can increase the returns.
And it sounds like you can’t really go to any old bank. You have to either go to a non-recourse lender, which is going to drastically reduce your options, or you have to go private lending.
Are those pretty much the options that you have if you’re a self-directed retirement account real estate investor? It’s either non-recourse in a limited number of banks or private lending if you want leverage?
Dmitriy Fomichenko 44:47
Yeah. There is a limited number of lenders who provide that, but that doesn’t stop you from getting the loan.
You can still get a loan. Those lenders will lend.
Maybe not all of them in all 50 states, but you will find a lender who will lend the money to you if property qualifies. It’s not a problem to get a non-recourse loan if it’s a decent property.
I’ve done it personally. I own a property in Phoenix. I purchased that six or seven years ago.
I had to come up with 40% down, so it was a 60% LTV loan. But it was a pretty straightforward process.
Again, you can get a loan. It’s not a problem. The terms are going to be a little bit different.
Andrew Chen 45:43
Can you say more about how the terms will be different?
Dmitriy Fomichenko 45:48
One criteria is that you’re going to have to come up with a larger down payment. Like I said, in my case, it was 40% down.
If you’re going to go to a conventional lender, if you’re personally buying a property, you probably can get an investment property loan with 20% down. So here you need 20-40% down.
And the reason is because the lender is taking more risk.
With a conventional loan, if you default on the property, a lender has to foreclose. They have an option of coming after you personally if you still owe any money.
But with the non-recourse, the only recourse the lender has is the property itself.
So they want to minimize the risk. That’s why down payment is typically larger.
But you can still make the numbers work. And 40% is better than 100%.
Andrew Chen 46:46
Dmitriy Fomichenko 46:48
I’m still using 60% leverage. I’m increasing my returns.
Andrew Chen 46:52
What about the rate, the amortization, the term? Do those tend to be similar as a regular bank-financed mortgage?
Can you get a 30-year fixed at, say, less than 4%? Or are those going to be different too?
Dmitriy Fomichenko 47:11
Different lenders have different criteria. The rate is going to be slightly higher than conventional.
But you don’t want to really compare that to the conventional because you’re comparing apples and oranges. If you really want to compare apples to apples, then you want to compare these non-recourse banks with “hard money” lenders.
You can get a “hard money” loan that is non-recourse, but you’re going to end up paying 10-12% interest on that. It might be a couple of points.
To give you an example, on my property, I had to put 40% down and my rate was 4.875% on that. It was actually a five-year fixed.
So it has been adjusting, but my rate is still under 5% right now, which is still great compared to the private or “hard money” lending.
Andrew Chen 48:11
What’s the amortization and term that folks can typically expect with these types of loans?
Dmitriy Fomichenko 48:16
They do have different options here.
You can go 30 years. You can go 20 years. You can go 15 and maybe even 10.
But you do have different options.
Andrew Chen 48:26
Got it. So it sounds like you cannot be personally involved because you’re a disqualified person, as you said.
Who takes title to the property? Is it your custodian or trustee? Their name is on the title of the property?
Dmitriy Fomichenko 48:38
In a case of a self-directed IRA, the custodian takes the title to the property.
It’s going to be something like this: ABC trust company FBO (which stands for “for benefit of”) Andrew Chen IRA, and then maybe the IRA account number.
Now, if you use a solo 401(k), then the title will be in the name of the 401(k) trust.
Like I explained earlier, with the 401(k), there’s no custodian. All the plan assets are held in the trust. So it’s going to be something like ABC company 401(k) trust, for example.
As a trustee, you control that, but the title is taken in the name of the 401(k) trust.
Andrew Chen 49:26
What I’m really taking away is you have to be very careful about planning to make sure that all the costs you need for rehabbing or whatever are able to come from the self-directed account and that you don’t have to mix money.
But in the worst case scenario, what if I misestimate? Lightning strikes, a tree falls on the house, and now I have a big expense. It’s a black swan event.
I didn’t expect that to happen, and I don’t have the money. I just have to bring in outside money, otherwise the investment could potentially go to zero or things could go very badly.
