Are all investments equally suitable for your retirement plan? Do some retirement account assets work better than others… and if so, why?

You can put almost anything into some type of retirement account—from a mutual fund to an alpaca farm! Awhile back, we wrote an article about some of the BEST investments to put in a retirement plan—especially a self-directed retirement account. Today, our focus is on what DOESN’T belong in that retirement account.

Qualified retirement plans or accounts are those that meet government tax code requirements for contributing pre-tax dollars that grow tax-deferred until withdrawal. They include 401(k)s, 403(b)s, and SEP plans. IRAs work very similarly, though not technically “qualified.”

Putting an asset in a traditional 401(k) or IRA gives you tax-deferred growth. But just because you CAN put an asset in a retirement account doesn’t mean you should. In this article, we’ll explain why, and we’ll name five assets you probably DON’T want in your retirement plan:

#1: Annuities

There are qualified and non-qualified annuities, which refers to their tax treatment and whether or not they exist in qualified plans. A qualified annuity is funded with pre-tax dollars, while non-qualified annuities are bought with after-tax funds.

While there is a notable exception to this rule, generally, annuities don’t belong in your 401(k). “Why not?” you might ask.

First, we wouldn’t recommend a deferred annuity inside or outside a qualified plan, for several reasons:

  • They offer a disappointing ROI for a long-term investment.
  • They are loaded up with various kinds of fees that diminish returns compared with non-annuity products.
  • They’re not flexible. Once your money is in an annuity, you can’t just move it into a different investment.

And as far as putting an annuity in a 401(k), IRA or other qualified plan, there’s little point to putting a tax-deferred product in a tax-sheltered structure.

One of the “rules” our friend Tom Wheelwright offers in his book, Tax-Free Wealth, is this:

“Never ever put a tax shelter investment inside another tax shelter.” 

That’s a good rule. And since annuities already grow tax-deferred, a retirement account is somewhat redundant. You might as well use the tax advantages for assets that aren’t typically tax-advantaged, while using the “built in” tax benefits of other assets outside of your retirement account.

As a general rule, if people are still growing their retirement account (as opposed to taking disbursements), we recommend growth investments rather than income investments in a qualified plan. This eliminates issues with where and how to reinvest interest or profits. If you are utilizing your qualified plan and taking advantage of tax-deferred growth, you’ll get the MOST out of it by putting growth investments in your retirement account.

And… there IS an exception.

If you are beyond age 70 and wish to maximize your retirement income, a Single-Premium Immediate Annuity (SPIA) can work well within a retirement account.

Why age 70? And why would we recommend a SPIA?

Annuity payouts are age-based products (the older you are, the more they pay). If you have a lump sum in your retirement account and/or if you have stocks and mutual funds in your retirement account (both are likely), purchasing a SPIA in your qualified plan solves multiple problems.

  • Your dollars won’t disappear in a crash if the stock market has a downturn.
  • Annuity payouts are generally recognized as safe, reliable and predictable.
  • You won’t lose a chunk of your retirement account to taxes by pulling money OUT of your retirement account to invest elsewhere.
  • You can choose to maximize income (life only) or leave the income stream to a beneficiary should you die within a certain amount of time.

The truth is, deferred annuities are often “over-sold” by advisors who are only licensed to sell life insurance. There are many different asset classes and—in many cases—you’re best off with greater diversification in a broader range of assets. However, immediate annuities work very well for income later in life.

(Extra tip: annuities avoid probate, so if you purchase one, select the right beneficiary and keep your beneficiary up to date!)

#2: Life Insurance

Most people will tell you that you can’t put life insurance in a qualified retirement account. You actually can—through a self-directed 401(k)—but you shouldn’t! And there are many reasons why.

First, similar to annuities, there is no reason to put a product with favorable tax law into a qualified plan. Permanent life insurance such as dividend-paying whole life already grows tax-deferred. That growth becomes tax-free at death when the policy remains in force.

Secondly, whole life isn’t really an “investment” in the typical sense, but it works wonderfully as a long-term savings plan. Now ask yourself—why in the world would you want your SAVINGS—the money you can use for emergencies as well as opportunities—locked up in a 401(k) and subject to all of the rules and restrictions of that environment? You wouldn’t!

You want your savings—your “emergency/opportunity fund,” as we call it—accessible at all times. Not just when you’re 59-1/2—or after you pay taxes and/or fees to free the money!

When your whole life policy is NOT in a qualified plan, you can either borrow against your cash value or withdraw from it. (We generally recommend borrowing against unless you cannot pay it back in a timely manner.)

When NOT in a 401(k), you can easily access cash to:

  • Start a business
  • Repair a roof
  • Pay for a wedding and honeymoon
  • Purchase an investment property (one not subject to qualified plan restrictions)
  • Or any other reason—without asking your employer for permission or paying taxes on the funds.

