Since the early 2000′s, the number of self-directed IRAs has more than doubled! These plans give individuals the ability to invest into assets that they understand and can control such as real estate. Investors who have knowledge and expertise in a particular investment can purchase them in a tax-free or tax-deferred environment
The and Checkbook IRA and Solo 401k are viable solutions that allow you to investment in virtually any asset including real estate, provide you with “Checkbook Control” over your retirement account, and minimize or eliminate custodian fees.
In this episode we talk to Dmitriy Fomichenko the founder and president of Sense Financial Services LLC, a boutique financial firm specializing in self-directed retirement accounts with checkbook control.
We also take a look at another available turnkey investment property in our Deal of the Day segment.
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Investing Using Your Retirement Accounts
Today’s show is about self-directed IRAs and Solo 401Ks. What is that? These are retirement accounts. A lot of people don’t realize what they can and can’t do with retirement accounts. Most people use these accounts to sock away some savings and then invest in mutual funds or the stock market, which I don’t personally think is a great investment. A lot of people don’t realize that you can turn those retirement accounts into self-directed retirement accounts where you can actually invest in whatever asset class you want.
There are very few restrictions but the great thing about it is you can invest in passive income investments like notes and income producing real estate. You can do this quite easily and you can have complete control over it. You know I’m big on control. It’s my ninth rule of successful real estate investing. When you have the control to invest and direct the funds within your retirement account into assets that you have complete control over as well because they’re hard assets, then you have an amazing and a powerful combination.
The contribution limits on some of these retirement accounts are actually quite impressive. A lot of people don’t even realize that they can do a lot more with their retirement account than what they are told they can do by their financial planners or stock advisers or custodians, because they really don’t know about it or they don’t want you investing in other assets. Today, we have a great guest who is someone I’ve known for many years. He specializes in working with investors who want to use their retirement accounts to invest in real estate related assets.
I’d like to introduce and welcome Dmitriy Fomichenko to the show. Dmitriy is the founder and president of Sense Financial Services, a boutique financial firm that specializes in self-directed retirement accounts with checkbook control. He began his career in financial planning and real estate investing fifteen years ago. He now owns multiple investment properties in various states and is a licensed California real estate broker. Dmitriy, welcome to the show.
Thank you, Marco. It’s great to be here with you.
I love your subject matter. I think it’s going to be invaluable to our listeners. Let’s begin by just asking the question: Where are you located?
Here in Southern California, in Orange County.
I met you back in the mid-2000s. Back then I know you were involved in selling investment properties, so you had your feet wet with investment property. My question is, at least to get things started, how did you go from real estate investing to starting Sense Financial?
That’s a really good question, Marco. It actually ties in close together. My background is in financial services. Actually as you can hear from my accent, I’m not from here. I emigrated in United States from former Soviet Union back in 1996. I didn’t speak in English at that time. I didn’t have any money. But I came here with the end in mind. I knew this was going to be my home.
A few years after coming here, I was introduced to a subject of real estate investing. Back in 1999, I came to one of the local meetings and it was life changing for me. It actually took me about two years to acquire my first property after I attended the meeting. In about 2000, I purchased my first property and then a year later, I purchased my second property. That was a really good timing here for California real estate. Both of those properties, they almost tripled in value. I had a good start and I basically just used that and leveraged that to start buying more properties.
Eventually, I started working for a local real estate investment firm, basically teaching other investors how to invest or how to grow their portfolios. Back in 2009, 2010 or so, it was a downturn in the market, and many people had damaged their credits. People wanted to buy more properties but they don’t have the ability to qualify for loans. I knew it was possible to use retirement accounts to invest in real estate, so I started researching the subject and just pulling all the information together, meeting with the experts and just started helping few clients first to utilize their retirement accounts. Then opportunity presented itself, and I went on my own and I started Sense Financial and pretty much the rest is history. Most of my clients they invest in real estate. My financial planning background and real estate investment experience really merged nicely together to help my clients.
That’s a great transition. It’s a niche that you found because from my perspective, it’s highly untapped. This is mind-blowing. The last ad that I read was at the end of 2013, there were $6.5 trillion piled up in individual retirement accounts, which is a mind-boggling number. $3 trillion of it, that’s about half, was “invested” in mutual funds, which I personally think is one of the worst investments anybody could make. It’s just a low return high risk type of investment that you have absolutely no control, no tax benefit.
