The Definitive Guide to Self-Directed IRA's
Self-directed IRA’s are like dynamite – very powerful, for sure... but also very dangerous.
But in the hands of a skillful user, dynamite is also artistic… even creative. (Ever seen Mount Rushmore?)
So too, Self-Directed IRA’s… powerful, dangerous, artistic, creative.
Clearly, the word’s been getting out, because self-directed IRA’s – while still a tiny sliver of the overall IRA market – are, nevertheless, booming in a huge way...
Just a few years ago, there were so few self-directed IRA's that it was mere fantasy for a self-directed IRA company to have over $1 Billion in assets under custody…
…But now, there are several SDIRA custodians who are well over the $10 Billion level.
That’s massive growth…
And it’s easy to see why. The core benefit of self-directed IRA’s is FLEXIBILITY!
Self-Directed IRA’s allow you to invest your retirement savings in practically anything…
- Real Estate
- Precious Metals
- Intellectual Property
- Private Businesses
- Hedge Funds
- Private Equity
- Tax Lien Certificates
- and on and on and on…
The raw potential here is astounding…
…And trust me… however much potential you’ve dreamed up for using a self-directed IRA, there’s far more ninja-level strategy you’ve never heard of that will blow your mind.
But here’s the trick to it:
If you have some expertise in alternative asset investing, self-directed IRA’s can change your life…
Otherwise, you should just stay away from them entirely.
The thing is, nearly nobody really understands self-directed IRA’s… (and that definitely includes most of the custodians and attorneys that claim to be experts!)
It’s so bad that even the U.S. Federal Government released a report in early 2017 that called out the IRS and the entire industry for not providing enough guidance on self-directed IRA’s.
It’s not that there’s a shortage of information out there…
…It’s just that none of it has been particularly effective at helping you get the benefits of self-directed IRA’s while avoiding the devastating risks… at the same time.
- There are plenty of self-directed IRA’s custodians who do a great job, but the law puts severe limits on how much they can really educate and advise you
- There is guidance from conventional financial advisors, and even directly from the IRS, all of which is designed to push you away from alternative assets and towards Wall Street investments
- There’s even a small handful of attorneys who, while having great technical skill, simply don’t have the ability to make this complex topic understandable.
This is where I raise my hand to help.
I’m not a conventional financial advisor, so I’m not biased in favor of Wall Street assets.
And I don’t run a self-directed IRA company, so the limits that apply to them just don’t apply to me…
And I’m not a lawyer, but I do teach a law class about the topic of self-directed IRA designed for California lawyers.
So what do I bring to the table for you?
What I bring is a ton of experience… a creative mind… and the ability to explain these concepts to you clearly.
My entire career revolves around helping people understand self-directed retirement accounts, like the self-directed IRA…
…and everybody from the University of California… to the top self-directed IRA attorney in America… to some of the most highly-respected publications in America all vouch for me:
- I’m described as a “nationally renowned expert” by the California CEB (Continuing Education of the Bar), a legal education program through the University of California for whom I teach self-directed IRA law
- Tim Berry, the nation’s top self-directed IRA attorney, describes me as “the best in the business.”
- Highly respected publications – like Forbes, Entrepreneur, TheStreet and others – have all published my articles about self-directed retirement investing
- I host the #1 podcast in America on the topic of self-directed retirement accounts called Self-Directed Investor Talk
I say this not to brag, but to communicate a simple point.
I’m going to tell you the truth about this stuff.
There’s zero conflict of interest.
I know this topic…
…And the truth is different from popular assumptions.
That’s the point of the report you’re now reading, Self-Directed IRA’s: The 360° Guide. I wrote this for 3 reasons, all of which benefit you:
- Self-Directed IRA’s are underused. I think more people can and should take advantage of them.
- Self-Directed IRA’s can be risky without the right knowledge… if you screw up, you could lose your entire IRA
- Self-Directed IRA’s can be extremely valuable for the right type of investor. If that’s you, you stand to win big.
But there are some things you need to learn so you can avoid the problems and enjoy the benefits…
And that’s what Self-Directed IRA’s: The 360° Guide is all about.
So let’s begin…
What is a Self-Directed IRA?
A self-directed IRA is a type of retirement savings account that allows you to invest in nearly any type of asset you want.
In a truly self-directed IRA, practically any type of investment is “on the table”… real estate, precious metals, private companies… you name it.
You’re probably already familiar with the more conventional type of IRA…
…You know, the type that limits you to stocks, mutual funds, etc.
Those are what I call “captive” IRA’s, because if you use one of those IRA’s, then your money is captive to the limitations of the IRA company:
- If you use a captive IRA company, your IRA can only buy what your custodian is selling.
- But if you use a truly self-directed IRA company, your IRA can buy almost anything you can imagine.
You may notice my focus on the word “truly” to describe self directed I.R.A.’s. That’s because a whole lot of IRA companies use the term “self-directed”… but it’s not true.
Here are just a few examples of companies that claim to offer self-directed IRA’s… but don’t:
- Charles Schwab & Company
- T.D. Ameritrade
I used to have an account at Schwab, and they did a great job helping me to trade conventional assets. I’ll bet that the others are really good, too.
But if you’re thinking bigger than just stocks and mutual funds, then captive IRA’s – like those offered by the companies above and nearly every other IRA company – just won’t do the trick…
…and that’s where the Self-Directed IRA comes into play.
Self-Directed IRA’s are Identical To Captive IRA’s
Would you believe that, under the law, there’s no such thing as either a self-directed IRA or a captive IRA?
That’s because the law that created the IRA (26 U.S. Code § 408) only established the “IRA” – the Individual Retirement Account.
The adjectives “self-directed” and “captive” and “conventional” aren’t found in the law at all.
What this means to me and you is this:
An IRA is an IRA is an IRA. They’re all the same.
The rules that apply to a captive (aka “conventional”) IRA also apply to a self-directed IRA and vice versa.
- All IRA tax benefits apply equally to captive IRA’s and self-directed IRA’s
- All types of IRA’s (traditional, Roth, SEP, etc.) are available in both a “captive” and “self-directed” variety
- All of the contribution limits and withdrawal rules apply equally to captive and self-directed IRA’s
- The wonderful estate planning (inheritance) features of IRA’s work identically for self-directed as for captive IRA’s
- The asset protection (protection from lawsuits) is the same for self-directed and for captive IRA’s.
From the point of view of the law, one IRA is the same as the next.
There are not different rules for captive IRA’s versus self-directed IRA’s.
But there’s more to it than that…
Self-Directed IRA’s are Radically Different From Captive IRA’s
Yes, I know I just said self-directed IRA’s and captive IRA’s are absolutely identical under the law.
They are. I’m not telling you something different now.
But one of the things the law allows is for IRA companies (usually called “custodians”) to select which types of assets that they will and will not service for their clients.
And that, as it turns out, is the difference between a self-directed IRA and a captive IRA:
- A self-directed IRA is an IRA opened at a self-directed IRA custodian.
- A captive IRA is an IRA opened at any other IRA custodian.
How do you know which you have?
Here’s a simple test: Call up your IRA custodian and ask if you can invest your savings into something like “dairy cattle”…
…if the answer is “yes” then you have a self-directed IRA!
So while it’s still true that an IRA is an IRA is an IRA, there’s one more fundamental truth:
Some of the rules (and the consequences of breaking them) really only apply to self-directed IRA’s versus captive IRA’s, so you must understand those rules...
…because if you plan to use the amazing flexibility that the self-directed IRA offers, you’ve got to be sure that you “stay in your lane” and always respect the rules.
(I’ll teach you about them in this guide.)
Why You Should - or Should Not - Use A Self-Directed IRA
First, let’s reiterate the terminology we’ll use from now on.
A “self-directed IRA” is an IRA that allows you to buy nearly anything you want.
A “captive” IRA is all of the other IRA’s… the ones that force the IRA owner to buy assets from the IRA company.
