Our friends at the American Association of Private Lenders (AAPL) have their fingers on the pulse of the market providing key insights, education, relationships and opportunities to individual and corporate level investors, vendors, and industry professionals. Turbulent times call for a responsible plan to build wealth. Our colleague Clay Malcolm shares The Evolving Mentality of an IRA investor as we travel through the stages or seasons of our lives, our needs change so should our strategies.
The attractiveness of IRA investing may depend upon the age of the investor.
Any person may simultaneously be two investors. On the one hand, someone may be purchasing assets with tax-advantaged money (i.e., held within a Traditional IRA, Roth IRA, 401(k), health savings account, etc.). On the other, they may be purchasing with personal money (i.e., nonretirement funds in a checking or savings account).
As you may know, one of the biggest advantages of a self-directed account is that you can exercise your own investment expertise and combine it with tax advantages. This is true whether the account is originating a note, buying an existing note or a fraction thereof, or investing in an entity that is making loans. Does that mean the investment strategy for both these sources of investing is the same? Often, the answer is “no.”
What is the difference between an IRA investor and a personal funds investor? The short answer is time, or at least the perception of a timeline because of the nature of the rules attached to tax-advantaged accounts. As an investor gets older, the contrast between IRA investing and personal investing tends to be less dramatic, but the interaction of time with asset selection and account rules is always influencing the decision-making process.
For a younger investor, the benefit of an IRA may seem a long way off. In a Traditional IRA, the account holder, with a few exceptions, must wait until at least age 59.5 to take a nonpenalized distribution of any of the cash or assets in the account. Because the wait seems so long, a younger investor may be more interested in investing with personal funds than with tax-advantaged funds. The earnings from these personal investments are more immediate. The investor interacts with the earnings as they come in, including spending the earnings or reinvesting them—and certainly paying taxes.
Traditional IRAs, HSAs and 401(k)s do have one avenue for immediacy: the tax deduction the investor gets for making contributions. Assuming this younger investor has established some cash in a tax-advantaged account, there seem to be some factors at play that influence their asset selection. It is a common perception that younger investors will opt for more risk. That may be a logical assumption, but there are some competing perceptions. One is that you need to be more careful with tax-advantaged account investing because it is “for retirement.” The thought that this money must be treated with care or the investor will be left out in the cold in old age is prevalent.
Whichever risk tolerance paradigm reigns for a particular investor, there are a few factual elements for the thoughtful investor at this age. First, the compounding effect of investment returns being tax-deferred has the most power for the younger investor. A risk-averse approach that provides consistent returns may very well produce excellent long-term results. A risky approach that provides one or two big wins can set the account up for more flexibility later.
Second, the younger investor may not need cash earnings. This may mean that a growth equity investment or a long-term debt instrument with interest-only payments could be more attractive than they might be for an older person.
And, last, the choice of a Traditional or Roth IRA may be a more relevant consideration at this point. An investor who is not in a high tax bracket at this age may sway toward a Roth because they do not need a deduction and because their tax bracket later (when they are going to take distributions) may not be lower than it is currently.
Investor who are between 45-70.5 years old have different time considerations when choosing an investment strategy. Investors in this age range demand more thought about tax-advantaged accounts due to the 59.5 age threshold. Retirement accounts are only part of a person’s total financial picture, and when distributions without penalty become available, a person’s personal and IRA finances often become more intertwined.
A prominent consideration at this point for the account holder is to assess the need for distributions. In a Traditional IRA, when the investor is 59.5-70.5 years old, distributions may be taken, but they are not required. Therefore, the account can continue to create earnings and compound, and/or it may be time to start taking money or assets out. This determination will likely affect the investment strategy. One of the advantages of debt assets in an IRA is the ability to determine cash flow and the period over which that income will persist.
It is a common strategy for an IRA to originate a note or notes that produce payments that align with the account holder’s personal cash needs. Principal and interest payments are made to the IRA, and then the account holder establishes a periodic distribution from the account. In a Traditional IRA, these distributions are taxable, whereas they are not if the account is a Roth.
Investors in this age group are also likely to be thinking about their risk profiles. If the preference is to be a little more conservative, the investor may look for debt that has significant collateral attached to the note. Remember, an IRA does have some restrictions in terms of the assets the account can hold. It may be prudent, therefore, to avoid allowing collectibles as collateral for a loan. While allowing collectibles as collateral is not a prohibited transaction in and of itself, collectibles received by an IRA will need to be liquidated in the event of default.
There are often more strategy adjustments being made to account activities and investment preferences for account holders over age 70. Certainly, the risk consideration for investments, mentioned previously, is front and center. It is common to see account holders opt for investments with lower return and less risk as they get older.
As for account changes at this age, remember that the ability to make contributions to a Traditional IRA cease at 70.5. And, distributions (known as RMDs or Required Minimum Distributions) begin to be mandatory on an annual basis at least. For Roth IRAs, these rule changes do not occur. RMDs, of course, can be satisfied using the periodic distribution strategy stated previously. It’s good to plan ahead to satisfy RMDs without having to dramatically reorganize investments.
For those who would like to have control over distributions without RMDs, a Traditional to Roth conversion is a possible strategy. The tax event associated with a conversion changes the status of the account from pretax money to post-tax money. And, since the IRS has collected its tax due, RMDs are no longer a factor.
Interestingly, the ability to continue to contribute to a Roth and the fact that RMDs are not mandated allows for a generational wealth angle that some account holders take advantage of. As mentioned previously, tax-advantaged accounts are only a portion of an individual’s overall financial picture. As one gets older, however, these accounts are often a larger part of the
picture. That said, for some account holders, the account can become an inheritance for that person’s beneficiaries. Because an IRA generally bypasses probate, it can be an attractive tool to pass wealth along.
Coming back to a Roth IRA, as opposed to a Traditional, the Roth allows the account to persist without being chipped away by distributions. Also, the idea that investment returns would necessarily need to be timed out can be disregarded. Not only would the account holder not have to satisfy RMDs, but an account’s assets (in this case, existing debt instruments or equity) do not need to be liquidated to be passed along to the account’s beneficiaries. Those assets can continue to produce earnings for the account even after that original account has become an account of the beneficiary or beneficiaries.
Investors using their personal funds may also change their preferences over time, but the interaction of age and an IRA’s rules produces a varying landscape for choosing investments. Yes, the core ability of tax-advantaged accounts to participate in private lending is for everyone. But for those of us working with account holders of various ages, everyone does not have the same goals for an investment. Certainly, this view changes due to external factors such as economic conditions and competing asset possibilities. For an investor who has a level of comfort with a certain asset class, however, often the changes in preference have to do with time. Fortunately, self-directed accounts allow for the flexibility to address account holder needs throughout their lifetime. ∞