How to make IRA contributions when my only income is real estate investments.

Question

I closed my business this year and didn't have enough earned income to be able to make my full IRA contribution.  I mistakenly thought being a real estate professional would allow my passive income from my rental properties to count as earned income for IRA purposes.  I had to take some of the money back or pay penalties.

I've read where I could start a self employeed Property management company and pay myself whatever I would need to in order to make IRA contributions but then I'm looking at 15% self employment tax.  I already have 40 credits with social security and 35+ years of social security contribution with no zeros so I'm not sure if it's worth the hassle and accounting.  MAYBE I could replace some of my lowest earning years when I was a teenager but I really wouldn't want more earned income than was needed for the IRA contribution threshold.

Anybody have an alternative strategies for IRA/retirement contributions without earned income OR another method to create earned income from my passive rental property income?

Is it even worth it considering the 15% self employment tax I would have to pay?

Should I just forget about the IRA and keep the passive income as is?

If it matters, I'm married and my wife is in the same boat since our only jobs are managing our rental properties. She also has 40 credits with social security although she would have a couple zeros for her 35 year work history at this point.

Philip Barr · Answer

Rental income is passive income, and contributions to retirement plans must be made from earned income.

You could set up a property management company for your properties, where you would own the property management company, and it would act under property management agreements for each of your rental properties and be paid a fee. Typically, we at Anderson Business Advisors prefer to use an LLC or a Corporation taxed as a C Corporation since it has tax benefits to offset the active income and paying yourself a salary. Then that C Corporation would sponsor a Solo 401(k) plan for retirement benefits. As the individual employee you can typically make up to $23,500 in contributions from your salary and as the owner of the company sponsoring the plan, in other words, the employer, you could contribute up to 25% of your salary. Contributions across all qualified retirement plans you participate in typically cannot exceed $70,000 in aggregate.

Stephen Nelson · Answer

@David Charles Edwards, it rarely makes sense to generate earned income so you can contribute to something like an IRA.

Example: If you reclassify $100,000 of rental property income as self-employment earnings, you pay a 15.3% tax on most of the $100,000. (The actual formula is 15.3% times 92.35% of the $100,000 and the resulting payroll tax bill will be slightly over $14,000.)

That $14,000 of permanent tax savings will in almost all cases exceed the tax deferral an IRA or 401(k) gives you. (Note that tax deferral is only a delay in paying the taxes.)

P.S. An exception to the above general rule would be if you're a few quarters short of qualifying for social security... In that case, it might make sense to pay $14,000 for a year or two to get a $12,000 a year Social Security benefit for a few decades.

Michael Plaks · Answer

So we want to fund a soloK with $23,500. Sure, why not. We need $23,500 of net income, meaning after all deductions. Even if there is no other deductions, we at least have to pay for tax return preparation and payroll service, and there is no way it's under $1,500.

We need at least $25,000 gross management income. Typical property management fee is 10% of rent. So we're talking about $250,000 gross rental income.

Keep these numbers in mind. Then add all the other costs, including setting this structure up.

And, by the way, if this corporation does nothing other than converting rental income into a property owner's salary, its legitimacy as a business entity might be doubtful.

No, I'm not against the idea. I'm simply suggesting a careful consideration of pros and cons.

Michael Plaks · Answer

@David Charles Edwards

Retirement contributions require what is known as earned income which is basically compensation for work. Therefore rental properties, with or without a real estate professional status, do not unlock this option.

Yes, you can in theory proactively (not retroactively) manufacture earned income by creating your own management company. Whether or not it makes economic sense is case-by-case. Sometimes when you run the numbers and take into consideration the hassle factor, you may decide to forego this strategy. In other situations, it may be worthwhile.

I assume you do not have other earned income that can let you fund your retirement.

Heather Taylor · Answer

@David Charles Edwards I can't speak to the employment tax or if it's worth it, but something to consider is the Solo 401(k) - it's for those who are self-employed or entrepreneurs. Contribution limits are larger than with IRAs. Also, with either an IRA or Solo (k), there are potential tax deductions in the year you contribute (larger contributions with the Solo (k) means potentially larger deductions!). The other great thing with either account is that you can choose to open it as a self-directed account and use the account for your real estate investing.

Dmitriy Fomichenko · Answer

You need earned income to contribute to a Solo 401k plan.

Dmitriy Fomichenko · Answer

@Deb S.

Possible in theory, but read the comments above, there are a number of things to consider...

Steve Smith · Answer

There's a lot of merit to that song and dance, but requires skill in buying SFHs below market often with seller financing to get good terms and skill in management. However, it's probably the safest real estate investment out there. You say it's not your kind of music, but with your current portfolio, you're all ready there. I'd bet you didn't get those properties paid for free and clear when you bought them, unless someone gave you a wad of money. Some debt would shelter a lot of income, give you appreciation, and the tenants would pay off your mortgages.

It may not be worth the hassle of creating a "job" for yourself to contribute to your IRA, but the number could easily favor that hassle. Philip has some good thoughts on that.

If your IRA is not a self directed Roth, convert it to one, and you can do that over 2 years or more to minimize taxes. Get up to speed on using your Roth to control real estate with leases and options and you can easily double the worth of your Roth every few years to provide for tax free retirement income. A lot of the Roth custodians have good and free educational info on creating wealth in your Roth. Also seek out some of the good investor gurus that know how to do this.

Todd Goedeke · Answer

@Philip Barr just as important benefit and advantage for a Solo 401k is the ability to roll over old IRAs and old 401k plans to a Solo401k . Then you can buy and leverage real estate without The UBTI.

Less costly  to have a small amount of consulting income or income from being a part time Lyft or Uber driver to be able to open a Solo401k.

David Charles Edwards · Answer

Why are you pushing solo 401k vs the individual IRAs we already have?  Im trying to keep things as simple as possible.

How to make IRA contributions when my only income is real estate investments.

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