So every IRA is either “self-directed” or “captive”, ok?
Good. You’ve completed lesson 1. 😊
Now before we move forward into the really good stuff, I want to make sure you understand fundamentally what an IRA is.
But rather than fill your screen with all of that reference material, I’ve placed it all in this handy-dandy drop-down box.
If you want to learn the basics of IRA’s – whether self-directed or captive – then just click the “+” icon on this box, and everything you need is right there.
We’re all on the same page about what is an IRA.
Now, onward to greener pastures:
The Astounding Potential of a Self-Directed IRA
What, exactly, can you do with a self-directed IRA?
Nearly anything you can imagine.
If you’re using a captive IRA, you could, for example, buy stock in a company in the oil business.
But with a self-directed IRA, you could:
- Buy oil and gas rights directly
- Buy real estate in order to drill for oil
- Own heavy equipment that is leased to oil companies
- Invest in research and development… and license your patents to oil companies
- Oh yeah… you could just buy oil stocks too, if you wanted to do something so unimaginative 😊
Obviously, you’re not restricted to activity in the oil business. That’s just one example.
If it's an investment asset, chances are very high it will work with a self-directed IRA.
But it’s not just the ability to invest in alternative assets that’s so appealing.
Here’s a little example:
Would you like to be able to buy assets in your Traditional IRA – and get a tax deduction for that money, of course – but somehow magically have that money end up in your Roth IRA, where you can withdraw it totally tax-free?
Well… that’s possible. It’s not a simple matter, and there are rules that have to be followed.
But the point is: It’s possible… and it’s only possible with a self-directed IRA.
But I’m getting ahead of myself, so…
How Self-Directed IRA’s Work Differently from Captive IRA’s
Captive IRA’s are superior to Self-Directed IRA’s in one and only one way: Simplicity.
With a captive IRA, the IRA company offers only one or a few closely related types of assets. And where those types of assets are concerned, captive IRA companies know the rules…
…They know how to acquire the assets on your IRA’s behalf.
…They know how to sell the assets on your IRA’s behalf.
…They know how to acquire valuations for your IRA’s assets.
They do all of these things a gazillion times each year. None of it’s new to them.
Take an IRA at a stock brokerage, for example.
You don’t have to explain to them how to buy a stock. That’s their expertise.
But things are different with self-directed IRA’s.
Consider the purchase of a piece of real estate.
If you call up your IRA company and instruct them to have your IRA buy a particular piece of real estate, what are they going to do?
There’s a lot that has to happen before that point, like:
- Contact the owner
- Negotiate terms
- Create a contract
- Sign the contract
- Perform due diligence
- Sign closing documents
- and on and on and on…
That stuff isn’t the job of your self-directed IRA custodian. Not only won’t they do it, but it’s actually legally perilous for them to get anywhere near that stuff, so don’t expect them to do so.
We’ll get into the role of your custodian a bit later, but for now, understand this:
The primary job of your custodian is to execute transactions that affect the assets or obligations of your IRA. It is not their role to find and vet investments.
Whose job is all of that?
…And that’s both inconvenient and wildly exhilarating, because it’s specifically that responsibility – the responsibility of finding your own investments – that gives you the ability to do so many amazing things in your self-directed IRA.
I don’t want to give you the impression that your custodian has nothing to do with this. They certainly do. But we’ll get into that more a bit later.
Self-Directed IRA’s and Risk: What You Must Understand
Doesn’t all of the added responsibility of owning and operating a self-directed IRA increase your risk?
Well, yes it does… maybe.
But the hubbub you may have heard about the risk of self-directed IRA’s is sometimes overstated and nearly always misstated.
Here are three things you should understand about the “risk” of using a self-directed IRA:
- If you feel that self-directed IRA’s are risky, you shouldn’t use them.
- If you listen to conventional financial professionals about this, they’ll mislead you. (I’ll prove it.)
- If you do use a self-directed IRA, don’t underestimate the harsh ramifications of screwing up. You can avoid screwing up by getting good professional advice.
Ok, now that the general advice on risk is done, let’s look at this from a different point of view, shall we?
Answer this question for me:
If you’re a master real estate investor, but you know little about the stock market, which is a safer investment for you?
Clearly, real estate would be safer. And for that, the right tool for the job is a self-directed IRA.
In that case, a self-directed IRA is the only way to invest in the asset class that’s actually safest and most likely to be profitable for you.
To avoid using a self-directed IRA just because the conventional financial world prefers conventional IRAs is nothing short of asinine.
Here’s some good advice on this matter:
Don’t use a self-directed IRA unless you have a clear idea of what you’ll do with it.
And if you do use a self-directed IRA, you should be prepared for the fact that it will require more accounting and legal advice than you’d need if you were buying mutual funds.
Why is that?
A self-directed IRA is almost like your own private hedge fund. You’ve got to keep records for things like taxes and audits.
It’s simple: There are rules, and you’ve got to follow them. Breaking them can be cataclysmic…
…And since you don’t know those rules, you need to get help from somebody who does.
But that’s not a big burden. You’re going to have a strong working knowledge of those rules just by reading this guide.
But more fundamentally, here’s some incredibly simple advice that can nearly eliminate the risk of breaking the rules.
- Is any part of this transaction prohibited or taxable?
- Are there any danger zones that would take my IRA out of compliance?
- At what milestones should I have you review the transaction again?
That’s it. Ask those three questions to a good IRA attorney before every transaction, follow their advice, and you’ll be solid.
By the way… there are a handful of good self-directed IRA attorneys out there right now:
Strong litigator and expert in
Self-Directed IRA audit defense
I wouldn't hesitate to rely on the advice of any of those guys... click their photos to get their contact information.
...But the best of them all, in my humble (but 100% accurate) opinion, is Tim Berry. He’s everything you want in a self-directed IRA attorney: An absolute expert, vastly experienced, incredibly creative… and he speaks like a human, not a lawyer-android hybrid.
Tim will also tell you if he doesn’t know something. That’s rare among attorneys.
My recommendation: Use Tim as your "general counsel" for all things related to self-directed IRA, and if you need additional expertise, Tim will refer you as appropriate.
Ok, that's enough about attorneys for now. Let's return briefly to the topic of "risk" associated with self-directed IRA's.
I'll take this opportunity to decimate the basis of the argument many conventional financial advisors use to recommend against self-directed IRA's, which is:
Didn’t the Securities and Exchange Commission Warn Against Using Self-Directed IRA’s?
Back in 2011, the SEC did issue a warning about fraud happening in Self-Directed IRA’s. You can see that report here.
This report was published because a few cases of fraud had been perpetrated by hucksters who convinced unsophisticated people to open self-directed IRA’s and invest in their wild schemes.
Those people lost money, and that’s a terrible thing. I hate to hear about anyone being victimized. I do not minimize the significance of the loss to those people in any way.
But to add a bit of context to what’s in that report, understand this:
- The SEC did not recommend against Self-Directed IRA’s. Quite the contrary, in fact:
- The total amount of financial loss in all of the cases described in that report was less than the collective loss of wealth that happens when the stock of Apple Computer declines by a single penny
Yet still… all you hear from conventional financial “experts” is how “risky” self-directed IRA’s are.
The thing is… they’re misleading you.
A perfect example?
Clark Howard is a very well known “consumer advocate” on radio, TV and the internet who usually gives pretty good advice.
But he absolutely made a fool of himself in his response to that report. He published a video that completely ignored what the report actually said, which you saw above.
Here's how Clark spun and - dare I say, misrepresented - that report for his own aims:
Stop the presses!
I just looked, and the video on Clark's website with the misleading content has been taken down, probably in response to this article I wrote for Forbes.
Kudos, Clark! If you'd like to see the original video published on another site, check this out. I'm hoping that the removal of the video means he's changed his position. Reach out and let us know, Clark!
Also in that article in Forbes, I addressed another of the most common criticisms from the conventional financial world:
“Self-Directed IRA’s Are Too Risky Because They’re Complex”
Gee whiz, people.
