Are you wondering whether you should cash out an old 401(k) or IRA? Is your #1 worry taxes? Could there be ways to reduce taxes so you keep more of that money to invest?
In this episode, Chris Miles shares strategies that some of his clients have used to reduce taxes when cashing out their IRA’s, even when they’re younger. Check it out!
Disclaimer: We are not giving investment advice nor recommending you cash out IRAs or 401(k)s. Please consult with your tax professional.
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Tax Reduction Strategies For Cashing Out Your IRA
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I want to talk about some tax strategies. If you are considering cashing out your 401(k) this year, especially now that you are in January 2023, you are wondering, “It is9 the beginning of the year. If I’m going to cash out my IRA, I can put the tax bill down to next year.” I want to talk about that. I’m not giving any investment advice here. I’m not suggesting you guys cash out your IRAs now because if you are not 59 and a half years old, you will have a 10% penalty. You will pay taxes on that money.
I want to talk about if you are going to do it and thinking about doing that seriously. This would be those of you that are not 59 and a half years old, although you could be. Let’s say you are not 59 and a half. You are looking to invest this money, get it working for you and not worry about paying taxes or at least putting in a better place like real estate investing where you get more tax benefits, but you want to retire before you are 60 years old. This could be a good option for you, or this could be some options you could use. Even if you are over the age of 59 and a half and you don’t have the 10% penalty, you are still paying taxes on that money, but you are looking for a way to reduce your tax bill when you pull up money out, get it to a better tax advantage place. You can make more money. There are some strategies here.
I will throw out a bonus here. I had a conversation with somebody. We talked about infinite banking. I’m going to throw this as a bonus. I’m going to give it to you. I had one woman. She was saying, “I have got the money a little bit in Roth IRAs. My financial planners have us pull only X amount of dollars out, so we don’t get tax too much each year, but I’m paycheck to paycheck.”
Even though she came asking about infinite banking, I said, “I can already see your whole situation. We can do a lot better. We can do better than $3,500 a month than these financial advisors are having you do. We can get this to be at least $120,000 a year that you can be cashing out, and some of it can even be tax-advantaged.” She said, “What are the ways I can fund this life insurance policy?” I said, “You can use your cash savings, which she had a decent amount of, but you can also use your IRA money to put in the policy.” Sometimes people talk about taking their IRA, putting it into a Roth IRA, and getting it tax-free.
Another way you can do that and still creates tax-free streams of income is by moving it to something that has the same tax rules as a Roth, which is life insurance. You could start cashing out X amount of dollars from your IRA to fund your policy. It goes in there, and if it is done right, even if you are older, within 6 or 7 years, you have as much, if not more, than what you have paid into it. It is if you do the policy right.
You can’t count on other guys that do insurance policies, but from our experience, we see this be the case. You can build more cash in there and pull off a tax-free income stream while keeping it guaranteed and protected from the stock market, crazy fluctuations, and the insanity that goes with that. That is one option. I’m going to throw that as a bonus, especially if you are over the age of 59 and a half. That is still an option to be able to fund a life insurance policy, especially if you are in good health.
Let me talk about some other strategies that will reduce your tax bill. I’m not a tax accountant. I’m not giving tax advice or investing advice. I’m giving you the three key strategies you can use. Number one, if you have a business or are thinking about having a side hustle or a side business, there can be a great way to minimize your taxes on this. If you have IRA money, you could use that to buy a franchise. That is another option. I would not call it passive. I would call this semi-active investing.
We have had people talk about franchises on this show before. It is a great option. You might be putting a little time into it, but if you have part-time hours available, that could be a great option. You could keep it inside of an IRA and use it to fund the business. The 10% penalty is the common denominator. With that IRA money, you are going to have to pay taxes on it one way or the other unless you have a way to write something else off against your taxes.
Let’s say you want to pull out $100,000 from your IRA, but the business opportunity or the thing you want to use this money for is to go into your business to pay some of those expenses. You are investing in your business. If you are spending money on the business, understand that those business expenses are a write-off on your taxes. They do not count against you. They help you.
If you are taking that money and you are using it to go and use it for business purposes, that money gets written off. You cancel out the tax you will be paying. If you are not 59 and a half, you still have the 10% penalty. You could be using that to help start a business and get a write-off while you are paying taxes. They cancel each other out for that.
