Alex wanted to buy a rental property in a nearby resort community. He expected a large return on his investment and even planned to use the beach house himself for the occasional family vacation.
That’s when the idea took hold. Why not use his Individual Retirement Account (IRA) money instead of investing it in the more traditional CDs, mutual funds and money-market accounts?
Alex knew that the Internal Revenue Service (IRS) allows taxpayers quite a bit of flexibility in investing the funds in their IRAs and that a self-directed form of IRA would allow him to expand his investment options. So why not?
Unfortunately, Alex didn’t realize that even with a self-directed IRA there are restrictions, referred to as prohibited investments and prohibited transactions. Investments in real estate properties that involve personal use are prohibited transactions. As a result, Alex could lose the tax-deferred status of his entire IRA — and owe significant penalties and interest.
Looking to expand the investment options for your retirement funds beyond CDs, money markets, mutual funds, and stocks and bonds? If so, a self-directed traditional or Roth IRA might be the answer.
With a self-directed IRA, you can invest in real estate, startups and small businesses, and a host of other less traditional investments. Not surprisingly, one of the most common investments has been residential and commercial real estate.
Creating a Self-directed IRA
Creating a self-directed IRA is relatively straightforward.
The self-directed IRA is not an invention of the tax code — the IRS provides considerable flexibility in the investment options available for all IRA accounts. The difference between a self-directed account and other forms of IRAs stems from the investment policies of the custodial institution that administers the account.
To establish a self-directed IRA, you must choose a third-party custodian that allows you to diversify your IRA assets across a range of investments that you choose.
The custodial institution must also provide the necessary transaction and record-keeping support services. That generally means the annual fees are higher than for other IRAs. Given the nature of the investments, your risk of financial loss is also generally higher with a self-directed IRA.
Once you’ve created your self-directed IRA, you have the option of transferring funds from existing IRA and 401(k) plans or simply making future contributions to fund investments under the new plan.
Before you begin investing those funds, however, you should familiarize yourself with the IRS rules regarding prohibited investments and prohibited transactions. As the penalties for breaking these rules can be substantial, it’s a good idea to seek professional advice.
Even with self-directed IRAs, you don’t have total flexibility in managing your investments.
The Internal Revenue Code specifically prohibits you from investing IRA funds in most collectibles, including the following:
coins (although there are limited exceptions)
certain other tangible property
Consequences of a Prohibited Investment
Any money you spend on these prohibited investments is considered to be distributed to you from the IRA and is potentially subject to the 10-percent tax on early distributions.
There are also transaction-related restrictions that apply to your self-directed IRA. As a general rule, you cannot personally benefit from a transaction, nor can your beneficiary.
The rules regarding prohibited transactions also apply to your fiduciary and members of your family, collectively referred to as disqualified persons.
According to the IRS, specific prohibited transactions include the following:
borrowing money from your IRA
selling property to your IRA
receiving unreasonable compensation for managing your IRA
using your IRA as security for a loan
using IRA funds to buy property for current or future personal use
The IRS considers your IRA to be separate from you. As a result, while you can direct the IRA’s investments, you cannot participate in a more active or personal way.
For example, you cannot personally repair or renovate your IRA’s investment property and you cannot contribute your personal funds for the repair or renovation project. Likewise, you cannot use property purchased by your IRA for family holidays or vacations.
You also cannot receive a personal benefit from your IRA’s investment. For example, your IRA cannot buy the empty lot next to your house so that you can preserve your views.
Your IRA account is intended to provide you with retirement benefits in the future, but no current benefit other than the peace of mind you gain from knowing that you are taking the necessary steps to provide for your retirement.
Consequences of a Prohibited Transaction
If you or your beneficiary is found to have engaged in a prohibited transaction, your entire IRA loses its tax status as an IRA.
As a result, the IRS considers all of the assets to have been distributed on the first day of the year in which the transaction occurred — and at their fair market value, so you may have sizeable taxable gains.
In addition, a 15-percent penalty applies to the deemed distribution — plus a 10-percent penalty for an early distribution if the IRA holder is under 59-½ years of age.
If any disqualified person other than you or your beneficiary is found to have engaged in a prohibited transaction, that person may be liable for the following: a 15-percent tax on the amount of the prohibited transaction, plus a 100-percent penalty if the transaction is not corrected.
Ultimately, a self-directed IRA can provide you with the flexibility you’ll need to include nontraditional investments in your retirement portfolio. However, if you choose a self-directed IRA make sure you understand the rules and restrictions in order to avoid penalties and other unintended consequences.
Do you need help with your self-directed IRA?