If what you’re looking for is the simplest solution in the world, don’t use a self-directed IRA.
There. Problem solved.
But if that’s the way you think, then… only use the 1040EZ to file your taxes, because using the full 1040 form is too risky because it’s complex (even though you could save a LOT of money).
And never drive – or ride in – a car. Walking is far less complex, and much safer.
And if you feel chest pain, take an aspirin, but don’t see a cardiologist. Because all of those medical procedures are so complex… just too risky.
Yes… All of that is a bit tongue-in-cheek. But still.
If “complexity” is something that scares you, self-directed IRA’s aren’t for you.
But the simple truth is this:
You shouldn’t be handling the parts of this that are complex. That’s what expert lawyers and CPA’s are for.
Besides, the complexity is a blessing.
Here’s what top self-directed IRA Tim Berry has to say about it:
So let’s not kid ourselves, my friends:
If you’re the type of person who responds to knee-jerk characterizations like “self-directed IRA’s are risky” or “self-directed IRA’s are too complex,” then, you shouldn’t use a self-directed IRA.
As for the rest of us…
Let’s begin to learn some of those rules so we can profitably exploit them for our own benefit!
What Can You Buy In A Self-Directed IRA?
Your self-directed IRA can buy very nearly anything you want from very nearly anyone you want.
The operative words here are very nearly.
So what does “very nearly” mean?
It means that there are almost no limits at all on what your IRA can own.
Some assets into which your fellow SDIRA owners have invested include:
- Real estate
- Precious metals
- Pre-IPO companies
- Promissory Notes
- Patents, Copyrights, Trademarks
- Heavy Equipment
- Accounts Receivable (Factoring)
- Livestock (!)
- Bitcoin and other Cryptocurrencies
- Hedge Funds
- Private Equity
- and much more…
It’s almost accurate to say “the sky is the limit” in your freedom to select assets for your IRA.
In fact, rather than attempting to list everything that is allowed in your IRA, the law only prohibits 2 specific asset classes…
Investments You Should Never Make With Your Self-Directed IRA
Back when the IRA was created by Congress in 1974 (actually a fascinating and dramatic story, check it out here), there were only two types of investments prohibited in IRA’s:
- Life Insurance
It’s pretty easy to know if you’re buying life insurance…
What does that mean?
Well, our pals at the IRS were kind enough to give us the following list:
So, if you were hoping to build a retirement fortune by collecting cases of Budweiser or Jim Beam, you’re out of luck.
There’s a bit of a curveball in that list… did you catch it?
It’s that last one: “Certain other tangible personal property.”
Here’s what that means in plain English: The IRS could add to that list at any time, without warning.
So here’s a good, safe way to make sure you don’t let your IRA buy something that later turns out to be a collectible:
Ask an attorney. It will be money well spent…
…because if you buy assets you shouldn’t, and the IRS catches you, it’s going to hurt.
How badly will it hurt?
Well, the IRS will treat your purchase of prohibited assets as a “distribution”.
Doesn’t sound so bad, does it?
Well… It is bad.
Imagine, for example, your IRA purchases a piece of artwork for $50,000…
Artwork is a collectible, and clearly on the “no-no” list.
But you probably didn’t understand that when you bought it, so you were expecting to let the art appreciate in value and then to sell it for a profit in the future… and to pay no taxes in the mean time.
After all, that’s the wonderful promise of an IRA!
That’s not what will actually happen.
Instead, the IRS will categorize the $50,000 you used to purchase the artwork as a “distribution”. You might call it a “withdrawal”.
What does that mean? Lots of taxes, penalties and interest.
You’ll owe some or all of the following taxes:
- Regular income taxes on $50,000
- A 10% early withdrawal penalty
- Interest (usually 3-7 year’s worth)
- Underpayment penalty (20%)
It’s entirely plausible that, depending on the amount of interest accrued, and whether the IRS hits you with all of the possible penalties, that you could end up paying somewhere between ½ and 100% of the $50,000 distribution to the IRS.
But here’s the awful thing: You don’t actually have that money, because you bought artwork with it…
…that means you’ll have to come up with the payment to the IRS of between $25,000 and $50,000 out of your own pocket.
Here’s the bottom line: Don’t buy prohibited assets. When the IRS catches up to you – and they eventually will – you’ll pay dearly.
S-Corporations and Your Self-Directed IRA: A Common Myth That’s [Mostly] Wrong
Far and away, the most common type of asset purchased in IRA’s of all types is the Corporation.
When you buy publicly traded stock, that’s what you’re buying: shares of a corporation (a business).
But all of the corporations you can buy on the stock market have one thing in common: They’re taxed as what’s called a “C” Corporation.
It’s totally kosher for your IRA to own that type of corporation.
But there’s another type of corporation called an “S” corporation.
Actually, it’s not a different type of corporation. It’s just a different tax classification that the IRS uses…
…And if a corporation has the “S” classification, then it’s entitled to some pretty major tax benefits.
But here’s the thing:
The law that created the “S” corporation status put some pretty strict limits on who can own shares in that type of corporation.
Unfortunately, IRA’s aren’t among the fortunate few.
So what happens if an IRA – or any unauthorized entity – becomes owner of shares of an S-Corporation?
In that case, the S-Corporation loses its “S” status… and all of the major tax benefits that go along with that.
In other words, it harms the corporation substantially… and by extension, it harms you as an owner of the corporation, and it harms the other shareholders as well.
Basically, you’re screwing everybody who is an investor in that corporation.
So, yes, there are definite negative ramifications for owning shares of an S-corporation in your self directed I.R.A.
But that’s very different from being classified as a “prohibited asset” for purposes of your IRA, and here’s why:
If you purchase a prohibited asset – life insurance or collectibles – in your IRA, the IRS will reclassify that transaction as a distribution, and you’ll be hit with nasty taxes, penalties and interest.
Shares of an S-corporation, on the other hand, are not prohibited assets, and will not cause the IRS to declare your investment in those shares as a “distribution”…
…But the corporation itself will suffer, as ownership of shares in an S-corporation by any unauthorized entity (including your self directed IRA) will cost the corporation all of the substantial tax benefits of being an S-corporation.
Bottom line on S-Corporations in your self-directed IRA:
Will the purchase of S-Corporation shares in your SDIRA constitute reclassification as a “distribution” in your IRA? No.
Will the Corporation purchased in your SDIRA (and all of your fellow owners of the corporation) suffer financially because of the loss of its “S” status? Yes.
Do yourself a favor and stay away from S-corporations in your self-directed individual retirement account.
A Special Note About Investing in Gold or Other Precious Metals
In recent years, I’ve seen a lot of marketing for something called a “gold IRA”.
There’s actually no such thing as a “gold IRA” or a “precious metals IRA”.
Companies who advertise these accounts are actually just Captive IRA custodians who limit their clients to ownership of precious metals, much like other captive IRA companies limit their clients to stocks or mutual funds.
But the very notion of a “gold IRA” seems to conflict with something you saw earlier, which is:
Both metals and coins are considered to be “collectibles” by the IRS, and are therefore prohibited in your IRA…
…so how can it be that so many companies are advertising the ability to own gold, silver or platinum in your IRA?
It’s because even though metals and coins are prohibited assets for your self-directed I.R.A., there are some exceptions stipulated under the law that allow your IRA to own precious metals and certain coins.
In essence, your IRA is allowed to own bullion and coins made of gold, silver, platinum or palladium as long as the purity reaches a particular standard.
I’ll tell you more about using your self-directed IRA to invest in precious metals in a moment, because there are some other rules unique to this asset class you need to understand, so stick with me.
What you’ve seen in this chapter is that there are almost no asset class restrictions for your self-directed IRA, so practically everything (other than life insurance and collectibles) is on the table, but…
…for self-directed IRA’s, the biggest question isn’t really “what”… It’s “who”…
Disqualified Persons: How to Destroy Your IRA in One Easy Step
By now, you know that you are allowed to buy nearly anything – other than life insurance and collectibles – in your self-directed IRA.
