Creating a self-directed IRA is relatively straightforward. It is not a creation of the tax code, but rather stems from the investment policies of the custodian that administers the IRA account. The agreement will allow you to diversify your IRA assets across a wide range of investments that you choose. However, when investing self-directed IRA assets, it is important that you and your advisor understand the types of transactions to avoid. These transactions, called “prohibited transactions,” can lead to serious tax consequences, including the disqualification of your IRA assets.
The prohibited transaction rules prohibit certain types of transactions with “disqualified persons.” Under the Code, “disqualified persons” include:
- The account owner and family members, including a spouse, parents, grandparents, lineal descendants, and any spouse of a lineal descendant.
- Any party that serves as a fiduciary to the IRA. A fiduciary is anyone who exercises discretionary authority or control over the IRA or its assets or provides IRA investment advice for direct or indirect compensation.
- Anyone providing services to the IRA, such as an advisor, broker, custodian, accountant, or attorney.
- Any entity (corporation, estate, partnership, etc.) in which you (or a family member) own at least 50%. Family aggregation rules will apply.
- An officer, director, a 10% or more shareholder, or highly compensated employee for an entity of which you own at least 50%.
- A partner or joint venture that owns 10% or more of a corporation, partnership, trust, or estate of which you own at least 50%.
Given the broad definition, there are countless examples of transactions which violate the prohibited transaction rules. Some of the more common examples include the following:
- Borrowing money from your IRA
- Selling property to your IRA
- Receiving unreasonable compensation for managing the IRA
- Using the IRA as security for a loan
- Buying property in the IRA for personal use
- Using the IRA in investment transactions or partnership agreements under which the account owner receives a benefit
If the IRS determines that you engaged in a prohibited transaction, the entire IRA account will be included in income for the year in which the transaction occurred. Moreover, if the account owner is under age 59 ½, he or she will be subject to the early distribution penalty. Quite obviously, this is a huge penalty and something you want to avoid at all costs!
Finally, even with self-directed IRAs, you do not have total flexibility in managing your investments. In addition to prohibited transactions, the IRS also specifically prohibits IRAs from investing in life insurance and collectibles. The prohibition on life insurance contracts includes whole life, universal, and term and variable policies. Under the statutory rules, collectibles include the following:
- Coins (although there are limited exceptions)
- Alcoholic beverages
- Certain other tangible property
If you invest any IRA funds in life insurance or a collectible, the amount invested will be subject to income tax for the year of the transaction. Of course, if you are under age 59 ½ when the transaction occurred, the 10% early distribution penalty will also apply.
Ultimately, a self-directed IRA can provide you with the flexibility you’ll need to include alternative 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 (and expensive) consequences.