I'm a CPA, not a financial advisor. But I'm the first point of contact for many of my clients. They'd rather ask me a financial question before they bounce it off their financial planner (if they have one).
Even though I don't give financial advice, I've seen many things over the years. I've had many clients make good decisions and many more make bad decisions. It seems the poor decisions often stick out in my mind.
Sometimes, the stars align and a great financial decision is made. Although it doesn't happen often, I have seen clients hit home runs. Let's discuss one of those situations: a guy who started with $50,000 and ended with $1 million. You might be able to learn from his story.
I had a client who was a successful entrepreneur. He was an IT programmer and developed software in the construction industry. He was married, a couple kids, and in his mid-40's at the time.
We carefully structured his retirement accounts over the years and he had been able to sock away some money. He was now planning to invest in the private company stock of a small start-up hospital structured as a C corporation.
He was questioning how the investment should be consummated. Should it be made from a retirement account? Should he just buy it personally by writing a check out of his checking account? What were his options?
Well we talked a little bit about his financial situation and how much money he had in retirement accounts. The amount of the investment was relatively small for him: $50,000. But he did have a few options available.
I asked him how confident he was that this investment was going to be a home run. He was very confident (they always are). I warned him that he had a better chance of losing all his money than hitting a home run. But, of course, he wasn't phased. He was going to do it.
Since he was so sure of the investment, I asked him if he'd considered using a Roth IRA. He wasn't exactly sure what a Roth was and said he didn't have one.
What is a Roth?
A Roth is a retirement account that uses after tax money (which means you don't get a tax deduction when you put the money in). The advantage is that you aren't taxed when you pull the money out (provided certain conditions are met). You also must consider the possibility of unrelated business income tax.
Some key components of a Roth IRA:
- You cannot deduct the contributions;
- Provided you satisfy the distribution requirements, any distributions of contributions and any earnings are tax-free;
- You are allowed to make contributions to a Roth after you reach age 70.5;
- Roth IRAs are not subject to Required Minimum Distributions ("RMDs"); and
- The specific account must be designated as a Roth when it is established.
There's one additional important point to note: While a Roth typically is used to invest in securities like stocks, bonds and mutual funds, it can also be used for alternative investments. This includes private company stock, real estate, private placements, tax lien certificates, and many other investment options.
The IRS created the Roth to allow investments to grow tax-free, provide asset protection, and to allow the assets to be passed to future generations with qualifying accounts.
A self-directed Roth IRA is technically no different than other IRAs. It's unique in that it's very flexible and puts the IRA owner in full control of investment options. You must select an account custodian--there are numerous custodians available--and the fees can be a bit higher. But if you understand the strategy, it can work out quite well.
So what ended up happening?
We converted his funds from a traditional IRA that were pre-tax to a Roth (after-tax). He had to pay tax on that money right away, but he could pull it out later tax-free. It's a great strategy if you're betting on a substantial return on your investment.
The hospital continued to grow and thrive. It was ultimately bought out and my client received upwards of $1 million for the sale of the shares. These funds went back into his self-directed IRA and he used them to invest in more traditional investments, but also put some of it in real estate. Once my client turns age 59.5, he can withdraw the money absolutely tax-free. It could not have worked out any better for him.
While this is the exception and not the norm, these things can happen. But beware. I almost never see it. At the end of the day, if you ask the right questions, do proper tax planning and do your own due diligence things can actually work out in your favor.