That’s good. Flexibility is good.
But there’s one rule that trumps all of that flexibility…
…one rule that renders all other considerations moot.
Your IRA’s assets must never, ever be used to benefit a “disqualified person”.
I’ll tell you who is a “disqualified person” in just a moment, but for now, understand this:
If your IRA transacts business with, or indirectly brings benefit to a disqualified person, then your IRA is guilty of something called a “prohibited transaction”.
Prohibited Transactions can be, and usually are, cataclysmic for an IRA.
The penalties for prohibited transactions are even worse – far worse – than the penalties for investing in prohibited assets.
Committing a prohibited transaction – even if only by accident – can eliminate your IRA entirely in the blink of an eye.
It’s that serious.
That means it’s critical that you identify these dangerous scallywags known as “disqualified persons”.
The IRS gives us a jumbled mess of a definition of “disqualified persons” here.
I will, of course, explain this in a manner that actually makes sense to you.
Broadly speaking, “disqualified persons” for purposes of your self-directed IRA include:
- You – the owner of the IRA
- Most of Your Family – your ancestors, descendants and their spouses
- Related Entities – any business or organization on which you or a family member have substantive ownership or influence
- IRA Account Professionals – your account custodian or anyone providing services connected to the IRA
Let’s have a look at each of these…
Disqualified Person #1 – The Self-Directed IRA Owner
You must never, ever use your self-directed I.R.A in a way that brings you personal benefit.
This may be confusing for you.
After all, doesn’t your IRA exist solely for your benefit, so you can have money to pay for your retirement?
Yes, it does… but only for the purpose of benefiting your retirement.
This is important: In the eyes of the law, you and your IRA are entirely separate entities.
If you use your IRA to benefit yourself in the here-and-now – or at any time prior to making proper withdrawals – you’ll be in a whole lot of trouble when the IRS catches up with you.
What are some things you might do to benefit yourself using your IRA’s assets?
Common examples of using your IRA for your own benefit are:
- Borrow money from your IRA
- Live in a house owned by your IRA
- Pay yourself to manage your self-directed account
- Sell assets to your IRA
- Buy assets from your IRA
- Use your IRA as collateral for a loan
- Personally accept a commission for purchase or sale of an IRA asset
- Allow your IRA to conduct transactions with other disqualified persons
You get the idea.
Basically, if anything about your life – other than your IRA balance – is improved by one iota on account of the use of your IRA or its assets, then you’re in prohibited transaction territory…
…and that’s very bad.
Those types of interactions with your self-directed IRA are pretty obvious and straight-forward. It really should be pretty easy for you to avoid those things.
But with prohibited transactions, the ones that hurt the worst are the most subtle and indirect…
Prohibited Transactions Case Study: Subtle, Indirect & Dangerous
Imagine this scenario:
Your self-directed IRA has invested in beach-front property.
You plan to live in that property after you retire, but for now, you’re just renting it out through a property manager who handles vacation rentals.
One weekend, there’s nobody scheduled to rent your property, so you allow your boss to use it for the weekend. Your boss has a great time, and all is well.
Your boss isn’t a disqualified person, so there’s no problem there, but…
Danger, Will Robinson!
A few months later, you get the promotion that everybody in your department has been gunning for.
Forget about whether you deserve the promotion. That’s not the issue.
The issue is this: Can the IRS reasonably claim that your gifting of the use of your IRA’s property to your boss helped to get you the benefit of a promotion at your job?
Yes, that’s a totally plausible claim… and it would cost you dearly…
…Even though it’s subtle, indirect and completely accidental.
Prohibited Transactions Case Study: The Property Next Door
Imagine this scenario:
John Doe owns a home where he and his family live. It’s a growing area with rapidly growing real estate prices.
The opportunity arises for John to buy the run-down home that’s directly adjacent to his home. The price is right, and he’ll win big with an appreciating real estate market and a little bit of fix-up.
So John buys that home in his self-directed IRA.
He does everything by the book…
When he bought the property, he used IRA money, and the property was titled in the name of the IRA. All good so far.
When he needed to repair the property, he called third-party professionals and paid them with IRA funds. All good so far.
When he had to pay his property tax and hazard insurance bills, they were paid directly from the IRA… exactly as they should be.
A year later, John sells that house, and his self-directed IRA enjoys a nice profit.
But 4 years later, when John is facing a random audit of his personal income taxes, the IRS takes a look at his self-directed IRA…
…and they declare him guilty of a Prohibited Transaction!
The IRS’ reasoning goes like this:
Real estate values are based on the values of similar properties in the area.
When a property’s value rises, it raises the value of the properties around it.
John knew, according to IRS reasoning, that by purchasing and renovating the property next to his own, then John’s personal residence would also increase in value.
To the IRS, this was a clear prohibited transaction.
It is a classic, though subtle, case of the assets of an IRA benefiting the owner of the IRA personally… even though that was never the intention.
Disqualified Person #2 – Your Family
To the IRS, using your IRA to benefit your family members is the same as using your IRA to benefit yourself… it’s prohibited.
Essentially, you can apply the same descriptions I used above to your family members…
…so even though it’s not you personally, each of these is still prohibited:
- Allowing your IRA to buy assets from or sell assets to your wife
- Lending your IRA’s money to one of your children or grandchildren
- Allow your aging parents to live in a property owned by your IRA
Here’s a good rule to follow:
If it’s a prohibited transaction for you, it’s a prohibited transaction for your family, too.
Curiously, though, the IRS doesn’t include all of your family as “disqualified persons”, though they do include most of those you’d expect:
- Your spouse
- Your children, grandchildren, etc.
- The spouses of your children, grandchildren, etc.
- Your parents, grandparents, etc.
What’s curious is who is not on that list.
Not included in the list of disqualified persons is:
- Your siblings and their spouses and children
- Your aunts, uncles and their spouses and children
- Former spouses – yours and your descendants
- Step-parents, step-grandparents, etc.
- Step-children, step-granchildren, etc.
So, for example, it is a prohibited transaction for your IRA to sell an asset to your wife…
…but sell the same asset to your brother or step-mother or uncle, and you’re in the clear.
This can be very useful…
As you grow in sophistication with the use of your self-directed IRA, you’ll discover that it’s frequently very helpful to have a trusted third party who can engage in transactions that are beneficial to your IRA…
…and this list of family members who are not included in the IRS’ list of disqualified persons is frequently a great place to start to find such a trusted third party.
Disqualified Person #3 – Related Entities
If you own any businesses, those business are (usually) considered to be a totally separate person from you in the eyes of the law.
But as the owner of that business, your fortunes are (at least partly) tied to the fortunes of that business…
…and from the IRS’ point of view, it’s probably you pulling the strings of any business you own… totally for your own benefit.
It’s for that reason that any businesses you own are also considered a “disqualified person”.
The IRS will see the activity of your businesses as, essentially, an alternate version of you.
And since you are disqualified person, so are any businesses you own.
This means you can’t pull any shenanigans by trying to use your business as a counter-party in an IRA transaction, or in any other manner.
So don’t even think about trying it.
But this does bring up a natural question…
What About Businesses That You Don’t Own Entirely?
This is a real trouble spot.
In their Retirement Plan FAQ’s, the IRS doesn’t actually say that any business that you own in full is a disqualified person…
…the bar is, unfortunately, a bit lower than that:
This seems pretty clear. If you own or control 50% or more of a business, then from the IRS’ point of view, it’s a disqualified person.
That seems fair. If an entity could be controlled by you and serve as your alter ego, then being a disqualified person for your self-directed IRA makes sense.
I get that.
But I’ve got a major warning for you:
This does not mean that an entity in which you own less than 50% is inherently “safe” for your self-directed IRA.
