Gimme (tax) Shelter

It goes without saying that any investment is made better if it can be sheltered from tax. So for this blog entry, we’d like to explain how to do that with any purchase of our notes.

Let’s start with the disclaimer that we are neither accountants, tax advisors, nor tax attorneys. What follows, therefore, should be considered as ideas or inspiration, rather than specific advice for any given situation.

With that said, individual retirement accounts (IRAs) were created to incentivize individuals to save more for retirement by investing in any of a wide range of products. We’ve all heard of various flavors, such as traditional, Roth, SEP, and self-directed (or SD-IRA). For today, let’s focus on the last of these—the SD-IRA—and what sets it apart from all the others.

Typical IRA custodians (think Fidelity, Schwab, Vanguard, etc) have a clear incentive to sell securities that are publicly traded—stocks, bonds, mutual funds, and the like. This is in part because they actually operate some or all of the funds in which they’d like you to invest, but also, and in their defense, it’s easy work for them as a custodian to track purchases, daily values, dividends, and redemptions. For that reason, custodial fees are often pretty small.

So why don’t these “typical” IRA custodians also let you invest in other, “unconventional” vehicles, like private equity, hedge funds, real estate, promissory notes, precious metals, or cryptocurrency? The short answer is that it’s just more work and expense (not to mention the fact that these custodians don’t offer such investment products), because there is extra paperwork, tracking of funds, and reporting requirements for these types of investments.

Enter dedicated SD-IRA custodians. These aren’t generally household names, and their custodial fees are generally higher. But that’s because they cater to smaller audiences and have to do substantially more work to ensure compliance with IRS laws and guidelines that enable IRA funds to be used in these unconventional investments. The investor may feel some pinch points at time of initial investment (needing to complete additional forms and submit additional documents from the entity in which s/he wishes to invest), and when fees are assessed (often on a quarterly or annual basis). But we can assure you that these extra steps and fees are well worth it for the tax deferral.

Let’s run two quick examples to see why. Example #1: say you invest $100,000 in a promissory note with a 10% annualized return, without any sort of tax shelter (like the SD-IRA), and let’s say your effective federal tax rate is 20%. That means the promissory note would pay you $10,000 each year, but about $2,000 of that would go the IRS.

On the other hand, Example #2: say you make that identical investment, but do so in a SD-IRA account. Now the annual 20% federal tax burden is removed, but you have effectively “traded” that for a custodial fee of 1-3% annually (depending on custodian, size, and nature of your investment). So now your $10,000 annual investment return loses perhaps $300/year in fees….far less than $2,000 in taxes. You’ve seen the charts on the effects of compounding it, so I won’t belabor it here, but that extra $1700/year (or so) over a typical IRA holding period will make a pretty massive difference (almost $210k, by our back-of-the-envelope calculation!—assuming a relative modest 8% annualize return on that $1700, each year for 30 years).

We at Coldstream Partners are therefore happy to help with the legwork of working with any SD-IRA custodian. We can provide investors with a list of such custodians, and then can provide any custodian all the paperwork to make the process as easy as possible for the investor.

By the way, for the uninitiated, the title of this post is an homage to perhaps the greatest Rolling Stones song of all time. If you’re like us, and wondered what the lyrics are, here’s a helpful illustration.