The more I study the differences between Keynesian economics and Laissez-faire economics, the better I understand why Mr. Nabors is saying what he says in his take on the Roth IRA Conversion question.  The fact that our nation’s currency is no longer backed by Gold in order for it to maintain its value allows for the unencumbered printing of new money by the Fed for our government to borrow, and is, by definition, inflation.  This will ineveitably lead to price inflation which reduces the purchasing power, and thus the value, of the currency. 

Which would you rather use to pay your taxes?  Today’s dollars, which you would use when you convert your IRA to a Roth this year, or the dollars whose value will almost certainly be worth far less when you retire? 

As Mr. Nabors points out, converting to a Roth this year is definitely a good deal for the government, but will it be a good deal for you when you retire, especially when you consider inflation? 

Let me know what you think!

“I’ll get back to you in a day or so”? Hardly! I have been swamped with new acquisitions, year end books, holidays, crises of all shapes and sizes, etc. I just didn’t take the time to write any blog posts. And for that I am truly sorry. It has been on my mind for at least the past three weeks, and now I am finally getting going again.

By the way… Happy New Year! It’s 2010!

First, a quick reminder about IRA changes in this new year. Certain restrictions have been removed as they relate to converting your Traditional IRA to a Roth IRA. Now, anyone with a Traditional IRA can convert it to a Roth IRA, regardless of income.

In fact, if you do the conversion in 2010, you may elect to pay the taxes due on the conversion over two years. The fun part is that neither of those two years is 2010! If you elect to pay the taxes in this manner, half of the amount converted will be treated as regular income in 2011, and the other half in 2012. If you do the conversion right now, you may not have to pay any taxes on it until April, 2012, a nice long window to set aside the needed funds.

But does it really make sense to do the conversion? Check out the “final note” at the end of this entry for someone else’s take on the complicated conversion subject. I am not going to try tackling that issue in my blog!

So, where was I? Oh, yes. We were talking last time about deciding which is better, a Roth IRA or a Traditional IRA. As of the last entry, we were talking about whether we wanted to pay the taxes on the Seed (the Contributions to the IRA) or the Crop (the Distributions at Retirement). I’d like to go through a brief analysis of the differences.

Our example from last time is that over 30 years, you have a total contribution of $150,000. Because of the great investments you’ve made, perhaps in Real Estate investments, your account has grown to $2,000,000 when you are ready to retire, which can be done with about a 14% annualized return on investment over that 30 years.

Which would you rather have, the Traditional or the Roth?

Let’s look first at a Roth IRA. If you’re in the 25% tax bracket, each year you would contribute $5,000 to the IRA and pay an additional $1,250 in taxes to the government on that money. Earning about 14% per year over the next 30 years – which, for Real Estate investors or people who know Real Estate investors, is not that difficult – your Roth IRA would grow to about $2,000,000. No taxes are taken out, and it is assumed that all the money in the account is earning 14% or so for the duration.

When it comes time to distribute the money in the account, you take out only 4% — a commonly recommended amount — of the account balance each year, while the remainder continues to grow at 14% per year. Your first year of distributions, you take out $80,000, tax free, and the rest of the account grows to $2,275,000. By year five of distributions, 4% of your account has grown to $134,000, and keeps going up each year.

Now let’s look at the Traditional IRA scenario. You contribute $5,000 to the IRA each year and earn 14% each year and get that account to $2,000,000, just like the Roth. However, instead of paying that $1,250 in taxes each year, you invest it in a taxable account that earns the same thing. (Hey, isn’t it reasonable that if you can earn 14% in the IRA, you can also earn it outside of the IRA?) The main difference is that you would have to pay taxes on the earnings from that taxable account each year.

If you’re putting that $1,250 into the taxable account each year at 14% return, in 30 years, it grows to almost $250,000, after taxes have been taken out each year at the 25% rate.

Guess what? It’s essentially a wash, even at that high rate of return.