On the contrary, all it means is that if you own 50% or more of a company, then it’s definitely a prohibited transaction for your self-directed IRA to engage with it.
My proof for that is an unfortunate fellow named Joseph Rollins, who squared off with the IRS in tax court over some activity involving entities in which he owned only 13%.
The U.S. Tax Court decided that, despite Rollins’ small percentage of ownership, that his influence was sufficient to merit the designation of “disqualified person” for that entity.
Rollins represented himself in court, and maybe it would have turned out differently if he’d had an experienced tax litigator on his side. Furthermore, this case deals with a non-IRA retirement plan, so it’s possible this wouldn’t apply to IRA’s… but it’s extremely like it would.
But what that case did was clearly establish the precedent that an entity can be deemed to be a “disqualified person” if you own far less than half of it.
But it goes even farther than that…
Recently, the California CEB (a legal education organization of UCLA – http://ceb.ucla.edu) asked me to teach the legal fundamentals of self-directed IRA’s and prohibited transactions to California lawyers.
When I did so, I suggested that there’s a different standard to be considered when evaluating whether an entity is a “disqualified person”.
I call that standard “Substantial Influence”.
That’s because, as the Rollins case clearly indicates, it’s entirely possible to have far more control over an organization than is indicated by the amount of legal ownership you hold.
- Members of Boards of Directors
- High-level Executives
- Informal But Highly Influential Advisors
Any one of these types of people may have zero ownership in a business, charity or association, but any one of those people may have actual influence over the entity so substantial as to be a de facto owner.
To be clear, this “Substantial Influence” doctrine is a creation of mine and not one that’s cited in case law…
…But it is supported, in large part, by the Department of Labor Advisory Opinion #93-33a which casts a very wide net:
In plain English, this says that if any substantive connection can be made between your IRA and any person (including entities) with whom your IRA transacts business, then your judgement as a fiduciary is affected and the transaction is prohibited.
So, while my “Substantial Influence” doctrine isn’t cited in case law, it’s strongly supported by common sense and by the Department of Labor, but of this I am certain:
You would be very, very wise to consider any entities or organizations over which you have substantial influence to be a disqualified person for purposes of your IRA, even if you have no ownership whatsoever.
Disqualified Person #4 – IRA Account Professionals
What people or entities who are unrelated to you still have an interest in or some level of control or influence over your IRA?
One obvious answer: Your self-directed IRA custodian or administrator.
They clearly have an interest in or influence over your IRA. For that reason, they are a disqualified person.
That’s one reason your self-directed IRA custodian will always carefully avoid giving you investment advice: If that advice leads to profit for them, they’ve just destroyed your IRA.
Your SDIRA provider also qualifies as a disqualified person because they “provide services to the plan” (your IRA). Anyone who provides services to your IRA is a disqualified person.
I suspect that this would include companies like appraisers, accountants, etc. But frankly, there’s not a lot of clarity on this issue…
…So as always, the best idea is to consult with an expert SDIRA attorney before engaging in any transaction.
So there you have it… disqualified persons are to your IRA as Kryptonite is to Superman… only worse, because once your IRA interacts with a disqualified person, the damage is done and can’t be fixed.
But while you know that allowing your IRA to interact with a disqualified person is the very definition of a “prohibited transaction”, something you may not know is:
What does it actually mean to commit a prohibited transaction in your self-directed IRA?
The rather damning answer is next…
Retirement Cataclysm: Prohibited Transactions in Your Self-Directed IRA
You’ve just learned about the types of assets your IRA isn’t allowed to purchase…
…And you’ve learned about the people and entities that must not be allowed to benefit from, or interact with, your IRA or its assets.
But the real question is:
What actually happens when you commit a prohibited transaction in your IRA?
In short: Financial pain… probably a whole lot of it.
But as with most things connected with IRS rules, there’s not just one answer to the question.
In fact, there are 3 different results that could happen based on the specific type of prohibited transaction committed in your account:
- Prohibited Asset Penalties
- Prohibited Transaction Penalties
- Fiduciary/3rd Party Penalties
Being penalized in any of these ways can be devastating…
…But “prohibited transaction penalties” – which are, unfortunately, the most common result – can be a genuine cataclysm for your IRA.
Prohibited Asset Penalties: Mandatory Partial Distribution
If your self-directed IRA is found to have purchased any prohibited assets – life insurance and collectibles, primarily – your IRA will be subjected to a mandatory partial distribution.
Before we continue, take note of this:
“Distribution” is the term used for withdrawal of money or assets from your IRA.
If you see the word “distribution” it means that the IRS is taking the position that some or all of the assets in your IRA have been paid to you.
The “distribution amount” is the size of the transaction from the IRS’ point of view.
In the case of prohibited asset purchases, the way it works is simple:
The IRS will act as if you requested a distribution in the amount of money used to purchase the prohibited asset.
Doesn’t sound so bad, does it?
Well, as ESPN’s Lee Corso says (way too much):
When a distribution is made from your IRA to you (assuming you’re below 59 1/2 years of age), you’re instantly subjected to the near-certainty of 3 negative results:
- Income Taxes
- Early Withdrawal Penalty
Depending on your income tax bracket and the amount of time that’s elapsed since your IRA purchased the prohibited transaction, it’s entirely plausible that you’ll end up with a tax bill for 40-70% of the amount you spent on the prohibited asset.
But here’s the kicker…
You must come up with the cash out of your pocket to pay those taxes, penalties and interest, because the “distribution” that the IRS is imputing to you was in the form of your prohibited asset, not cash.
So imagine you unwittingly purchased a piece of artwork in your IRA and paid $50,000 for it…
…When the IRS catches up to that, they’re going to tag you for, conservatively, half of that amount - $25,000 – in taxes, penalties and interest.
Bottom line: The stakes are high when you buy a prohibited asset… so don’t do it. Ever.
Prohibited Transaction Penalties: Mandatory Full Distribution
If you commit a prohibited transaction in your IRA – which almost always means you’ve let your IRA get “too close” to a disqualified person – then the IRS will hit you with the ultimate penalty:
Mandatory Full Distribution.
The Mandatory Full Distribution is a death warrant for your IRA.
Whereas the mandatory partial distribution only causes you to owe taxes, penalties and interest on the portion of your IRA that was used to buy a prohibited asset…
…with a mandatory full distribution, the entire account is forcibly distributed to you, effective as of January 1 of the year you committed the error, and:
It doesn’t matter how big or small the size of the errant transaction… your entire IRA is distributed and ceases to be an IRA.
That means that you could have an IRA worth $1,000,000 but if you commit a prohibited transaction with only $200, the entire account will be transformed into a normal non-IRA account.
Let’s step through this so you can see how horrible this particular penalty can be…
- Your IRA: $1,000,000 balance
- Prohibited Transaction: Your IRA reimburses you $200 for expenses
- The IRS takes 5 years to discover the prohibited transaction
- You’re assessed for federal & state income taxes on $1,000,000, easily reaching 50% total
- You’re assessed for an early withdrawal penalty of 10%
- Failure to Pay Penalty reaches to 25%
- At current IRS interest rates of about 4%, 5 years of delay would cost about 21.6%
- So far, you’re at 106.6% of your IRA balance, which means…
Your IRA has been wiped out entirely… and then some… because of a full distribution.
And that’s not the end of the bad news…
In the event that, somehow, your entire IRA balance isn’t consumed by taxes, penalties and interest, you’ve got something else to contend with:
Your IRA has ceased to be an IRA.
This is not a minor issue.
There are some serious practical ramifications of this:
- Your former IRA is no longer protected by the laws that keep IRA’s away from creditors
- Your former IRA no longer will be conveyed to your choice of beneficiaries
Point #1 is why you’ll soon see that much of the case law that’s relevant to IRA’s is not happening in tax court, but in bankruptcy court, because:
…if a creditor can prove that you’ve committed a prohibited transaction in your IRA, then your IRA is wholly unprotected from them.
