April 30

Alternative Investments for Your IRA

The investment options for an IRA are almost unlimited.  Just stay away from insurance policies and collectibles, and abide by the law against self-dealing.  Of course, you should not use any investment that is already tax-advantaged, like tax-exempt securities, either.  If you have a traditional IRA and put your money into a Tax-free bond, when you take out the interest you will be taxed on it, as you are with all distributions from a traditional IRA. So you will effectively lose the tax-exempt status of the bond…not a good move.  It also doesn’t make sense to invest in tax-free investments with Roth IRA money (where the distributions are tax-free) because you can put other money into them and still have tax-free income.

The most popular non-traditional investment for an IRA is real estate, and we will tackle that in the next article.  For now we will discuss some other interesting alternatives.

Structured settlements

In case you don’t know, the term structured settlement refers to a payout that is received over a number of years, usually due to a lawsuit or an insurance claim.  For example, if someone is injured in an accident, he may receive payments for lost income on a monthly basis for a certain number of years (or for life).  If he needs all the money at once, he could sell his right to receive the payments to someone else.  The same principle applies for a lottery payout, or any other debt that is being received as a series of payments.

You could purchase the monthly payments from that person using IRA funds.  To do that, you would have to determine what interest rate you would need to receive and then calculate the present value of the stream of payments discounted at that interest rate.  In English, what you are doing is calculating the amount of money that you would have to invest at the stated interest rate to be able to receive that stream of payments for that period of time.

For example:  Someone is receiving $500 per month for 10 years.  If you decided that you need to receive 15% interest, you would calculate the present value of 120 payments of $500 discounted at 15%. If you were to do this in Excel, you would use the function PV (Present value).  The arguments in the function are:

PV(Rate, Nper,Pmt,FV,type)

When you enter PV into a cell, it automatically prompts you for the rest of the information, so you don’t have to remember this.

“Rate” is the interest rate, “Nper” is the number of payments, and “Pmt” is the payment amount.  “FV” is optional, and means “future value”.  It is used if there is a lump sum payment at the end of the stream.  “Type” is also optional.  If the payments come at the end of the period, “type” should be “0” or left blank.  If the payments come at the beginning of the period (ie first payment is made immediately rather than at the end of the first 30-day period) then “type” is “1”.

If the payments are not all the same amount, you would use the “NPV” function, which allows you to enter specific payment amounts.

The biggest risk to this investment is that the payer may not make the payments, in which case you would have to make your own collection efforts. If the payer is a large company, though, chances are you won’t have any problems.

This concept applies to any investment where you are buying a series of future payments.

Stock Options

If you know what you are doing, buying options is a great way to earn a high income, and the tax-advantaged status of the IRA allows you to keep more of that income.

Books can be written (and have been) about investing in options, but basically it works like this:

There are 2 types of options:  Puts and calls.

If you buy a put option you are buying the right to sell a stock at a certain price for a certain period of time.  You would do this if you expect the price of the stock to go down.  Buying the put locks in the price of the stock.  For example, if stock A’s current price is $100 and you think the price will go down, you can buy an option to sell the stock at $100 anytime in the next 3 months.  If the price then goes down you have 2 choices.  You can sell the stock (assuming you own it already) for $100, or you can sell the option.  The option price goes up as the price of the stock goes down.

If you sell a put option you are promising to buy the stock from someone else if they exercise their option.  This is the other side of the option transaction, and is also called “writing a put”.  In this case you are expecting the price of the stock to rise, because if it does, the option will decline in value and the person who bought it will not exercise it.  Puts can be sold as insurance against the decline in price of a stock you currently own, in which case it is called a “covered put”.  If you don’t own the stock it is called a “naked put”.

Call options work in the opposite direction.  A call option is the right to purchase the stock, and is purchased if you think the stock will rise in value, because it would be locking in the purchase price at a lower amount.  If you sell a call you are promising to sell the stock at a certain price and are betting that the price will go down.  However, if the price of the stock rises and you don’t own the stock (which is called a naked call), you would have to purchase the stock in order to sell it to the call holder.  This gives you unlimited liability, which is why you are not allowed to sell naked calls in an IRA.  In order to sell a call in your IRA you would have to own the stock, in which case it is called a “covered call”.

There are also many combinations of options…spreads, straddles, strangles, etc…which are way beyond the scope of this article.

Options are a great way to make money rather quickly, but they are also a great way to lose money just as quickly.  Therefore, you should never invest in them without first either obtaining a thorough understanding of how they work as well as an effective trading strategy or hiring an expert to guide you (I would suggest the latter).  This is definitely not an investment for the faint of heart, especially where your retirement funds are concerned.

Business Assets

This is an umbrella term I am using to cover any assets a business might have, including equipment, accounts receivable, inventory, even the business itself.  If you know someone who is in business and you want to help them out, you could lend money from your IRA.  Just remember that you can’t lend money to yourself or your family (a list of disqualified persons is in a previous article), and you have to make sure that you don’t incur expenses over and above the amount of funds in the account.  If the business operates at a loss, you can’t just add funds to cover the shortfall.   You would have to take on additional debt within the IRA.  Also, if you buy a business that goes bankrupt you may lose your retirement savings.

You could also buy business equipment and lease it out to businesses.  If you are familiar with a certain asset type (construction equipment, medical equipment, office equipment) you could use this strategy.  Just remember that you cannot benefit from the business…therefore you could not be paid for repairing the equipment, running the business, etc.   Your IRA custodian should be guiding you and advising you as to what you can and cannot do.

These are just a few of the options that you have for your self-directed IRA.  For other ideas, just think about what you know, and work from there.  Find an IRA custodian that is willing to think outside the box,  and a tax advisor who will do the same, and you should be able to come up with some great ideas.

In the next article we will talk about the various ways you can invest in real estate (and derivatives thereof) in your IRA.

Please note:  This is not meant as investment or tax advice.  Laws are constantly changing and all advice must be personalized, so you have to consult a competent tax advisor and IRA custodian in order to be able to adapt this information to your own situation.

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