I had one client who did that. They were looking to invest, but he saw a franchise opportunity. It was a single franchise. It wasn’t a big chain store or a restaurant. It was a business that he bought from a small mom-and-pop business. He used that money to invest and buy that company. He bought the equipment, supplies, and everything. That was a write-off against his income. How many times have you seen where businesses even have a net loss in those first few years? It is common for him as well. He used that net loss from the business to offset the taxes of the IRA he pulled out.
I don’t encourage this, but you can avoid the 10% penalty if you are in financial hardship. They will waive the 10% penalty if you can prove financial hardship. What if you have a financial hardship that requires you to start a new business? You can access this money, not have the 10% penalty. Even though you would pay taxes normally, use it for your business to generate more income, and therefore you will be able to get that benefit. There are ways to reduce it potentially.
I had other clients where there have been opportunities where it is more of a business partnership. They can put that money into the business partnership. The business partnership costs $100,000. I said, “You have your investment money, but you have this IRA money sitting there, not knowing what to do.” What if you took the IRA money, $100,000, you cashed out, and in this one couple’s case, they were already over the age of 59 and a half, used that to pay the $100,000 fee to get that business started and invest the rest? The returns on the rest are returning over 50% a year.
I said, “This could work out great in your favor because not only are you able to use that money and wash the taxes out because it is a business write-off, but you got the rest of your money work for you, making a much higher rate of return than you would let it sit in a mutual finer IRA.” Even if it was a self-directed IRA that you could use to invest, which you can do, they gave them the opportunity to be able to make better income.
The numbers always depend. When you are trying to do this strategy, it depends on whether it puts you in a better position. That is always the case. How does this improve your cashflow or returns on your money? I will give you another example. This is a bonus here. I had somebody using the IRA money that he used to pay off debt. They help consolidate and pay off their debt, freeing up a ton of cash right there. $100,000 freed up $4,000 a month.
The accountant was freaking out. When he realized $100,000 produces a freed-up cashflow of $48,000 a year, I shouldn’t say this in a CPA, but in the mathematical sense, that makes sense because you are not going to get that return putting your money in a mutual fund. He saw the light. He saw that without a guaranteed rate of return because he was able to pay off debt using that money.
Even though they didn’t avoid the 10% penalty and any taxes, the cashflow made sense because it was a big enough return to offset that one-time tax they had to pay. The truth is you are going to have to pay taxes on this money anyways. This is giving you an extra bonus. The 10% penalty if you take it out early is the only thing we are worried about because you are going to pay tax on that money regardless.
Here are ways again to reduce it. Business can be a great way to do it again. As a bonus, you could even be using this to pay off debt or do other things that help generate a lot more income from yourself or better cashflow for you that gives you a benefit month after month. The second way to do it is you become what is called a real estate professional.
There are a lot of different things you got to qualify for. One, this is not somebody who owns a couple of turnkey properties. This is somebody who usually has some active management going on. Your real estate is becoming part of your daily life or weekly life. To do this, you generally have at least 750 hours of work or some involvement in real estate for the entire year. That is about a fifteen-hour-a-week average.
If you work full-time, this isn’t going to work because if you have another job or income source coming in, you have to exceed by at least one hour a year on their real estate side versus what you are doing on the other side. If someone works 40 hours a week, you got to work 41 hours a week. It is way more than fifteen hours a week to qualify as a real estate professional. If you have somebody who is a spouse that has been at home for a while or has a part-time job or business, it is going to be a great option.
We have somebody working for a company where their husband does a lot of contract work. Even if it is one hour more a year of real estate activities, they are partnering with a guy mentoring, helping them out with this, managing the property, dealing with more of that, and they are doing other passive investments, but they are doing this as their active investment. Giving them the hours they need qualifies him as a real estate professional while she is working in the job market. He is a real estate professional, and this has become a business.
When you have business write-offs, you use it to offset it. It is the same thing here. You can not only take all these expenses you are doing for your real estate business. This can include a cell phone, utilities, different expenses, and travel expenses if you are traveling around and looking at real estate properties. A lot of your vacations can end up being written off like any other business. These things can be written off.
What happens is with the properties you have an appreciation, you can start taking depending on the type of properties you buy. You can even start doing cost segregation, which means you get accelerated depreciation. You can be writing off more or close to as much as you are investing per year, offsetting the tax, especially if that money you are using to buy those properties was your IRA. You can cancel out or even get in a better position.