I think you’re in a great space and in a good niche. That begs the question: Why don’t more people take advantage of using their retirement accounts to invest in other investments, more prudent investments instead of just dumping it into the stock market and giving that control over to Wall Street?
That sounds a good question, Marco. I think the number one reason is because people just simply don’t know that it is even possible. When I talk to somebody and tell them that you can use your retirement account to invest in real estate or you can become a private lender and lend out of your IRA or 401K, people disbelieve that. The reason for that is because most of us have been conditioned by the industry to believe that all we can do is just buy or invest in stocks and mutual funds because your financial advisor or stock broker, they don’t want you to know it’s possible. They want you to keep investing, using them and their services.
You got to ask yourself this question, if you have a retirement account managed by somebody else, is there somebody else who’s going to care more about your retirement and about the performance of your retirement account more than you do? I’m sure you’re going to come up with the right answer, that’s really no. No one is going to care more about that, that’s why you need to be in control. You need to learn this and you need to make the right decisions.
Another point that I’d like to make, that’s actually was the reason why it drove me out of the financial services industry is that, if you have your money under management by some advisor, just like most people, if they make money off of your investments, regardless whether they’re going up or they’re going down, does that make any sense? You got to ask yourself this question. To me it doesn’t make any sense, but that’s how most people are. They have their portfolios with some advisor and they get a percentage of assets under management, regardless of the performance. You just need to get out of that situation.
I agree with you. Most people don’t realize that they can take their retirement accounts and take control and direct the funds that are in their accounts into other investments. I’m a big fan of maintaining control and having direct control, it’s my ninth rule of my Ten Rules of Successful Real Estate Investing. This is a great way to do that, to take control back over your retirement funds and put them into alternative. I don’t like that word, alternative, because I think real estate is really primary investment class.
You’ve got three primary types of retirement accounts. Correct me if I’m wrong in this, but my understanding is you’ve got the self-directed IRA, then you have a variation of the self-directed IRA, which is a self-directed IRA with checkbook control, which I’ll let you explain in a minute. Then last but maybe not least, you have this more mysterious type of product called a Solo 401K. Maybe it’s best if we just go down the list and you can compare and contrast each one of these so the audience understand what they are and the pros and cons of each.
Let’s start with the self-directed IRA. If most people thought about self-directing their retirement accounts, they probably know what the self-directed IRA is. That is a custodial account just like your conventional IRA or 401K that is held with Fidelity or Schwab or Merrill Lynch or Wells Fargo. It’s a custodial account, but it’s with a self-directed custodian. It’s a custodian that allows you to use your retirement dollars and make other alternative investments. I know you don’t like that word but alternative to the stock market which is the norm, what most people offer up.
You can use the self-directed IRA custodian and then you can tell them, “I want to buy a property with it or I want to do a private loan out of my IRA.” They can help you make that happen. There are some drawbacks to this model. If you’re just making one single investment that might be fine, but if you have multiple investments, if you’re more hands-on and you’re doing more active investing then there’s some disadvantages working with a custodian directly, because you don’t have access to your funds directly. You always have to go through a custodian.
To give you an example, I go to investor meetings often. I just do network with investors and often deals are made at those meetings. If there is a wholesaler there and he has a deal and you happen to learn about that. If you wanted to purchase that inside of your retirement account, you can’t really do that, because you have to submit a paperwork to the custodian and then get that approved and then they will issue the check. It’s going to take several days, but if it’s a great deal, it’s going to be gone by then.
Also, every time you do a transaction, whether it’s making an investment or paying a bill for the investment property. It comes with the fees. Custodians are there to make money. They don’t make money off of your investments like traditional custodians, but self-directed custodians make money when you make transactions. If your account is sizable, it’s very possible you might be paying a thousand dollars or more.
Alternative to that, to gain the control over your retirement account and to reduce the cost is to do what’s called a checkbook IRA. It is also known as an IRA owned LLC. It’s pretty straight forward, the way it’s done. They make investments with your retirement account directly under the custodian, set up a special purpose LLC and they specialize in doing that. Then, your IRA makes the investments into the LLC. Basically, IRA buys units of the LLC. It has a special purpose single-member LLC that is created specifically for the purpose to be owned by your IRA.
