I am of course a CPA and not a financial advisor. But for many clients I am their first point of contact. They would rather ask me a financial question before they bounce it off their financial planner (if they even have one).
Even though I don’t give financial advice, I have seen many things over the years. I have had many clients make good decisions and many more make bad decisions. It seems the poor decisions often stick out in my mind. However, there are a few situations in which 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.
I had a client who was planning to invest in some private stock of a small start-up hospital. He was questioning how the investment should be structured. 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 has in retirement accounts. The amount of the investment was relatively small for him – $50,000. But he did have a few options available to him.
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 wanted to proceed and the dollar amount of the investment wasn’t sizeable based on his financial situation. He was going to do it.
Since he was so sure of the investment I asked him if he had a Roth IRA. He wasn’t exactly sure what that was and said he didn’t have one. We ended up converting funds from his traditional IRA that were pre-tax and put them into a Roth (after-tax). He had to pay tax on that money right away but he could pull it out later tax free. This is a great strategy if you are betting on a substantial return on your investment. Let me explain.
What is a Roth?
Many people utilize a traditional IRA and many folks have heard of a Roth IRA. 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). But the advantage is that you are not taxed when you pull the money out (provided certain conditions are met). A few key components of a Roth IRA are:
- 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 ½.
- Roth IRAs are not subject to Required Minimum Distributions (“RMDs”).
- The specific account must be designated as a Roth when it is established.
But there is one additional important point to note. While a Roth typically is used to invest in securities like stocks, bonds and mutual funds, they can also be used for alternative investments. This would include 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 not any different than other IRAs. It is unique in that it is 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? 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 ½ 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.