Here's a little-known fact about IRAs: They aren't restricted to just stocks, bonds, mutual funds, and the like. You can actually invest in a broad range of potential money-makers -- including real estate.
There are, as you probably suspected, a bunch of rules to follow, though. For one thing, you probably can't do this if your IRA is maintained through your brokerage or a bank. They prefer that you fill your IRA with items they sell. You'll need a "self-directed IRA," probably managed by an independent administrator. As Laura Bruce at Bankrate.com has noted, these outfits will generally charge between 0.40% and 1.5% of your account's worth each year, as a service fee. (And within that range, you can expect to pay less if your account is big, and more if it's small.)
As you're setting up this kind of IRA, consider designating it as a Roth IRA. (Learn lots of important stuff about IRAs in our friendly IRA Center.) The benefit there is that all your withdrawals will be tax-free.
Other rules include a restriction that you not live in the property while it's in your IRA -- it should be an investment, not a home. You can rent it out and park the rental income in the IRA. (Further digging will reveal even more rules, such as a prohibition against renting to your children or parents, but not brothers or sisters. This kind of investment will require a lot of homework.)
Why you should do it
So why consider such a strategy, investing in real estate in an IRA? Certainly, professional money managers have found big money in real estate. Real estate investment trusts like Boston Properties
Direct real estate holdings aren't for novice investors, but if you really know your real estate, you may do well investing in it directly. And this is one way to do so, with some tax benefits included.
Why you shouldn't
For starters, real estate isn't a sure-fire path to riches. Just as stock markets can slump, so can real estate markets. And in general, real estate hasn't grown as quickly as stocks over the long run. But that's an aggregate view. If you find a very compelling bargain in real estate and you manage the transactions well, you can profit handsomely. It will take a lot of know-how, though, and lots of research. (This is where alternative investments, such as simple broad-market index funds, can shine, as they require very little digging.)
Think also of how much money you have in your IRA account to tap. If it's not very much, you may have trouble finding attractive real estate deals. (You can only add the annual maximum contribution to your account each year, which is currently $4,000 for most of us and $5,000 for those 50 and older, and will be $1,000 higher for each group in 2008.)
Another consideration is that annual service fee. Let's say that you have $50,000 in your IRA. If you're being charged 1% each year, that's $500. In just five years, you'll have paid roughly $2,500. That's not an insignificant amount. Meanwhile, if you're fortunate enough to be earning, say, 10% on your real estate investment each year, the fee will reduce that effective gain to 9%, which doesn't compare favorably with the stock market's long-term historic average annual gain of about 10%.
Nevertheless, I think that for most of us, the stock market offers the best chance of long-term gains. A simple investment in an S&P 500 index fund will instantly plop you in 500 of America's biggest companies, many of which have been and are likely to continue to be strong long-term performers. Many of its components, including ExxonMobil
Take some time to learn more about how IRAs work and how you might make the best use of yours in our IRA Center. I also encourage you to take advantage of a free 30-day trial of our Rule Your Retirement newsletter service. It's prepared by Robert Brokamp, a smart and witty guy who distills what you really need to know into a manageable volume each month. A free trial will give you full access to all past issues, allowing you to gather valuable tips and even read how some folks have retired early and well. Robert regularly offers recommendations of promising stocks and mutual funds, too.
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Longtime Fool contributor Selena Maranjian owns shares of no company mentioned in this article. She would have bought some shampoo at her local Walgreen's recently, had there not been a couple fighting and then making up in the shampoo aisle. Try any one of our investing services free for 30 days. The Motley Fool isFools writing for Fools.