Your IRA owns the LLC. You become a manager of the LLC. As a manager of the LLC, you literally have now checkbook control over your retirement account. You open up a bank account for the LLC as a manager. You’re the signor on the account. Now, you can make all of the investments in the name of the LLC without going to a custodian, so you can simply write the check for the same deal, you can just write the check and execute transaction immediately.
What you’re saying is you have a single-member LLC set up that obviously has its own checking account. That LLC is owned 100% by your IRA and is obviously inside of your IRA. The fact that you’re a manager of that LLC, it allows you to write checks or make investments directly without going through a custodian for approval.
Exactly, the custodian is still there, you can’t eliminate the custodian with this set up. They are required by the IRS to hold your IRA. The investment of the IRA is the LLC and that’s what allows you to bypass the custodian when you make the investment. A custodian is still there but they’re a passive custodian.
You obviously still have to follow all the rules and regulations that define a retirement account, an IRA.
That’s right. There is a prohibited transaction rules that still would apply to the IRA owned LLC, just as it will apply to an IRA itself.
Are there any drawbacks to this particular set up, having an LLC inside of an IRA?
There could be drawbacks. For example, you and I live in California so if you are conducting business in California, if you make investments in California, the California LLC comes with the higher price tag. That could be one of the drawbacks. If you’re not conducting business in California, then you can go with the out-of-state LLC, that’s also a possibility. But it really depends on everyone’s particular situation. Once I know more of a situation and the size of the account and the potential investments that they want to make, then I can make a recommendation on what makes more sense.
Tell us about this more mysterious Solo 401K because I’ve learned a little bit about it. I really like what I see and from what I understand it sounds like a great tool for many, many people. Maybe break it down, tell us what it is, how it works and what makes it different than the more traditional 401K that people have with their employers.
Solo 401K is just as the name implies, they are designed for those people who are either independent contractors or they have a small business where it’s just the business owner and maybe his spouse. You can actually have part-time employees who work under thousand hours a year. If you’re in that situation, if you’re self-employed or own a small business without full-time staff, then you can adopt a solo 401K.
The solo 401K is basically your traditional 401K but because there are no other participants in this 401K other than yourself and your spouse, there are no employees that participate then it doesn’t have to go through the same qualification and testing requirements like other full version of 401K. You can say it’s a simplified version of the 401K. It’s a lot easier to maintain. It’s a lot more cost effective.
If you have a self-directed solo 401K, it comes with a number of great benefits. Number one, the Solo 401K doesn’t require a custodian unlike an IRA. For an IRA, a custodian is required, that’s an IRS rule, we can’t do anything about this. You can bypass the custodian by setting up special purpose LLC just like what we discussed to get the checkbook control. With Solo 401K, the custodian is not required but what’s required is that the assets of the 401K be held in the trust.
What we do is we create a trust specifically for the purpose to hold assets of the 401K. The client becomes the trustee and the administrator of the 401K. That also gives you a checkbook control so that you obtain a tax ID number for the trust. You can go to any bank of your choice or any financial institution and open up a bank account in the name of the 401K using 401K trust tax ID number. You now have a checkbook control over your retirement account.
I was frustrated in the years passed with the limitations that IRAs and self-directed IRAs have in terms of what you can contribute every year. But with Solo 401K it seems that you have a much higher cap, do you not?
That’s another great benefit of having a Solo 401K comparing with the self-directed IRA. With the traditional and a Roth IRA, you can only contribute up to $6,500 per year. The limit with the Solo 401K and contributions is $59,000. That’s pure participant. If you’re a husband and wife team working together, if you own a business together, you can potentially shelter up to $118,000 of your income combined into a retirement account. Think about the tax impact it’s going to make.
This is perfect for a higher income earner.
Definitely, they’ll have more benefit but for average folks too. If you can shelter significant portion of your income into a retirement account that lowers your taxable income and that lowers your taxable bracket too. It’s just a great tax sheltering vehicle that not only gives you control, but also gives you some tax benefits.
Aside from the higher caps, contribution limits that the Solo 401K offers versus a self-directed IRA, in what situation will a person want to go with a self-directed IRA as opposed to Solo 401K?
Let me talk about a couple of other things. What the Self-directed Solo 401k also has is what’s called the participant loan. In a participant loan, it allows you, the plan participant, to take a loan from your retirement account.