Here’s why. When you take 4% from the Traditional IRA ($80,000 in the first year), you can pay the taxes with the earnings – not the principal – from the other, non-IRA account. You can even pay the taxes on the earnings in the non-IRA account, and still have earnings left over to grow the non-IRA account!  All the rest of the money in the IRA is still growing tax free at 14%. Tax free until it’s distributed.

And it happens that way year after year, as long as you earn more than what you distribute each year.

By the way, I’m blown away by this analysis. Certainly, it’s a major simplification. And it would take enormous discipline to not only maintain the 14% return every year, but to keep from dipping into that non-IRA account and using it for other things, such as a new car, or your daughter’s wedding, or even an addition to your house.

But in its simplicity, I have learned something. I have been touting the benefits of Roth accounts for a long time, but now I’m starting to change my tune.  To be sure, there are other advantages of the Roth over the Traditional, such as the inheritance differences. So the jury is still out on the subject, at least for me.

By the way, each individual’s situation is unique. There is nothing here that can be said for everyone. To help you understand what the best course of action is for your situation, you should consult with the financial planner of your choosing.

A final note. I just downloaded and read a very informative special report on whether to convert your Traditional IRA to a Roth IRA. You can get it, too, by signing up at www.RicEdelman.com. It’s called the “IRA Conversion Conundrum”. Very interesting reading if you’re considering the conversion this year. It touches on all the things that should be considered when making this important decision. (By the way, I have no business relationship with Mr. Edelman, so I get nothing for recommending that you check out this report. I just want you make sure you’re as informed as possible.)

Thank you and have a great week!

Think about the last time you were in the grocery store choosing vegetables. Some of them seem rather expensive, don’t they? If you’re like me at all, you think “Gee, y’know, I could grow this in my back yard and get them for almost nothing!” The tomatoes, for instance. When I was a kid, my mother always had tomato plants in the summer that produced what seemed like bushels of tomatoes, all for the price of a few plants. One year, she even started the tomato plants from seeds and really saved a bundle!

But, alas, these days, I just don’t have the green thumb needed to raise a productive vegetable garden. That specialized knowledge has eluded me, or at least the desire to acquire that knowledge has eluded me. It’s not something I enjoy doing for very long. I don’t have a passion for it, or a need for it.

It boils down to this question. Do I want to pay for the seed or do I want to pay for the crop? In this case, I’ve “decided” to pay for the crop at the higher prices because I don’t have the specialized knowledge to pay for the seed and gain the crop at a later time.

There’s a similar question that can be asked when trying to decide whether to go with a Traditional IRA or a Roth IRA. To be sure, there are a number of good questions to ask when trying to decide between a Traditional and a Roth:

Do I need the deduction now?
Can I afford to pay the taxes on the contribution amount now?
What Tax Bracket am I in now vs. the one I’ll be in when I retire?
What do I anticipate my asset base will be when I retire?

But here’s the question of the day:

Do I want to pay taxes on the Seed (the IRA contributions) or the Crop (the distributions at retirement)?

This can be a very important consideration to someone who has specialized knowledge in an investment vehicle that could consistently earn the investor significantly higher than average returns than you might find with a diversified portfolio of stocks, bonds, and mutual funds. And this points to one of the other questions above: What do I anticipate my asset base to be when I retire?

If you anticipate your asset base growing to be significantly higher than the sum total of your contributions over the years, you may want to think about setting up a Roth IRA instead of a traditional IRA. For a Roth, only the contributions are taxed. When it comes time to distribute funds from a Roth IRA, they are distributed tax free.

Now, say over 30 years, you’ve contributed a total of $150,000 to your IRA, and because of your specialized knowledge, of Real Estate investing, perhaps, that your IRA grows to over $2,000,000. Which would you rather pay the taxes on, $150,000 or $2,000,000?

Guess what? The answer is not nearly as straightforward as you might think. Think about this for a day or so, and I’ll be back soon to run an analysis in my next post.