Talk to a CPA about this, and I would recommend a CPA that has experience with real estate investing. Don’t go to the normal Jackson Hewitt, Liberty Mutual, or those general types of things. Don’t do this if you are trying to do TurboTax. This is not going to work. You need a CPA with good real estate investing experience to know what they are doing and help you figure this out. As a real estate professional, you can show losses off of your active income each year. It would be a huge benefit if you got IRAs. One way is to take that IRA money out and get it to generate passive income without you having to retire.You need a CPA with good real estate investing experience to know what you’re doing and help you figure things out. Click To Tweet
Before I get to the third and final one, I thought of a bonus one for you. Here is another added bonus for you guys. One thing you can do that you are not necessarily cashing the money out of the IRA, although you could, is you can get what many people know as a health savings account. You have to have the right health plan to couple with this. You can put in over $7,000 a year per family into a health savings account. You could slowly start to draw from your IRA and transfer it over to the health savings account with zero penalties and tax. It is like doing a rollover of your IRA. They won’t penalize you. There is no tax. I get the benefit of spending on those health costs. That is dental costs, massage or chiropractic, and other ways you can use these for medical expenses.
If you are already paying out of pocket for these medical expenses, why not use your IRA money to go and pay for those expenses? It is a big bonus for you guys right there. You can’t move money from your IRA to a health savings account to help fund it. That is one way to get a little bit of money out without worrying about penalties or taxes.
The third main way I was going to talk about, I gave you a couple of bonuses already. The third main way is oil, specifically working interest in the oil investment world. If there is ever drilling and those things are going on, there are oil investments out there where you can use IRA money to put in that. This is not a one-for-one type of benefit. This is a reduction strategy. It is a way to reduce your taxes.
Depending on the type of investment you are looking at, sometimes a company will pass along when you are putting money in that. It can even be a syndication or a partnership type of deal you are going into with these oil investments. If it is a working interest where they are doing the drilling, and this is a working interest type of deal, you might be writing off anywhere from 75% to 80% of whatever money you invested that year. This is specifically for domestic oil drilling.
The US government, even though they try to throw a lot of blame and hate on oil companies, no matter how green you go in your ideologies, the truth is we need oil. If you ever use a piece of plastic, you need oil. You use almost any product, for that matter. A lot of my office is made from oil products. As much as there is this hate relationship with oil companies, we are relying on oil, even if you go electric cars from this point forward.
For that reason, the US government has also given you some love. They give you the benefit that if it is a US-based domestic-type of oil exploration and drilling, they will give you the tax benefit. If you cash out $100,000 from your IRA to do this oil investment, you might be able to write off anywhere from $75,000 to $80,000 off of that money coming over. You are still going to pay taxes on the returns.
There are some additional tax benefits with oil. For example, for about 15% of whatever returns you are getting of that money, you tend not to pay any taxes, while for the other 85%, you are paying ordinary income tax. If you are putting money in working interest, you can move money from the IRA, use that money and reduce the bulk of your taxes from that money. Even if there is a 10% penalty, the majority of your money ends up getting replaced. You end up not having to pay taxes on that money. That is the third way.
One great strategy you are going to use for the bank and help take from IRA to fund the policy. It doesn’t avoid taxes or anything like that, but it is potentially moving into a Roth IRA with a penalty. You can move it to a Roth IRA or life insurance and now earn tax-free returns. The other thing I mentioned is business expenses. You can also become a real estate professional where you can write off and show losses because of depreciation on your properties. I mentioned the bonus with the health savings account, but the third one was oil investments, specifically oil drilling and working interest type of things. You guys do that. There are lots of ways to reduce it.
It might be worth not worrying about any of these strategies. It might be worth doing something else. There are other strategies that I know people teach out there that could help reduce your tax bill. I’m not going to teach about those as viable options, but I am going to do an episode that you guys want to tune in to where I’m going to talk about these sexy tax strategies that you should not do. They are almost guaranteed to give you massive headaches and potentially a big tax bill anyways. I’m going to talk about that in a few weeks.
For now, know these strategies. There are plenty of them. There are lots of ways that we strategize with our own clients to do the same thing. Every situation is different. If you are looking for ways to do that and want to do it safely, talk to a CPA or your accountant about that, especially if they have real estate investing experience. You can reach out to our team and say, “Is it possible I can generate passive income with this money?” Reach out to us at MoneyRipples.com and contact us on that form right there. Make it a wonderful, prosperous week, and we will talk to you soon.