The total amount invested in individual retirement accounts (IRAs) continues to grow. According to the Investment Company Institute, Americans have invested more than $15 trillion in IRAs. As the money invested in IRAs has increased, so too have the kinds of investment options available to IRA holders. One of these—the so-called “self-directed IRA”—has become especially popular. Self-directed IRAs allow investors to hold a wide variety of non-public assets, including LLCs, limited partnerships, rental property, and even bitcoin.
Self-directed IRAs are legitimate, but investing in non-public assets in an IRA can be tricky. This space is so treacherous that most large brokerage firms stopped offering custody services for IRAs with non-public assets several years go. Their exit opened the door to an entire industry of self-directed IRA custodians. Unfortunately, mistakes in self-directed IRAs can be costly and not every self-directed IRA custodian is as careful as they should be, so do your homework and learn the rules. Here are few of them.
The Internal Revenue Code (IRC) prohibits certain types of investments in IRAs. For example, an IRA can’t invest in life insurance policies, or collectibles such as artwork, rugs, antiques, gems, and stamps. Certain coins purchased for their precious metals content are permissible, but coins purchased as collectibles are prohibited. Shares in private corporations might be permitted, depending on the ownership, but buying stock in S corporations is not allowed.
The IRC also prohibits IRAs from engaging in transactions with “disqualified persons.” Disqualified persons include any fiduciary to the IRA (including the IRA owner), members of the IRA owner’s family (spouse, ancestors, lineal descendants, or spouses of lineal descendants), or a corporation, partnership, trust or estate where 50% or more of the shares, profits or beneficial interests are owned by any of these. Any officer, director, or 10%-or-more shareholder or partner of these entities is also disqualified.
Most prohibitions are intended to prevent IRA owners from benefiting from IRA assets without paying taxes. If an IRA owner buys rental property in her self-directed IRA, the IRA owner is prohibited from allowing any disqualified person from using that property, even if fair market compensation is paid for its use.
Likewise, the IRA owner can’t hire a disqualified person to manage their property, or “fix up” or repair the property. Instead, they need to hire an independent person to do the work, and payment would come from the IRA itself. If the IRA owner paid for services on behalf of the IRA, the payment would be a prohibited transaction, or would at least be deemed a contribution to the IRA.
Prohibited transactions can flow either way between an IRA and disqualified persons. For example, the IRA is prohibited from lending to or borrowing money from a disqualified person. Nor can IRA assets be used as security for a loan to a disqualified person. IRA assets can never be used to buy personal property.
The IRS levies steep penalties on prohibited transactions. The standard penalty is a tax on the disqualified person involved equal to 15% of the transaction amount. If the transaction isn’t promptly corrected, the penalty increases to 100%. In addition, the IRA will also be penalized, usually equal to 100% of the transaction amount. If the disqualified person is the IRA owner or a beneficiary, the penalty is even more draconian. In that case, the IRA itself is fully disqualified—meaning the entire IRA is deemed to be distributed, and the IRA owner is immediately liable for taxes on their entire IRA holdings.
Prohibited transaction rules for IRAs are complex. Penalties for violating those rules—even unintentionally—can be severe. If you’re considering making an investment in a self-directed IRA, take the time to consult with a trusted and competent advisor.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.