I just read a news article about the various options available when rolling over a 401(k) from a previous employer. (I like to call that an ”Orphaned 401(k)”)   The article talked about the normal options of cashing it out (a bad idea unless you’re over 59 1/2 or you’re losing your house for some reason), rolling it over from the previous employer’s 401(k) to the new employer’s 401(k), or actually rolling it over to an IRA. 

At the end of the article it talks about also converting the 401(k) to a Roth IRA and having to pay the taxes on the amount converted.  That could be “a big shock at tax time”, because the amount converted is added to ordinary income.  In some cases, that could push the taxpayer into a higher tax bracket, and create an unexpected burden. 

The one thing the author failed to mention – which is a very interesting oversight because we are so close to 2010 — is the fact that during 2010, and only during 2010, the government has set up a much more favorable environment for converting from a traditional IRA or a 401(k) to a Roth IRA.   Here are the rules in a nutshell for 2010:

• There are no income limits for converting to a Roth in 2010.  Usually, only those who make under $100,000 are allowed this conversion.
• If you convert in 2010, you can spread the tax burden over two years, by reporting only half the converted amount in each year. 
• If you convert in 2010, you can delay reporting the conversion until 2011.  That’s right.  You can pay the taxes over two years, but those two years are 2011 and 2012, not 2010. 

Adding this information to the article, a clear strategy emerges for those wishing to convert their orphaned 401(k)s to Roth IRAs. 

Wait until 2010.  Heck, it’s only three months away. 

The tax burden, while still there, will be delayed and then spread out over a longer time, giving the taxpayer a decent amount of time to set aside a little each month for the eventual payments needed, making it, in my opinion, significantly more manageable. 

This is definitely one strategy to consider and may not fit for everyone.  As always, and as the article said, sit down with your tax advisor to determine the best scenario for your situation.

Compounding has been called “The most powerful force on earth!” by none other than Albert Einstein, one of the smartest men of the 20^th century. He certainly knew about “Forces”, at least in physics, but he was also well schooled in financial matters and he considered compounding a magnificent invention of the financial world.

Compounding is a financial term bandied about that essentially means earning money on your earnings. Most people associate the concept with Interest, as in Compound Interest. You put money in a savings account at, say, 5% interest, and, for simplicity’s sake, it compounds yearly. The earnings on $10,000 at 5% annual interest for the first year would be $500.

Compounding just means that the base on which you are earning that 5% resets to the $10,000 PLUS the $500.00. So, in year 2, the account earns 5% annual interest on $10,500, which works out to be $525, an increase of $25 over last year’s earnings. Now you’re earning money on your earnings!

This example represents a fixed rate of return, simple interest investment opportunity. At the interest rate and the amount invested in this example, you’d never get rich or earn anything truly significant. However, apply some of your specialized knowledge and compound larger sums of money at larger rates of return, you could start to generate some significant wealth.

For example, say you understand how to wholesale houses, one form of specialized investment knowledge. I have a few friends who are making some serious money doing this. It involves using a small amount of money to control a single family home through a contract to purchase, and then selling that contract to another investor for a markup of, say, a few thousand dollars. If you put $1,000 down as earnest money for the contract and then sell the contract for $6,000 to someone else, that’s a 500% increase on your investment. I know people who can do this multiple times a month.

Another form is to actually purchase the house for $30,000, do a little bit of cleanup for about $1,000 and have some holding and closing costs of about $2,000, and then to sell it to another investor for $43,000. That $10,000 profit represents a 30% Return On Investment. This, again, can be accomplished in 30-60 days.

If you didn’t spend the profits and put them back into the bank to use for more investing, then you are using another form of compounding. This one is not a fixed rate of return and you may not earn money on your entire portfolio with every investment, but you can earn significantly higher returns with that specialized knowledge and do more and more transactions each month with the extra money you have.

Here’s what I mean. If you have only $1,000, perhaps you can do only one wholesale transaction in your first month for your 500% return. After that’s done, you now have $6,000 and you can do three in the next month. Now you’re up to, say, $21,000, for a 350% return. And that’s just in one month! You could conceivably do five or six wholesale deals in a month, but you start bumping into time being your limiting factor, not money. And if you did six wholesales a month at $5,000 profit for each one, that’s one heck of a living!

