Self Directed IRA

[Jason Stephens]

Good evening, I recently have been looking to get started in real estate investing and now I am up to the stage of finding financing. My father has enough money to finance my deals in his 401k and he's 60 years old. He would be willing to loan me the money in return for an 8-12% return on his loan. His funds would include all rehab costs. How does he convert his money from a 401k into a self directed IRA and are there any penalties involved or costs for him? If anyone can provide knowledge or links to explain how this works would be ideal. Thanks!

[Brandon Hall]

@Jason Stephens I can poke holes in your plan. 

In summary, you and your father need to sit down with a CPA separately and then together to understand your options. This situation seems too risky and doesn't align with your father's risk tolerance, considering he expressed interest in taking a withdrawal to pay down his mortgage and live "stress free."

First off, I want to correct your understanding of how to calculate returns. If a 15% tax hit is incurred, a 10% earnings does NOT result in a -5% return. Example: principal of $100k is taxed at 15% leaving $85k to work with. You have a decent year and earn 10% on that money resulting in a $8.5k gain. Ending principal is $93.5k resulting in a 6.5% loss, not 5%.

Second, if your father takes an early withdrawal in the amount of $300k, he instantly jumps to the 33% tax bracket for 2015 (regardless of whether he's single or MFJ). Depending on his other income, his effective tax rate may be anywhere between 25 and 30%. Since your father is past 59 and a half in age, no early withdrawal penalty will be assessed. So I'd say the minimum expected tax liability on a $300k withdrawal is $75k.

That's a huge and completely unnecessary tax bill fraught with risk for your father. I'm all for for parents helping their kids, but not when it means tapping into a retirement account. Additionally, a 12% return is quite poor when adjusting for the risk your father is taking. You should be considering more like 15-18% or the full intention to pay his tax bill at year end plus some.

My other thought is this - it doesn't sound like you've flipped a property before, so inherently there will be a huge learning curve that will cost you time and money. Your budgets will be inaccurate and your expected returns will be lower than expected. It would be a shame to have an unsuccessful flip and have to go to your father and say "well sorry."

Lastly, since you are having to use your father's money and you have no real estate experience, I naturally assume you haven't managed your finances in a way that allows you the capital to invest yourself, so what makes you think you can handle $300k? It may be harsh, but it's likely a true statement.

It's okay to put your real estate dreams on hold while you build up a savings account. Take a job with a builder to further reduce your risk. Learn on someone else's dime. Invest a significant portion of your capital WITH your father to reduce his risk. His situation is way riskier than yours. He needs to understand that and you need to understand that.

I'm all for taking risks that are well thought out and worth the return. This doesn't seem to be one of those risks. It will be a shame to see you father broke in retirement due to a bad deal and ignorance.