Committing a prohibited transaction is a big deal. And the really bad news is:
It’s almost always completely irreparable.
It’s a real financial apocalypse.
This is why you mustn’t behave as if it’s optional to get competent legal advice about your self-directed IRA at every turn…
…Your entire life’s savings could be lost in the blink of an eye.
Fiduciary/3rd Party Penalties: Penalty + Unwind
It’s actually possible for a prohibited transaction to be committed in your self-directed IRA without your knowledge or involvement.
Imagine, for example, if you turned over control of your self-directed IRA to a conventional financial advisor who doesn’t know the rules for IRA’s…
The financial advisor directs your self-directed IRA to purchase a piece of real estate at an excellent price from your parents.
Clearly, this is a prohibited transaction, because your parents are a disqualified party for your IRA.
But… the mistake wasn’t actually yours… it was the mistake of 3rd party fiduciary.
In this case, the penalty is a bit less severe. It has two parts:
- Payment of a 15% penalty of the amount of money involved
- Account must be returned to condition before prohibited transaction occurred. (Property must be sold and capital returned to the account.)
To me, this is amazing…
It appears to me that any transaction that would be an account-destroying prohibited transaction if I committed the error is something far less severe if committed by a 3rd party.
That is very interesting, and gives rise to a strategy we’ll revisit in the “Checkbook IRA” section of this guide, coming up shortly.
But first, we have a big choice to make: What self-directed IRA company will you choose to hold your account?
Let’s take a look…
Self-Directed IRA Custodians: the Good, the Bad & the Ugly
An IRA custodian is a company that holds title to assets for the benefit of your IRA.
To be a custodian, the company must meet specific financial requirements laid out by federal and state law.
It’s kind of like a bank, only you can deposit and withdraw assets other than cash.
No matter what type of IRA you use – captive or self-directed – your choice of custodian is extremely important…
…But that decision is of absolutely central importance if you’re using a self-directed IRA, because the custodian is directly involved in so many more “moving pieces” of your investment strategy.
It’s a big deal to choose the right self-directed IRA custodian. More importantly, it can be devastating to choose the wrong one.
The competence of your custodian is a limiting factor for your self-directed IRA.
Fortunately, there are a lot of good self-directed IRA custodians from which you can choose.
In fact, I’ll give you a full list in just a moment.
But here’s a crucial reality that no self-directed IRA company will ever tell you:
Things change. A good custodian today can be a bad one tomorrow. You must strive for custodial independence.
It’s custodial independence that will allow you to move your assets easily and inexpensively from one custodian to the next in the event that your chosen IRA provider goes south on you.
How do you achieve custodial independence?
I’ll tell you more about that in a moment, but first there are some fundamentals we must cover.
You Must Use A Custodian To Have An IRA…
If you want to have a self-directed IRA, or an IRA of any type, you must have a “custodian”.
It’s not optional.
When Congress created the IRA, they chose to make it be a special type of “trust”, and all trusts necessarily have a trustee.
In the case of IRA’s, the trustee is called the “custodian”.
What Is The Job of a Self-Directed IRA Custodian?
From your vantage point as an IRA owner, the primary job of your self-directed IRA custodian is to administer transactions that directly affect the assets or obligations of your IRA.
They have other responsibilities, too… but most of those involve reporting on the activity of your account to the government.
As far as the benefit you receive from your custodian, they simply administer transactions that affect the assets or obligations of your IRA.
It’s not their job to find deals for you.
It’s not their job to vet deals for you.
It’s not their job to give you legal opinions.
It’s not their job to give you tax advice.
For your purposes, the only thing they’re there to do is to administer transactions that affect the assets or obligations of your IRA.
In other words – and I say this with respect to all of my friends and colleagues in the self-directed IRA custodial industry – they’re “paper pushers”.
That’s ok. They’re necessary, and I’m grateful for the good ones.
But just to be sure that you understand where your responsibilities and the responsibilities of your custodian diverge, let’s consider a hypothetical:
In this hypothetical, you’ve decided to purchase a piece of real estate in your IRA. You’ve picked out the property already, and you’ve got the money in your account.
Is it time for your custodian to spring into action?
Here are a few of the things involved in any real estate transaction that are beyond merely selecting the property:
- Contact the owner
- Negotiate terms
- Create a contract
- Sign the Contract
- Perform Due Diligence
- Sign Closing Documents
Some of these things require your custodian. Some don’t… and you need to understand the difference.
Remember: The fundamental rule is that your custodian serves to administer transactions that affect the assets or obligations of your IRA…
…so for each of those activities, let’s see if your custodian needs to be involved by asking ourselves: Does this involve the assets or obligations of my IRA?
- Contact the owner – Your IRA’s assets or obligations will not be affected by speaking to a property owner.
- Negotiate terms – Execution of the contract is subject to your IRA’s assets, but negotiation of terms does not affect the asset or obligations of your IRA.
- Create a contract – Contracts can be drawn up without regard to the assets or obligations of your IRA. (Note that performance of the contract does involve your IRA’s assets, and payment of legal fees to create the contract involves your IRA’s assets, but those things are not the same as merely creating a contract.)
- Sign the Contract – Signing the contract will create an obligation on behalf of your IRA, so this requires the involvement of your custodian.
- Perform Due Diligence – NO – Performance of due diligence does not affect the assets or obligations of your IRA. (Payment for performance of due diligence does require the involvement of your custodian.)
- Sign Closing Documents – YES – Closing documents will require transfer of assets from your IRA and acceptance of other assets into your IRA, thus your custodian is required.
So here’s the thing: It’s up to you to do all of the organization and direction to bring the deal to closing. Your SDIRA custodian will not be involved in that…
…but where issues of legal title, conveyance of capital, and legal documents are concerned, that’s where your IRA provider must be involved.
Just remember this:
Your self-directed I.R.A. custodian is not:
- A lawyer
- A title company
- A property inspector
- A mortgage lender
- A property manager
- A real estate agent
- A contractor
- Or any of the myriad of professionals required in a real estate transaction
Bottom line: Your self directed I.R.A. provider will only be involved in administrative issues related to the accounts.
My Comprehensive List of Self-Directed IRA Companies
Ok, here’s what you’ve been waiting for…
…my comprehensive list of self-directed IRA companies.
But note first: This doesn’t mean I’m recommending that you should or should not do business with anyone in particular on this list:[table id=1 /]
(Note – if you know of more self-directed IRA companies that are not included in this list, please reach out to me at [email protected] so I can add them to the list. Nobody is excluded on purpose.)
The Checkbook IRA: Self-Directed IRA's on Steroids
The Checkbook IRA is a self-directed IRA… but much more.
Sometimes, “more” is better…
And sometimes, “more” can kill you.
Same thing with a checkbook IRA LLC and your IRA.
It gives you literal checkbook control over your IRA funds.
Want to invest your IRA funds? If you’re using a checkbook IRA LLC, it’s as simple as stroking a check from your IRA.
It’s truly powerful, somewhat intoxicating, and without proper education, truly dangerous for your self-directed IRA.
Using a checkbook IRA – also known as the IRA LLC or the checkbook IRA LLC – erects something like a Chinese wall between your custodian and your IRA’s assets.
You do get the ability to absolutely control your IRA funds… but your activities are almost entirely hidden from, and not subject to the prior approval of, your self-directed IRA custodian.
With a checkbook IRA, you’re 100% in the driver’s seat.
But here’s the thing:
All of the rules – particularly those about prohibited transactions – still apply to every single transaction that you execute through a checkbook IRA…
…and since a checkbook IRA effectively eliminates your IRA custodian’s visibility into the activities of your IRA, it also largely eliminates your custodian’s ability to help you avoid prohibited transactions.
Now, having read chapter 6 on self-directed IRA custodians, you know that it’s not the job or responsibility of your custodian to give you legal advice or to prevent prohibited transactions.
Nevertheless, custodians are frequently able to gently nudge you in the right direction when they see you veering off course towards a prohibited transaction.