By the way, this is more than just compounding. This is building a business that will set you for life.

Now why am I talking about compounding on a blog for Self Directed IRAs? Because, of the tax consequences of earning the money we’re talking about are significant if the earnings are not sheltered in some way.

We’ve already talked about the fact that you can do Real Estate transactions in your IRA, including wholesale deals. If you do get up to five or six wholesale deals each month, do you really need that much to live on? Why not take one or two of those and do them in your Self Directed Roth IRA or your Solo 401(k) and let the earnings grow tax free? Then those high compounding rates will not be compromised by removing taxes every year.

And you can experience the true growth that compounding affords!

Last week, I held a three and a half hour seminar talking about Self Directed IRAs.  I talked about the normal stuff you talk about at a seminar — Who I am, why am I qualified to be here telling you this, and, oh yes, the subject matter. 

We talked about what an IRA is, the different types, and a whole list of alternative investments that can be done in your IRA.   We also talked extensively about making sure you don’t run afoul of the Prohibited Transaction Rules.

But the main message that I really hope everyone went away with is this. 

If you have Specialized Knowledge in a particular area that lends itself to being an investment — Real Estate, for instance — combining that knowledge with the power and flexibility of a Truly Self Directed IRA can be one of the greatest wealth building tools on earth! 

Now go get that specialized knowledge and rock your world!

Why use an IRA? In a word, Taxes.

Simple, right? Sure, it’s a simple answer. And obvious, too. But it has significant implications. Take a look.

The basic premise for an IRA is to provide a tax-favored way for individuals to save for their retirement. Whether in an IRA or not, most people know that saving for retirement is the responsible thing to do, and saving for it for as long as possible, i.e., starting as young as possible, maximizes the chances that a person will actually have enough to live on in his retirement.

Let’s look at an example where Mary saves for her retirement inside of an IRA and where Kevin saves for his retirement without the benefit of an IRA. Both are 25 years old when they start saving for retirement, and they both do the exact same things and get the exact same return over the next 35 years.

Each year for 35 years, they each take $5,000 of their earned income, after taxes, and put that toward their retirement accounts. Each of them earns 7% annually on their invested money. John’s earnings are taxed at 25% each year, while Mary’s earnings are not taxed because they’re growing in an IRA.

The results: At the end of 35 years, Mary has almost $740,000 in her IRA, while John has only $501,000. A difference of $239,000. At 7%, Mary is earning over $50,000 a year on that amount, and John is only earning $35,000 on his amount.

What’s more is that Mary has been putting after tax money into her IRA, which means the IRA is a Roth IRA. If she decides to retire now that she’s 60 years old, she can start taking money from her IRA, still without paying taxes. She could take only the earnings every year and have over $50,000, tax free, to live on every year.

However, John still has to pay almost $9,000 in taxes on the $35,000 he’s earning every year. Net, he’s only getting $26,000 a year on his investment, while Mary is earning almost twice as much per year.

The only difference was that Mary used an IRA and John didn’t.

The difference becomes even more pronounced if they are able to use specialized investment knowledge or business acumen to increase that annual return significantly. For instance, raising the annual return to only 12% creates a nest egg for Mary of $2.7M, earning $290,000 per year tax free, while John’s nest egg is a mere $1.3M earning $142,000 on which he has to pay over $35,000 in taxes for a net of only $107,000 per year.

That’s a huge difference.

Bottom Line: Use an IRA. Start early (or now, if early isn’t possible any longer) and learn as much as you can about investing to gain that specialized knowledge that will help you to earn significant returns year in and year out.  You’ll be glad you did!

An Individual Retirement Account (or as the IRS booklet calls it, an Individual Retirement Arrangement), is a personal savings plan that allows an individual to set aside money for retirement in a way that has tax advantages. Investments made within an IRA plan grow in a tax free environment.  IRAs are the result of the Federal government implementing a series of laws designed to encourage people to save for retirement themselves instead of counting on company pension plans or other company retirement vehicles.

