The self-directed IRA, Pt. 1: formation
By Warren L. Baker
Editor's note: In a continuing series of articles, tax attorney Warren L. Baker will be writing on the topic of self-directed IRAs – from the basic formation process to the complex tax and legal ramifications involved when investing using these structures.
In my last article, "The Self-Directed IRA: Retirement Dream or Tax Nightmare," I provided on overview of the rapidly expanding area of self-directed IRAs. This article will begin to dig deeper into the topic.
For purposes of background information, lets first discuss what a self-directed IRA is. The majority of Americans that have a retirement plan, whether it’s in the form of an IRA, 401(k), 403(b), etc., have their money invested in traditional types of investments, e.g., stocks, bonds and mutual funds. However, the general rules governing an IRA allow for any type of investment except for investments into life insurance contracts and collectibles (e.g., rare coins, antiques, wine, etc.). The most common investments for self-directed IRAs include: real estate, loans, tax liens, and privately-held companies.
That sounds great in theory, but in order for you to actually invest 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 financial institution that holds your retirement account must be able to facilitate the investment or you are out of luck. The reality is that most large investment institutions (e.g., Charles Schwab, Fidelity, etc.) have traditionally not allowed investments outside of publicly-traded securities. Thus, one of the first steps in the process of forming a self-directed IRA is generally to roll or transfer some (or all) of the retirement account to a new IRA custodian. But before we get to that issue, a few other steps will need to occur.
Step No. 1: Can the funds be moved?:
Prior to selecting a new IRA custodian (discussed more in Step No. 2), the retirement account owner needs to determine whether his or her retirement account is even eligible to be moved out of its current location. For example, many 401(k) plans significantly restrict the movement of money while the retirement account owner is still working for the company that sponsors the plan. In other words, if the 401(k)’s underlying plan documents will not allow the account owner to move their money, transferring funds into a self-directed IRA might not be possible. This is an issue that the IRA owner needs to resolve with their current plan administrator.
In general, if the retirement account that is owned by the client is structured as an IRA (or a 401(k) from a previous employer), it can be moved — in whole or in part — to a new custodian without incurring current tax consequences.
Step No. 2: The new custodian:
Once the retirement plan holder determines that they are eligible to move some (or all) of their retirement funds, they need to select a self-directed IRA custodian. Often, an experienced attorney will help in this selection process. Although there are an increasing number of IRA custodians that are willing to hold alternative IRA assets, there are dramatic differences between these custodians. Some custodians offer very minimal customer service, but have lower fees. Other custodians claim to offer the opposite. Another issue to consider is whether the custodian will allow the IRA to purchase a limited liability company, which is important if the client wishes to have maximum control over the structure (see Step No. 4).
Step No. 3: Rollover or transfer?:
After setting up a new self-directed IRA, it needs to be funded, which can be done in one of two ways:
1. The client can request a rollover — meaning that the old retirement plan administrator sends a check to the client that is made out to the new IRA custodian. The client then must deposit the check into the new IRA within 60 days. If the client fails to deposit the check in time, the entire amount will generally be treated as a taxable distribution.
2. The client requests a trustee-to-trustee transfer, in which the funds move from the old custodian to the new custodian without the client coming into physical possession of the funds.
Step No. 4: IRA or IRA/LLC:
Let’s assume for a moment that the client’s goal is to invest into a piece of residential rental real estate. Once the new self-directed IRA is funded, the client needs to decide whether he or she is going to invest the money directly out of the IRA (i.e., the IRA custodian buys the property on behalf of the IRA) or whether the IRA is going to purchase a LLC and invest using the LLC. With the client serving as the manager of the LLC, the latter option allows the purchase of property using a check from the LLC’s checking account, which will likely speed up the property purchase, depending on the custodian’s ability to move quickly. Also, the IRA/LLC model will reduce the future costs due to reduced custodian involvement (i.e., lower fees).
For tax purposes, because the LLC is a flow-through tax entity, investments made using either method are normally tax-deferred (Note: There are major exceptions which I will discuss in future articles). However, the control/flexibility allowed by the IRA/LLC creates problems if the client does not operate the structure is a legal fashion (Again, these issues will also be discussed extensively in future articles).
To be continued…
Disclaimer: The foregoing is not intended to be given as legal, financial or tax advice, but intended for informational purposes only. If you require legal, financial, or tax advice you should seek the assistance of a qualified professional.