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an IRA/401(k) LANDMINE for Affluent Investors

Episode #324:  There’s an asset class that affluent investors REALLY love… extraordinary cash flow is the norm and the tax benefits are the best around. But there’s a HUGE LANDMINE just waiting for affluent investors who try this in their self-directed retirement account. I’m Bryan Ellis. Today, you affluent investors learn how to sidestep certain disaster in Episode #324 of Self-Directed Investor Talk.


Hello, Self-Directed Investors, all across the fruited plane. Welcome to the show of record for savvy self-directed investors like you, where in each episode, I help you to find, understand and profit from exceptional alternative investment opportunities.

For you folks with a bit higher net worth, you need to pay close attention today.

So for those of you who may not yet quite be in the high net worth world, something you should know about your wealthier brethren is that one of the most popular asset classes among them is one I’ve mentioned here before, but only very briefly… and that is oil well drilling.

It makes perfect sense because the cash flow beats the heck out of basically everything else, and the tax benefits makes real estate and other supposedly tax efficient investments look like child’s play. Yes, the risk is theoretically higher, and that’s why this is the domain primarily of accredited investors.

But to set up this dilemma, and the brilliant solution for it, let’s consider a scenario, with real numbers.  So here’s the deal.

This investor… we’ll call her Tara… has decided to invest in an oil drilling deal. It looks like a pretty good one, I’m actually quite familiar with it… she’s got to invest $150,000 to buy into the deal, and based on the preliminary geological research, the expectation is that she’s going to bring in something on the order of $12 to $13,000 per month or so, based on current oil prices.

Now if you’re doing the math, you know that $12,000 per month equals $144,000 per year, which is shockingly close to being a 100% cash-on-cash return. Well, that’s one of the reason high net worth investors love this stuff… the cash-on-cash numbers are just breathtaking, enough so that the additional risk is quite regularly totally worth taking.

So that’s great, right? Tara makes this investment, and assuming it works like expected, then she yields a MASSIVE cash-on-cash return for 5-7 years until the oil well runs out… and then she’ll likely do it again, if she’s like most high net worth investors I’ve worked with.

And to make it better, she’s doing this in her Roth IRA… so all of that juicy ROI is totally tax free! Right? Right? Isn’t it tax-free?

Well… no.

Here, my friends, we consider an important distinction between the two types of income: Earned and Unearned. Earned income is just what it sounds like… money you earn from a W2 job or a 1099 contracting position or something like that. You work, you get paid. That’s earned income.

Unearned income, on the other hand, is profit from investments… it’s a more passive type of thing So if you buy stocks and they rise in value or pay dividends, that’s unearned income. If you buy real estate and it appreciates and/or generates cash flow for you, that’s unearned income.  If you make a loan and are repaid for that loan, that’s unearned income.

So here’s the thing: it’s widely believed that IRA’s and 401(k)’s – particularly the Roth variety – are just not taxable. Unfortunately, that’s not true. It’s almost ENTIRELY true that any UNEARNED income – the kind from stocks and real estate and loans, for example – pretty much all of that will be tax-favored inside of a retirement account and that’s great!

But this is where we return to Tara’s oil & gas deal. Yes, she’s going to make a lot of income from that deal. But there’s a catch. Federal tax law makes it abundantly clear that under most circumstances, the income generated from drilling an oil well and selling that oil is NOT UNEARNED income, but is EARNED income.

That means two things: First, that the money is taxable. And second, that the tax rate that’s relevant in that case is NOT personal income tax rates, but is the income tax rates for TRUSTS, since both IRA’s and 401k’s are, under the law, types of trusts.

And that, my friends, is BAD news. You see, income tax rates for trusts are, for all intents and purposes, 37%. That’s astronomical. If Tara brings in $12,000 per month on average as expected, that equates to $144,000 per year. 37% of that is over $53,000… so her IRA would have to stroke a check for over $53,000 to pay income taxes. That would leave her with a net of nearly $91,000 per year which is still just off-the-chain exceptional… but still… that’s a BIG tax bite.

What to do, what to do? Most of the time, investors do oil & gas deals OUTSIDE of a retirement account because the VERY BEST tax benefits in oil & gas don’t really apply to IRA’s and 401k’s. But in Tara’s case, that’s where she happens to have the available capital, and quite justifiably, she doesn’t want to miss this opportunity.

So here’s what I recommended to her: Since we can’t eliminate those taxes, why don’t we just slash them dramatically? You may remember that one of the thing that President Trump’s signature tax bill did was to slash corporate tax rates to 21% as the maximum. So I suggested that Tara form a c-corporation inside her IRA, and capitalize it with $150,000 from the IRA. She could then buy the oil & gas interest with that money, inside the corporation. That money – we’ll just say $144,000 per year – will still be taxed, but not at 37%. It’ll only be taxed at 21%. Bottom line… she’ll pay about $23,000 PER YEAR less in tax this way!

Over the course of 5 years, that’s a very real saving of over $100,000… just by using the subtle brilliance you learned right here on Self-Directed Investor Talk!

Now before I sign off for the day, I’ll go ahead and answer the question I know is coming: Maybe. The answer is maybe. The question, of course, is something like: “Bryan, I just heard you talk about the crazy results people are getting from oil and gas deals… can you hook me up with some of those opportunities?” Well, the answer is MAYBE.

There are some qualification requirements. So the best path to take is this: If you’re interested in learning more, just text me now at 678-888-4000 and I’ll be happy to have a team member talk this through with you. Again, just send a text to me at 678-888-4000 and we’ll chat about it right away.

My friends… invest wisely today and live well forever!

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