An IRA is a type of plan called a Defined Contribution Plan. Before 1974, when the first laws were passed allowing IRAs, most if not all the retirement plans were Defined Benefit Plans. A Defined Benefit Plan, usually called a Pension, detailed the benefits you would receive based on how many years you stayed in the plan. If you stayed on the job for X number of years, your employer guaranteed a pension that gave you a list of benefits AFTER you retired, with the employer taking the responsibility for the cost of those benefits. I won’t go into the issues created in many companies by not funding these liabilities until they were current liabilities….

Foreseeing the potential issues with Defined Benefit Plans, the Feds passed the IRA laws (ERISA in 1974 was the first) to allow companies to transition from Defined Benefit Plans to Defined Contribution Plans, where the onus for building one’s retirement account could be removed from the employer and placed on the employee. 401(k) accounts are the main example of employer sponsored Defined Contribution Accounts where the employee is responsible for the Contribution, directing a portion of earnings from each paycheck to be placed into the 401(k) account. The money so diverted is not subject to income taxes and the earnings on the money in the account are also not subject to taxes.

This transition from Defined Benefit Plans to Defined Contribution Plans really took hold in the 1980’s. Very few companies remain that offer traditional pensions to their employees, but most larger companies offer 401(k) accounts to their employees.

Whereas 401(k) accounts are used in place of employer sponsored pension plans, IRAs establish a way for individuals, outside of employer sponsored plans, to contribute money each year toward their retirement. Many different IRA types exist, each with their own requirements and characteristics. Recently, new types of IRAs or IRA-like accounts have been introduced which encourage individuals to save for other life events apart from retirement, such as Education and Health Care. All these types of accounts have as their main benefit the fact that the money in the accounts can grow tax free while still in the account.

To summarize, an Individual Retirement Account allows you to contribute money from your earnings each year toward saving for your retirement. In most cases, the amount of the contribution is deductible from your taxes and any appreciation you realize within the account is not taxed while it is still in the account. These benefits alone are enough to encourage millions of Americans each year to contribute to IRAs to save for their retirements.

I appreciate your indulgence as I get going on this blog. I have had a couple false starts, but I am getting back in the saddle again. I have a number of posts ready to go and more lined up behind those. Back in March, I was talking about 401K(s) and IRAs, and some of the alternative investments you could do in them. Back then, the stock market was hitting new lows and it was looking pretty dreary.

In the meantime, though, the stock market has bounced back from those lows and has been very impressive. From a technical standpoint, we are out of the bear market because we have come back over 20% from the lows. In fact, from its intra day low of 6440 back in March, it has soared almost 45% to close yesterday at 9320. Anyone who caught that rise has seen a nice run up in their portfolio. Not enough, probably, to recoup all the losses from the previous eight or nine months, but a nice change of pace, though.

At the same time, my investors continue to chug right along at a nice solid, consistent double digit return on their investments. Not as much as the stock market during the past four months, but then, they don’t have to worry about whether it’s going back down sometime soon or not. And the reason for that is the ACTUAL topic of today’s post.

You see, the last time I wrote, I talked about investing directly in Real Estate, specifically owning and managing rental property, within your IRA as a means of making some surprising returns on your investments. But being a landlord is not for everyone. Most people at this point are saying, “I’ve never done anything like that. I don’t know how to buy an investment property and fix it up, let alone find and manage a renter. Especially, if I’m not going to get any immediate benefit from it. I mean, I have to wait until I retire to take advantage of the money in my IRA.” In addition, you probably have a full time job or a business that isn’t directly related to real estate. Who wants to take the time to learn all that you need to know?