Think about this, if you have an IRA and you’re 40 years old or whatever, if you’re under retirement age, and for some reason you need some cash, you can’t access your IRA because if you do, you’re going to have to pay taxes on it, plus the penalties. The combined impact might be up to 50% will go to taxes and penalties. If you have a 401K, the IRS allows you to take a loan from your 401K up to $50,000 or 50% of the balance, whichever is less, and that can be used for any reason, anytime, normally it’s a five year loan. It’s a great, great tool.
We talked about the high contribution limits, we talked about the loan which I call that, you now create your own bank. Think about this, if you ever need money, you go to the bank and you apply for a loan. You wait for their approval. If you have a Solo 401K, you now have your own bank that you’re the one who’s approving it. If you need to take a loan, you’re the administrator of the plan and you’re the one who’s approving this loan. You’re applying for the loan and you’re approving that. It’s a great, great feature.
Another benefit that’s worth mentioning is the ability to make after-tax contributions into a Roth 401K. The Solo 401K comes with the ability to have a Roth account and you basically, can make contributions post-tax. Comparing with the Roth IRA limit of $6,500, the Roth 401K limit is $24,000. That is not subject to income limitation, because with the Roth IRA if your income is over a certain limit, then you can’t contribute to Roth. But with the 401K, if you make a million dollars, you can still make a contribution to Roth 401K.
Just to be clear, the difference between a Roth and a regular IRA is the Roth uses after-tax dollars whereas a normal IRA or self-directed IRA, you’re putting in before tax dollars. The same applies to the Solo 401K. If you have a Roth Solo 401K, what you are contributing are after-tax dollars versus the pre-tax dollars in a Solo 401K. Is that true?
That’s right.
I don’t want to play devil’s advocate here but I’m just wondering, most people are probably quite honest and they’ll manage their self-directed IRA with the checkbook or more particularly the Solo 401K honestly. But I see an area here for abuse. Is it possible for people to abuse the funds in their Solo 401K and take the funds out and use it for things they shouldn’t be?
It is possible, yeah because you have the control, but with control comes the responsibility. By setting up the 401K and by becoming the administrator of the plan and the trustee of the plan, you now have taken a fiduciary responsibility. That is the same of an attorney. If you are an attorney and somebody came to you and asking you to represent them, then you have a fiduciary responsibility to do what’s best for that client.
The same example can be with a real estate agent, if you’re a real estate agent and you have a client who wants you to sell their home, you are to do what’s best for them, not for you. You have the same fiduciary responsibility and you’re to act accordingly. If you want to play with that and obviously, the penalties are very serial for violations up to 100% of the account balance. You can actually lose it all by messing with this, so it’s not worth it. It’s not difficult to manage that. The rules are very straight forward. We provide guidance and support to our clients if you’re not sure.
The bottom line is that it’s very difficult to commit a prohibited transaction unintentionally. Intentionally, yes, you can make that happen but unintentionally, it’s very difficult. If you’re not sure, just ask.
Without going into too much complexity, how do people qualify for these particular plans? Is that what you call them, plans?
Yes, Solo 401K plans. Basically, there are two things that’s needed to qualify. If you are self-employed, if you have some self-employment income that you’ll report on a schedule, you qualify. If you own a business and you don’t have full-time employees working more than 1,000 hours a year for you, then you qualify. That does not include you and your spouse. Obviously, you and your spouse can work full-time for your business and you’re fine because you’re considered owner-employees. You’re just not allowed to have other employees working more than a thousand hours.
Once you understand the benefits of the Solo 401K plan, if you don’t qualify it’s not difficult to qualify. There are a number of opportunities that you can generate self-employment income, especially in this day and age when we’re living in electronic society. If you’re good at something, you can find with the help of the internet, with the help of the web, you can find people who need your services. You can easily generate some self-employment income. You can get involved in some network marketing organizations.
I know people who are part of that, some of the network marketing organizations, not necessarily to market the services but because they believe in those products and they just use their membership just to buy their own stuff for themselves and they generate some self-employment income. That makes them eligible.
I know we spoke about this question before, I have reluctance in using an IRA or Solo 401K but I guess it’s really client specific. When you put property into a retirement account of some sort, you lose that depreciation benefit because you have to maintain separation between you and your assets within the IRA or the Solo 401K. Therefore, you can’t take the depreciation benefit.
