The self-directed IRA: Retirement dream or tax nightmare?
By Warren L. Baker
Author's note: Over the next few months, I will be posting a series of articles on the topic of self-directed IRAs. The article below will provide readers with an overview of the subject matter.
Investing your retirement funds into alternative investments, such as real estate, privately-held businesses, private loans, tax liens, etc. can be liberating for many people, but beware of tax and legal landmines.
To start with, what is a self-directed IRA? The vast majority of people that have a retirement plan, whether it is in the form of an IRA, 401(k), 403(b), etc. have their money invested in traditional types of investments, e.g. stocks, bonds, mutual funds. However, the general rules governing IRAs allow for any type of investment except for investments into life insurance contracts and collectibles — e.g. rare coins, antiques, wine, etc.
That sounds great in theory, but in order to actually invest your retirement funds into assets outside of the stock market, you will need your retirement plan custodian to allow this type of investment. In other words, the company that holds your retirement account (e.g. Charles Schwab, Fidelity, etc.) must be able to facilitate the investment or you are out of luck. This realization leads many people to an Internet search engine.
Typing “self directed IRA” into Google will bring a bevy of results. Many of the top results will be sponsored links from companies that would like to assist you in setting up one of these structures (aka “facilitators”). In addition, you will find many articles and commentaries on the topic. However, the information online, as with many complicated legal topics, ranges from very helpful to blatantly wrong. Furthermore, it is likely that questions will immediately come to mind, such as: “What does 'checkbook control' mean?”, “What is a ‘custodian’ and what role do they play?”, and finally, “How do I make this happen?”
There are two basic methods for investing your retirement funds into alternative assets and both require you to first “roll” (aka “transfer”) your current retirement assets into a new IRA held by a specialized type of custodian. This will likely raise the first major snag: Am I even allowed to move my retirement funds from their current location? This is a question that you will need to ask your current custodian, but in general, IRAs and most 401(k)s from a previous employer are eligible to be rolled tax-free into a new IRA. Once you determine that you are allowed to move your retirement account, you will need to decide the exact method you will use to purchase the alternative assets.
Let’s assume for a moment that your goal is to invest into a piece of residential rental real estate. You can either: (1) request that the new custodian purchase the property directly on behalf of the IRA; or (2) you can direct the custodian to first invest the IRA into a limited liability company (LLC) that is thereafter 100 percent owned by the IRA and purchase the property using the LLC.
With the account holder of the IRA serving as the manager of the LLC, the latter option gives you the flexibility to purchase the property using a check from the LLC’s checking account, which, depending on the custodian’s ability to move quickly, will likely speed up the property purchase. For tax purposes, because the LLC is a “flow-through” tax entity, investments made using either method are normally tax-deferred (but see more on this below), just like investing into stocks, bonds, mutual funds, etc. using an IRA.
The method of setting up an IRA-owned LLC structure is normally facilitated by a third-party company — hence the ads on Google. Surprisingly, most attorneys and accountants do not understand these structures to the extent necessary to facilitate the setup process.
Once you have set up your self-directed IRA structure, it is vital to be well-informed of the federal and state rules and regulations prior to investing. According to federal law, if you use the structure in a way that creates a prohibited transaction, the IRA will lose its tax-favored treatment and the entire value of the IRA — not just the amount involved in the specific transaction — will be taxable to you in one year. In addition, you could face substantial penalties and interest charges.
The most common way for a prohibited transaction to occur is an interaction between the IRA (or IRA/LLC) and a disqualified person — which includes the account holder of the IRA, his or her spouse, many of his or her family members, and certain businesses and business partners associated with him or her. Also, if a disqualified person personally benefits from the IRA’s investments, a prohibited transaction will occur. The classic violation of this rule occurs when the IRA account holder tries to use the property owned by the IRA for his or her personal benefit — think: vacation property in Hawaii. Immediate tax consequences
In addition to prohibited transaction concerns, it is possible for the IRA to invest in a manner that creates immediate tax consequences to the IRA itself. As mentioned above, an IRA’s investment income is normally tax-deferred until a later date when the IRA account holder removes the money from the IRA. However, if an IRA invests using debt-financing (i.e. a mortgage) or earns income from an active business, the IRA’s income is not tax-exempt and the IRA will have to file a tax return and pay a tax. Although this situation complicates the filing requirements imposed on the IRA, it is not illegal.
Finally, if all of the above was not enough, you must also be properly educated on the following issues prior to investing out of a self-directed IRA:
1. State-specific issues that can apply to alternative types of IRA investments (e.g. possible state, county, and city filing requirements and taxes).
2. Dealing with expenses that arise from alternative types of investments (e.g. real estate maintenance costs, property taxes, etc.).
3. Proper record keeping in order to prove, if necessary, that none of the above prohibited transaction or tax issues arose.
4. How to deal with ongoing IRA contributions and eventual IRA distributions.
Next up: "The Self-Directed IRA, Pt.1: Formation"
DISCLAIMER: THE FOREGOING IS NOT INTENDED TO BE GIVEN AS LEGAL, FINANCIAL OR TAX ADVICE, BUT INTENDED FOR INSTRUCTIONAL USE ONLY. IF YOU REQUIRE LEGAL, FINANCIAL, OR TAX ADVICE YOU SHOULD SEEK THE ASSISTANCE OF A QUALIFIED PROFESSIONAL.