I have a mortgage payment coming up, and the asset is damaged, and I have to just fix it to get it back in a rentable state. And I just have to use outside money.
What happens? What are the consequences?
Dmitriy Fomichenko 50:16
Typically, if you’ve got something like that, you must have the insurance. It’s something that you have to do ahead of time and buy the insurance, because you have to think about things like that.
Usually, insurance will cover most of it. You might have to come up with a deductible.
But in the unlikely scenario of where you’re just out of money in your IRA and you need additional influx, you have to look at a few different options.
Number one, you can make a contribution to an IRA. That’s going to be limited up to $7000 for this year, but you can put some additional money.
If you have any money in any other retirement accounts, you can do a rollover from those retirement accounts.
If those options are not on the table or you exhaust those options and still need more funds, you could potentially take a private loan, not you personally but IRA taking a loan. You can put property as a collateral in an IRA to get the loan.
Or you potentially can sell off a portion of the property and bring in a partner. But you’re not allowed to use personal funds because that will violate the IRS rules, because IRA is a separate entity from you and you’re a disqualified person for IRA.
Andrew Chen 51:45
Makes sense. Let me ask this another way.
If stupidity takes over and you accidentally use personal money, I’m just wanting to understand, what is the consequence on the other side of this?
Dmitriy Fomichenko 51:59
Whether you mix personal money in an IRA or if you do something else that is prohibited, you basically commit a prohibited transaction. In that case, the entire IRA will be deemed distributed.
The IRS will treat that you actually took all the money out of your IRA, and you’re going to have to pay taxes and penalties on that.
If you commit a prohibited transaction, sometimes penalties can be up to 100% of an IRA. It could be pretty serious, so not to be taken lightly.
You do need to understand what the prohibited transactions are. They’re not difficult to understand.
Typically, a prohibited transaction arises when there is a disqualified person involved. By the IRS’ definition, a disqualified person is someone, basically yourself, your spouse, and your immediate family members, kids, grandkids, and their spouses, your parents and grandparents.
So you want to make sure that all the transactions that your IRA or 401(k) involve are at arms’ length, meaning that none of these people are involved in the picture, in the transaction, in any capacity.
Andrew Chen 53:15
Got it. Good safety tip. Folks, don’t do that.
Let’s say you invest in real estate with your self-directed account. Are you allowed to live in the property?
A lot of people, for example, do “house hacking.” They’ll buy a multifamily property. They’ll live in one unit and rent out the others.
Are you allowed to live in the property?
Dmitriy Fomichenko 53:34
Absolutely not. Living in the property, what I just covered, is an arms’ length transaction.
You’re a disqualified person. You cannot be involved in the transaction.
Living in the property, even if you’re paying rent, if you’re doing it illegally, without an agreement, because it’s not your property. It’s your IRA’s property or 401(k)’s property. So that will violate.
Even if you’re paying a market rent for that rental, that is still not allowed because you’re receiving a personal benefit and that’s not allowed. You’re a disqualified person, so you absolutely cannot receive a benefit from the investment.
Andrew Chen 54:23
And the consequence would be a deemed distribution?
Dmitriy Fomichenko 54:28
Andrew Chen 54:29
Let’s say you sell property and you realize a large capital gain from the sale of real estate from your self-directed account.
I’m assuming there’s no tax consequence at the time of sale. Is that right?
Dmitriy Fomichenko 54:44
A retirement account is considered a tax-deferred vehicle. The sale of the property will be treated, generally speaking, no different than if you purchased some stocks, and then a few years later, you sold with a large gain.
If you did that personally, obviously that’s going to be a taxable event. But if you did that inside of a retirement account, all of that gain will be sheltered from taxes because an IRA or 401(k) is a tax shelter vehicle.
The same concept with the property. If it’s done inside, no tax consequences.
Andrew Chen 55:28
So just like any other traditional tax-deferred account then, you just get taxed at ordinary rates. When you withdraw after 59 and a half, it’s not. But any transactions before that are just tax-deferred like any other retirement account?