When you use a checkbook I.R.A., you give up the benefit of having another well-informed set of “eyes” on your transactions.
But if you’re able to implement processes that expressly protect you from harmful decisions even more effectively than your custodian could provide, then a checkbook IRA can be an astoundingly wonderful thing…
…It could even help to protect you from bad IRA custodians (more on that momentarily).
And contrary to conventional wisdom about checkbook IRA’s:
A properly structured checkbook IRA can substantially reduce the negative effects of prohibited transactions in your self-directed IRA!
All of that is the point of this chapter: To explain to you how Checkbook IRA’s work, and to give you the arguments for and against them so you can make an intelligent decision.
The 4 Big Reasons You Should Use a Checkbook IRA LLC
Reason #1: Checkbook IRA's Give You Instant Access To Your Capital
The biggest, most immediate benefit of using a checkbook IRA is summed up in one word: INSTANT.
If you, or someone close to you, holds check writing privileges for the capital in your IRA, your access to that money is instant...
...and sometimes, instant access can make all the difference.
Imagine you’re a real estate investor. You’re constantly on the lookout for a great deal, but you really don’t know when the next great deal is going to appear…
…But when it does, you must be ready to pounce. Otherwise, that great deal will vanish.
If you’re using a self-directed IRA in the normal way, you might miss the opportunity. That’s because you are forced to involve your custodian in every substantive step of the transaction…
And every piece of involvement from your custodian costs you in one way you just can’t afford: time.
- It’s the custodian who must sign the purchase and sale agreement.
- It’s the custodian who must fund all of the expenses, like earnest money, inspections, appraisals, attorneys, etc.
- It’s the custodian who must sign all of the closing paperwork.
With every point at which the transaction shifts away from your control back to the custodian, the amount of time required grows… and that can be fatal to your deal.
Even the speediest of custodians – and there are some impressively fast ones – simply can’t consistently perform at the near-instant speed needed to respond to unplanned opportunities.
And in real estate, missing any one deal could cost you a literal fortune.
And that’s where the checkbook IRA can be so handy.
Reason #2: The Effect of Prohibited Transactions Can Be Substantially Reduced
You'll recall that there are 3 forms of "punishment" for prohibited transactions:
- Full Distribution (aka complete devastation of entire account): Usually involves your use of the IRA assets to benefit yourself or a disqualified party
- Partial Distribution (aka complete devastation of a portion of the account): Usually result of purchase of prohibited assets
- Penalty (aka relatively minor penalty): Usually the result of a fiduciary (like your custodian) performing a prohibited transaction without your control of the transaction
By structuring your checkbook IRA LLC correctly, it's actually possible to relegate most prohibited transactions that could occur to the much less painful "penalty" level.
I'll share more with you about this later in this chapter.
Reason #3: Lower Fees
Depending on the amount of activity and number of assets in your self-directed IRA, it's possible that using a self-directed IRA could save you a huge amount of fees.
For example, I know of one many who owns about 200 pieces of real estate in his self-directed IRA...
...This guy pays an asset fee of $200 per year for each of those properties, totaling $40,000 per year to his self-directed IRA custodian!
If he had those properties inside of a checkbook IRA LLC, he'd likely only pay $200 per year to the custodian, because he'd only owe an asset fee for the LLC itself, not for each of the assets within the checkbook I.R.A.
That means he'd pay $200 per year to the custodian rather than $40,000!
Additionally, some I.R.A. custodians will "nickel and dime" you for every single activity like contract signatures, funds transfers, insurance purchases, etc...
But when those things can be handled directly by your self-directed check book IRA LLC, most of that goes away entirely.
Reason #4: Independence from Your Self-Directed IRA Custodian
Most self-directed IRA custodians and administrators do a great job, and will do a great job for years to come.
But there are some exceptions...
...And it's because of those exceptions - like American Pension Services and Summit Trust who are in receivership, and a few other custodians as well who simply don't show much respect for their clients - that you must always strive for one characteristic in the way your IRA assets are structured:
That's a nice way of saying that you need to make sure it's easy for you to move from one self-directed IRA custodian to another if something goes wrong in the future.
Remember this: When you do not use a checkbook IRA, then all of your IRA's assets are titled in the name of your custodian.
Sure, they're all for the benefit of your IRA, but under the law, it's your custodian who owns those assets... not you, and not your IRA.
So what happens if you decide you want to switch to a different IRA provider?
The answer: For each asset in your account, legal paperwork will have to be executed which conveys title to those assets from your current custodian to the new custodian.
If you have few assets, or if your assets are simple assets, that may not be a problem.
But if you have many assets and/or you own complex assets requiring public notice or special legal expertise for conveyance (like real estate), you could face a huge expense just by transferring from one custodian to another.
Recall in Reason #3 the example of the man who has an IRA that owns 200 different pieces of real estate...
If he decided to change custodians, he'd be in for massive expense and a lot of time.
For each property, he'd have to pay a lawyer to draft a deed conveying each property from the current custodian to the new custodian. He'd also have to pay recording/filing fees to the government, and he may even have to pay hefty transfer taxes, depending on the local laws.
(Note - your IRA is generally only immune to income tax, but not to property tax, transfer tax, etc.)
In that case, the IRA owner would certainly be looking at many tens of thousands of dollars just to change custodians.
But here again, if the only thing his IRA owned was an LLC, and that LLC owned those 200 properties, the transfer becomes far simpler...
...one asset - the LLC - would have to be transferred, not all 200 pieces of property separately. Sure, there'd be some legal fees... but probably a few hundred rather than tens of thousands of dollars.
Even the most forthright of self-directed IRA providers will never tell you that it's in your interest to structure your account so that you can transition to a new provider easily if you choose, but you can count on this:
If the time comes that you need to make a change, you'll be thrilled you structured your IRA's holdings this way.
So the basic notion here is this: There are some exceptionally great reasons to use a self-directed check book IRA L.L.C.
But here's the truth of the matter: not everybody should use a checkbook IRA...
Who Should Not Use a Checkbook IRA?
The Checkbook IRA is not for everybody... far from it.
In fact, unless one or more of the benefits above specifically address a need of yours, then you should not use a checkbook I.R.A. L.L.C.
Checkbook IRA's can either substantially increase or decrease the inherent risk of using a self-directed IRA...
...but usually, the risk is increased because the owner of a shiny new checkbook IRA will be too cavalier about the whole situation.
You see, having a checkbook IRA is much akin to starting a business. No longer are you concerned exclusively with buying and selling great assets, but you've got to concern yourself with a slew of other serious considerations like:
- Record keeping
- Tax filings
- LLC maintenance
- Manager compensation
- Asset protection
- Asset valuations
All of these issues are, to some degree, inherent to the use of a self-directed IRA. But when you use a checkbook IRA, your compliance obligations increase exponentially... as does your risk of error.
Before choosing to use a self-directed IRA, you should ask yourself this question: "Am I actually reliable enough to handle all of the obligations of owning a checkbook IRA LLC?"
If the answer is anything other than a resounding yes... then don't do it. It's just not worth the risk.
But if you are the right type of person - someone who is well organized, meticulous and careful - and if you have a particular specific purpose for using the Checkbook IRA LLC, then it can be an absolute godsend.
The Right Process for Setting Up A Checkbook IRA
Checkbook IRA’s are created by using the money in your self-directed IRA to purchase ownership of a single-member LLC.
(An LLC is just a type of business entity – kind of like a corporation – that is compatible with IRA rules. “Single Member” means that there’s only one owner of the LLC, and that’s your IRA.)
Let’s imagine that this LLC is called “Your IRA LLC”…
It's kind of like Your IRA LLC is your own personal investment fund, because that’s really what it is!
When your self-directed IRA purchases ownership of Your IRA LLC, an exchange takes place that looks something like this:
Money comes out of your IRA… and ownership of the LLC passes into your IRA.
But where does that money go when it leaves your IRA?