Dmitriy, when does it actually make sense to use your funds within your IRA and 401K to acquire these assets? This is the reluctance that I have with using retirement accounts. But I guess for many people it does make sense, maybe you can touch upon that.
The depreciation equation sometimes confuses people because they’re trying to compare apples to oranges. When you buy a real estate inside a retirement account, there is no depreciation deduction because it’s a tax defraud vehicle that you’re using. You need to compare that with where is your current retirement account invested? If it’s invested in a stock market or mutual funds, you need to ask yourself a few questions. Number one, what kind of control you have over your investments? Number two, what kind of returns are you getting from your investment?
To answer that you have, I’m sure the audience will agree that you and I, we have every little control over the stock market. We pretty much have no control over the performance of the stock market. We can try to guess it and time it, but that’s it.
When you buy a real asset or some other alternative investments, like if you do a private lending or investing trust deeds or mortgage notes, you have control over what type of property you’re buying, the location of it. You have control who’s going to live in it, as far as the improvements you’re going to do on the property and you have a lot more control.
It’s a tangible asset that’s not just going to appear overnight, which may happen with some of the companies that you invested in. As far as the performance, if you’re investing in a stock market, how has it done for you? Most people, if you will, it’s probably between 3% to 7% an average over the long term. If you invest in a real property or buy a trust deed, if your performance is better than that then it does make sense because it’s lower risk and better performance even though there’s no depreciation.
I personally believe there’s a lot more risk now investing in the stock market than there was in years past. I think the stock market is over inflated and I think many economists are saying that there’s a lot of downside risk or a coming correction. Who knows? A crash in the stock market today could potentially be much bigger than what we saw in 2008.
It’s a very scary place to be. Sometimes it’s better to sit on the sideline and cash and just wait it out, but the disadvantage of that is your cash is being eroded away every year through inflation. Investing in income producing real estate is for many people, in my opinion, for most people, the best decision to make from an investment perspective.
Let’s just touch on financing real quick here. Financing is a possibility within a self-directed IRA or Solo 401K, but it needs to be non-recourse, meaning you have no personal guarantee tied to that financing. Can you comment on that real quick?
Correct, if you have funds in the retirement account and consider buying a property, you don’t have to have all cash. You can get a mortgage typically you need about 40% down because it has to be non-recourse loan. Non-recourse means that the lender has no recourse against yourself and your IRA. The property is the only security for the loan.
They’re pretty easy to get about the same, your credit is not important here because the lender is not looking at your credit. They’re looking at the property. Make sure the property has a value and it produces sufficient cash flow to pay the mortgage. You can easily get the mortgage on a property.
We do work with some lenders that will finance investment property within a retirement account. That’s definitely an option for our clients. Dmitriy, is there anything I didn’t ask you that maybe that I should have asked you or that you just like to add in wrapping up here?
I think we talked about a number of different topics. We can go by, we can keep talking but I know your time is limited. If anybody wants to learn more about this, you can just give them my website and just direct them what they can learn more because our website is very educational.
That’s how I usually wrap up the interviews, just letting you give our audience your contact information and tell them how they can find you on the internet or wherever. Why don’t you just do that now?
Our website is SenseFinancial.com, you can reach us at (949) 228-9393. I do offer a complimentary consultation to all of the listeners so we can chat about your situation, you can ask questions and I can learn more about you a little bit and your situation and give you a best recommendation.
I know Dmitriy is a very stand-up guy since I’ve known him for about ten years. Dmitriy, the information you’ve provided today is very valuable. I know we could’ve spent at least another hour on this subject because it gets quite deep and sometimes it’s difficult to keep this out of 30,000 foot level.
If anybody is interested in more information, they can just go to your website and contact you directly and you can educate them. Plus, your website is full of information, so it’s a great educational tool. Thanks for your time today, Dmitriy. I appreciate you being on the show.
Thank you for having me.
Thanks.
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That wraps it up for this episode. Be sure to download our free report, The Ultimate Guide to Passive Real Estate Investing. You can find that at PassiveRealEstateInvesting.com. While you’re there, be sure to submit a question or topic for our future show. More importantly, be sure to subscribe to our show on iTunes or Stitcher Radio. That information is on both of our websites.
We want to thank everyone for listening. We appreciate you being here. We will see you again on the next episode.
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