Your qualified plan should hold investments—not your savings. And if you want exposure to the life insurance asset class in your retirement plan (a very smart move), you can obtain that by investing in life settlement funds.

#3: Real estate

Many people advocate for purchasing real estate within a self-directed IRA. While we are big fans of real estate investing in general, there are some compelling reasons to invest OUTSIDE of your qualified retirement account.

Mortgage complications. Properties are harder to mortgage when owned by an IRA, requiring larger down payments and other “hoops” to jump through. You’re also not likely to secure the best rates.

Profitability. A higher down payment can mean less potential ROI on your investment.

Less control. It’s harder to take advantage of some of the flexibility real estate offers, such as the ability to obtain a simple cash-out refinance. And there are restrictions on the property. You can’t stay in your vacation rental or allow friends and family to do so—ever. If you are handy, you can’t work on your own property, which can offer significant savings if you have relevant skills. Also, you won’t be able to ever take advantage of the significant tax breaks available by converting an investment property into a home.

Taxation. Real estate is already tax-advantaged, and you don’t need a tax-shelter in a tax shelter. You could end up with debt-financed income (UDFI) or unrelated business income tax (UBIT) issues, depending on the structure. When you do eventually pay taxes, you’ll be taxed at income rate versus capital gains. This means you could potentially pay a higher tax rate!

So by all means, invest in real estate, but consider carefully whether doing so in a retirement account makes sense!

#4: Oil and Gas

One of the main advantages of investing in oil and gas development is the fantastic tax benefits investors receive in the very first year of the investment. Development costs can be substantial and can be immediately written off in the first year. Unfortunately, these tax write-offs won’t be realized on your tax return if the underlying investment is “trapped” in a qualified plan retirement account.

That said, investing in mineral rights leases (completely different from an oil and gas development partnership) can work in certain situations.

Mineral rights leases operate much like bridge loans and are an income investment (as opposed to a growth investment). Once you are at a stage in your life where you are withdrawing income from your retirement plan, a mineral rights lease can be a great investment within an IRA or other qualified plan. (This is not ideal at an earlier stage in life because it is not always easy to reinvest income generated from a lump-sum investment within a qualified plan when it stays in a plan.)

#5: Target Date Funds

Nobody should have these in their 401(k)—but MANY people do! As a matter of fact, more new money is going into Target-Date funds (TDFs… also called “life cycle funds”) than into any other type of investment in qualified plans.

This is NOT good!

The track record of TDFs is disappointing. While they didn’t lose quite as much as the stock market overall in the last market crash, they lost a LOT.

Target-date funds are supposedly constructed as an “all in one” product that will automatically be adjusted and assets reallocated to be more conservative as fund-holders near retirement. Yet in the 2008-2009 crash, those with a “target date” retirement of 2010 suffered substantial losses.

According to Consumer Reports, in 2008-2009, the average 2010 target-date fund lost over 23 percent. These were funds purchased by people who intended to retire in or around 2010. CNN Money reported that Vanguard Target Retirement 2010 and Fidelity Freedom 2010, lost about 26 percent and 29 percent of their value, respectively, in 12 months. One small fund run by Oppenheimer Funds fell almost 45 percent.

How is this possible? Simple math. If your target-date fund is comprised of 50 percent stocks, a 50 percent drop in the market could cause a 25 percent loss.

Since those big losses, target-date funds have come under tremendous scrutiny. As a result, the disclosures as to what the funds are comprised of and how the assets are re-allocated have become more detailed. This makes TDFs one of the most complicated and inflexible products around.

TDFs are a “set it and forget it” investment—for better or worse. If a certain financial market becomes unstable or takes a dive, you have no flexibility to get rid of just “part” of your TDF portfolio. Maybe you don’t want exposure to bonds, REITs, or stocks at a certain point in time. Too bad—you’re stuck with whatever is in the TDF. And sadly—so is the TDF. A TDF can’t respond to market conditions quickly because it’s not designed to respond to market conditions. They are designed to respond only to your changing age and nearing retirement date—not market conditions.

TDF’s don’t have the flexibility that a managed fund would have. There’s no quick re-writing of the pages of disclaimers informing investors exactly what’s in the fund and how it will be adjusted over the years. Thus, the rules TDFs put in place can become a straightjacket as market conditions change.

Is it time to re-evaluate your retirement account?

With the stock market near historic highs, it’s an excellent time to get off the roller coaster ride and diversify your qualified plan. And by “diversify”—we DON’T mean simply putting dollars in different kinds of mutual funds! Nearly all segments of the market can sustain big losses in a stock market downturn. Unfortunately, the stock market is subject to systemic risk that—like the tide—tends to raise or lower all boats.

Partners for Prosperity specializes in self-directed retirement accounts and alternative investments outside of the stock market. If you would like more information on any of the investments mentioned in this article, contact contact Partners for Prosperity today! We’d love to help you make the most out of your retirement account assets. Find out more about “P4P” here.

—by Kim Butler and Kate Phillips