Good points, all. Which leads me to another type of investment you may hold in an IRA. Secured Loans. In this case, that means a Promissory Note and a Mortgage. I call them Private Mortgages. Do you know someone like me who invests in Real Estate? Who buys houses or apartments, fixes them up, and either sells them or rents them out? Instead of getting directly involved in the Real Estate Investing world by doing it yourself, why not become indirectly involved by lending money to those folks at very attractive rates of return, with all the profits from them going back into your IRA tax free?

Here’s what I mean. I’ve been an investor for a number of years. My preferred way to finance my properties is to use other people’s money. When I have a house to buy and renovate, I usually borrow the money from a private individual to purchase, fix up, and then market the property for sale. In return, the private individual gets a higher than normal rate of return for the money, plus a recorded mortgage on the house I buy. He acts just like the bank, with all the rights that come with it, including the right to foreclose and take the house back, if for some reason I default on the loan. (I’ve never done that, by the way, and I run my business so that I never will have to, the Good Lord willing!) When I sell the house, I can pay off the mortgage and pay back the private individual.

And as I said above, this can all be done with IRA money, as an investment of the IRA. The money is invested with the Real Estate investor directly from the IRA. Along the way, monthly payments on the mortgage are made directly to the IRA and the interest portion of those payments is the profit for the IRA. When the Real Estate investor sells the house, the money from the payoff of the mortgage goes back into the IRA, and it’s then ready to start the process all over again.

What are the benefits of this type of investment? They can be significant.

• Higher rate of return – what has your return been lately?
• Consistent rate of return – the rate is fixed, instead of heading up or down on the day’s news, over which you have absolutely no control.
• The investment is secured by significant equity in Real Estate – for many investors, the total loan to value of all loans against a property stays below 60%.
• Passive investment – Just set it and forget it!
• It’s growing tax free in your IRA – and if it’s a Roth IRA, you’re able to even take it out TAX FREE when you retire!

Investing in Private Mortgages. Even in today’s market, they can provide a safe, secured, high return investment alternative to the ups and downs of the stock market.

The last time, we talked about 401(k)s and the alternatives you have with your 401(k) when you leave a company.  I mentioned rolling your 401(k) over to a Self-Directed IRA was my favorite option.  An option that opens you up to a whole new realm of investment possibilities.

Here’s an example.  Did you know that you may purchase and hold Real Estate in your IRA?  With the proper custodian in place, you can direct that custodian to use money in your account to purchase a Single Family Home in Westland, MI, say.  Subsequently, you may direct the custodian to pay, from your IRA, for the fix up costs of the property.  Then you may put a renter in there and all the rental income goes back into your IRA.

I know what you’re saying.  “But, like stocks, house prices are falling all around us, too!!!  That’s going to cause my retirement account to slide further!”  And on the surface, that’s a legitimate concern.  But let’s look a bit deeper.

When you purchase a stock, there’s a set price you have to pay.  That price is what the stock is going for right now on the market.  There’s no negotiation, just pull the trigger and hope you get it for less than what you saw it for a few seconds ago.  And then hope that is goes up in order to collect a profit.

When you purchase a house, especially in today’s buyer’s market, you have much more flexibility.  The fair market value of a house, even in today’s market, might be $100,000, but what if it’s bank-owned?  I have picked up houses recently for 25 cents on the dollar from banks.  In our example, that means we could pay as little as $25,000 for the house that’s worth $100,000.  Even if the value of that house drops another 40%, I still have equity that can be recouped.  And that means I have at least some of my profit baked into the purchase right when I buy!

Many of the homes out there at prices like these need little more than carpet and paint.  To be conservative, let’s say I spend $10,000 in remodeling, holding, closing and marketing costs, putting my total cost at $35,000.

In addition, rents have stayed relatively stable.  I can rent that house out for $850 a month!  With only $35,000 into the house, adding up that $850 over a year gives me over a 29% gross cash on cash return EACH YEAR on my retirement funds, regardless of the value of the house!  Now to be sure, there will be some other costs to renting the house, some of which may significantly reduce your return (like vacancy!). 

Next time, I will address the next question that is going on in your minds right now.

“What?  Me a Landlord?”