Dmitriy Fomichenko 55:43
Correct. Generally speaking. So you will pay the taxes in the amount that you take distribution.
If you sold a property worth a million dollars and when you reach 60, you’re not going to pay taxes in the million dollars. You’re only going to pay taxes on the amount that you take out.
If you only take out $50,000 when you’re 60 and then the same amount every year, you’re going to be paying taxes on the amount that you take out in the year that you’re taking it out.
But one other concept or important note is that there could be taxes that your IRA will owe, and that’s UBIT tax. That stands for unrelated business income tax. This tax is assessed when there is income that is unrelated to the nature of the IRA.
For example, if you invested in an active business with your retirement account. One example will be flipping a property. Flipping is considered an active business.
If you actually buy a property, fix it up, and then sell it in three months, that’s considered a “flip.” And that income may be subject to UBIT tax.
Andrew Chen 57:06
Even if it was done entirely in a self-directed retirement account?
Dmitriy Fomichenko 57:09
Yes, because it wasn’t a passive investment. All the investments inside the retirement account must be passive.
If you engage in an active type of business, as a result, the income from that type of business will be subject to UBIT tax. And that’s tax you’re not responsible for. It’s your IRA that’s responsible to pay the tax.
So you want to make sure that the investment that you make with your retirement account is passive.
Andrew Chen 57:37
And it sounds the account administrator or custodian would know how to process any tax liability, if that happened. Is that right?
Dmitriy Fomichenko 57:48
That will not be the administrator’s or custodian’s responsibility. That will be your responsibility.
You’ll have to work with your CPA because the IRA will have to file a special form with IRS. It’s not a tax return, but reporting that income and paying those taxes. But that’s outside of the custodian’s responsibility.
Andrew Chen 58:11
I see. They just pay the amount, but you actually have to calculate the amount.
Dmitriy Fomichenko 58:16
Yeah. The tax amount, whatever is involved in that calculating and filing and reporting, that’s going to be your responsibility.
Andrew Chen 58:27
Got it. So it has to be passive investment.
What are other asset types that you can invest in with a self-directed account besides real estate? Sounds like you’ve invested in “hard money” loans, so private debt.
Can I invest in a closely held business, tax liens, physical assets like antiques or jewelry, intellectual property, Bitcoin?
Dmitriy Fomichenko 58:50
The better question is what can you not do?
Andrew Chen 58:56
Sure. What am I not allowed to invest in?
Dmitriy Fomichenko 58:59
Because with the self-directed IRA or 401(k), like I said, you can invest in virtually anything.
Now, there’s a couple of limitations. One of them I explained, which is a prohibited transaction that arises as a result of a disqualified person being involved in the transaction.
You cannot invest in a property that you’re going to live in.
Or if you’re a real estate agent and you set up a solo 401(k) and you want to buy a rental, you as an agent cannot represent your 401(k) on that transaction. Whether you get paid or not, you cannot represent or provide services to your 401(k).
But the IRS actually don’t have a list of investments that are allowed. They don’t have such a list. What they do have is they have a list of transactions that are not allowed, prohibited transactions.
We talked about the transactions that may arise as a result of a disqualified person being involved. But the assets that are specifically not allowed are collectibles. Anything that is considered collectible.
You mentioned antiques. That most likely will be considered collectible, so you won’t be able to invest in that.
Another problem is if you buy an antique vase, where are you going to store that even if it was allowed? Because you cannot have it in your possession as a disqualified person.
Now, if you’re buying some gold, you won’t be able to keep them in your possession, but there are repositories that specialize in this and they can hold the precious metals for you.
So you cannot invest in collectibles and life insurance contracts. Other than that, a disqualified person can invest in virtually anything.
You have tax liens, tax deeds, physical real estate. You can invest in syndications. You can invest in real estate outside of the U.S.
You can invest in Bitcoin or other cryptocurrency, although you need a checkbook. You can do that with a custodial account.
But you can invest in virtually anything other than these prohibited transactions.
Andrew Chen 1:01:32
Why can’t you invest in Bitcoin with a custodian? You acquire “checkbook control.” Why is that?
Dmitriy Fomichenko 1:01:38
Because the custodian cannot open an account. To invest in Bitcoin, you need an exchange account.
A custodian will not be able to set up an exchange account or transfer funds to the exchange account. They’re not going to do that. So you do need “checkbook control” for that.
Andrew Chen 1:01:58
One thing I’m actually curious, based on this discussion, it’s really interesting.
Mitt Romney, he’s a former presidential candidate and he used to work at a private equity firm called Bain Capital. Legend has it that his Roth IRA is $100 million, which is obviously mathematically impossible to achieve in a lifetime by simply doing contributions and investing in the stock market.
And that’s because he did it self-directed. He invested in companies that became very valuable. And then when they exited, big distribution into his Roth IRA account.
I don’t know all the details. I assume he did that through his firm, Bain Capital, which he also worked at. I don’t know if he was involved in those exact transactions.
But even if he wasn’t, I’m just curious, the disqualified person rule. Just like Mitt Romney’s case, if I work at a private equity firm whose job is to go buy companies, turn them around, sell them for a profit, can I use my self-directed retirement account to co-invest if I work at that company?
Let’s say I don’t work in that particular transaction.
Dmitriy Fomichenko 1:03:13
I’m not sure I can talk on this in general terms or comment on Mitt Romney’s because I don’t know exactly how he’d done it or thought about this.
But you’re exactly right. It’s mathematically impossible to accumulate that much wealth just from the contributions, so you have to make these alternative investments.
But it has to be at arms’ length. You personally cannot be involved in the transaction. You can make the investment, but you personally cannot be involved in the transaction.
So we will have to look at each particular scenario and see if that transaction is prohibited or not. I’m assuming he did it correctly. I’m sure he knew what he was doing and was following the rules.
But if you’re personally involved, if you work in a firm, that may or may not be allowable. You have to look at the circumstances.
Andrew Chen 1:04:11
Cool. Any other important rules or considerations that folks should be aware of when it comes to self-directed retirement accounts?
Dmitriy Fomichenko 1:04:19
I think it’s a great tool, very powerful to help you build wealth for the future. And you can do that in a tax-deferred environment or even tax-free if it is Roth.
Whether it’s a Roth IRA or a solo 401(k), which has a Roth component, you can actually invest tax-free with your solo 401(k) as well.
But you obviously need to understand the prohibited transaction rules.
One piece of advice I always tell my clients is that if you’re not sure about something, ask. But ask before doing this, not after.
And I had that happen. I had people come to me and ask me questions after the fact, after they did the transaction, which in a couple of cases was prohibited transactions.
But that’s one way to avoid making a mistake is to talk. It takes just a minute to make a phone call or send an email. I always respond to my clients quickly.
And it just takes a few moments to actually ask that question. If you’re not sure about something, ask. That’s how you can avoid potential trouble, potential prohibited transactions.
Andrew Chen 1:05:43
Great. This has been really helpful. I’ve really enjoyed our chat, Dmitriy.
Where can listeners find out more about you, your work, your services?
Dmitriy Fomichenko 1:05:50
Probably our website, sensefinancial.com. You can see it actually just behind me.
They can also find me on Facebook, on LinkedIn.
Or I would like to extend an offer to all of your listeners to schedule a complimentary consultation. I’d love to speak with you one on one, talk about your goals, and help you with your strategy, and share some of the experience and wisdom that I gained over the years.
Andrew Chen 1:06:28
All right. Excellent.
If you have a link to this complimentary consultation, if there is a signup page, then send me that link. I’ll link to that in the show notes as well.
Dmitriy Fomichenko 1:06:37
Andrew Chen 1:06:38
Perfect. Dmitriy, again, I really enjoyed our chat.
Best of luck to you. Stay safe, obviously, during this crazy time. And we’ll see you soon.
Dmitriy Fomichenko 1:06:49
Andrew, thanks for having me. Great questions. I enjoyed the chat as well.
Andrew Chen 1:06:54
Take care. Bye.