It goes directly into the bank account of Your IRA LLC.
And who owns, and therefore wholly controls, Your IRA LLC?
Why, it’s your self-directed IRA, of course!
And since you have the authority to direct the activities within your IRA, you also have one very important power:
The ability to decide who gets to be “in control” of Your IRA LLC on a day-to-day basis.
Whoever is in control of Your IRA LLC – whether yourself or someone else you select – has substantial authority. Without involvement from the custodian or anyone else, they can:
- Buy & Sell assets
- Spend the money in Your IRA LLC’s bank account
- Accept money on behalf of Your IRA LLC
- Sign documents on behalf of Your IRA LLC
This person, technically called the “Manager” of Your IRA LLC, wields practically absolute power over the assets of your self-directed IRA.
Nothing that they do is inherently subject to immediate review by your self-directed I.R.A. custodian, by the IRS, or by anyone else.
It is wholly up to the manager of Your IRA LLC to make sure that they follow the rules and don’t make any mistakes.
For that reason, selection of the manager of Your IRA LLC is a critical decision. We’ll look at that question a bit more in just a moment when I tell you how I think checkbook IRA’s should be structured.
How To Set Up a Checkbook IRA
In order to have a checkbook IRA, you must have an LLC owned by your self-directed IRA.
All LLC’s are required to have a document called an “operating agreement”. It lays out the rules that govern how the LLC’s assets will be managed, and the manager of the LLC is subject to this agreement.
There are some clauses that should, and some clauses that should not, be included in the operating agreement for your checkbook IRA LLC. Doing it any other way could cause you to create an LLC that’s prohibited from day 1.
That would be an absolutely, total disaster.
Additionally, that operating agreement must also be correctly filed in the correct state, which may or may not be the state where you live…
…And it can not be filed in such a way that you are the initial owner of the LLC. Doing so would require you to sell the LLC to your IRA, and that’s clearly prohibited.
Because of all of that, The simple answer… the best answer… the only answer to the question of “how to set up a checkbook IRA” is this:
Hire an experienced attorney to do it.
Setting up an LLC for use as a checkbook IRA is never a do-it-yourself operation.
Please, I implore you: Don’t even think about using a LegalZoom or other boilerplate type of LLC. Those documents have clauses that are very bad for IRA’s, and do not have clauses that are necessary for IRA’s.
Don’t use a boilerplate “checkbook IRA” LLC document, either. Those are becoming increasingly common, but should also be avoided.
It’s likely that your checkbook IRA LLC will require language that is specific to you and your circumstances alone, and no boilerplate document can help with that.
Don’t do that. Just don’t do it.
This absolutely requires the involvement of an attorney who is extremely familiar with self-directed IRA law.
Tim Berry, the Phoenix-based attorney who I consider to be the top expert on self-directed IRA’s in America, said this about setting up Checkbook IRA’s: “Setting up a checkbook IRA is a perilous thing. Just by including certain common clauses in your LLC documents, or by excluding some other little-known but absolutely necessary clauses from your LLC documents, your LLC could be operating as a prohibited transaction from day 1, and by extension, every transaction performed in your LLC is also prohibited.”
Which Attorney Should You Hire To Form Your Checkbook IRA LLC?
(Those are uncompensated endorsements. I think both of those guys can do a great job with this type of work.)
Should you choose to work with a different attorney, here are a few tips for separating the really good ones from the pretenders:
- Make sure your attorney has personally drafted at least a dozen customized checkbook IRA LLC’s for their clients in the last 2-3 years. More is better.
- Ask your attorney to tell you about the last 3 times they had to customize a checkbook IRA LLC operating agreement, and to explain the reasons that justified those customizations. This helps to confirm that they don’t simply create boilerplate documents.
- Ask your attorney to tell you 3 specific issues that they’ve observed in case law or audits as being “problem areas” for the way checkbook IRA’s are used by others. If they can’t give you specific examples, they probably don’t have any experience beyond basic, surface-level knowledge.
- Finally, ask your attorney whether an alternative to the self-directed IRA - like the Solo 401(k) - may be better for you. Many times, the answer will be a resounding yes.
I’m giving you these guidelines because, unfortunately, there are precious few attorneys who have even the slightest awareness of the rules surrounding IRA’s, and even fewer who are truly expert in the topic.
But there are a lot of them who claim expertise simply by virtue of being an attorney, even though they have absolutely no, or extremely little, substantive experience.
You need more than that for legal work that is literally foundational to your retirement savings strategy. You need somebody who really knows what they’re doing.
What Terms Should Be Included In Your Checkbook IRA LLC?
This is one of those places where I need to reiterate: I’m not a lawyer, and I’m not giving you legal advice.
I mention that again here because I’m about to share with you some of the features you might suggest to your attorney for inclusion in your Checkbook IRA LLC.
Many of these ideas will be very good for you.
Some of them may not be fitting at all.
Only your attorney who is familiar with your situation can say for sure.
So here are a few ideas to consider for inclusion in your Checkbook IRA LLC:
Checkbook IRA LLC Structure
Like most business entities, it’s possible for one or many different people to own portions of the LLC.
The LLC used in your Checkbook IRA LLC should have one and only one owner: Your IRA. This means that your LLC will be considered to be a “single-member” LLC, because the word “member” means “owner” in the context of LLC’s.
Additionally, there are two different “management styles” for LLC’s.
In one scenario, the LLC is managed (operated by or under the control of) by the owner (member) of the LLC. That is called a “member-managed” LLC.
The other scenario involves management of the LLC by a third party, who is called a “manager”. In that case, the LLC is called a “manager-managed” LLC.
For your checkbook IRA LLC, you should use the “manager-managed” style so that you can select a person who will have control over your LLC, and thus over your IRA assets.
If you choose “member-managed” for your checkbook IRA LLC, your IRA custodian will be in control of your IRA LLC. Clearly that’s not what you want!
Who Should Be The Manager of Your Checkbook IRA LLC?
One of the most important decisions you’ll make with your checkbook IRA LLC is the selection of the “manager” of your LLC.
The Manager of your LLC is effectively the “CEO” of your self-directed IRA. It is the manager who has the authority to invest the capital in your LLC, which are your retirement funds.
Many, many self-directed IRA owners choose to make themselves the manager of their checkbook IRA.
That’s a reasonable choice, and certainly gives you the most control over your self-directed IRA.
But a much better choice is to select someone with whom you have an excellent relationship, but who is a non-disqualified person.
Why? It all comes down to one issue: Prohibited Transactions.
You’ll recall from our look at prohibited transactions that there are 3 different types of PT’s that can happen in your IRA’s, with 3 different degrees of severity ranging from a relatively minor penalty all the way to complete annihilation of the entire account.
Far and away, the least severe happens when a fiduciary rather than the account owner, commits a prohibited transaction.
When a fiduciary – such as an unrelated person serving as manager of your checkbook IRA LLC – commits a prohibited transaction, the IRS will usually hit your IRA with a 15% penalty, and will require the transaction to be unwound.
But if you as the account holder committed the same prohibited transaction, odds are extremely high that the result would be mandatory full distribution…
…in other words, the annihilation of your account.
The only difference is who controlled the capital in that case.
For that reason, if you choose to use a third-party manager for your checkbook IRA LLC, you’ll want to include some verbiage in the operating agreement that gives the manager sole authority to make investment decisions.
Your goal here is to make it very, very clear to the IRS that your LLC manager has independent decision making authority... and for that to legitimately be the case.
If you take this path of having an independent non-disqualified third party to serve as your checkbook IRA LLC's manager, consider asking your attorney about these suggestions:
- Manager of your Checkbook IRA LLC should have a separate written employment agreement that does include reasonable compensation
- Except for criminal or wreckless acts, your checkbook IRA LLC manager should be employed for a set period of time so that it can not be argued that you could fire the manager as a motivator for allowing you to control the activities of the manager
- Your manager should have full independent discretion to invest your IRA funds regardless of your opinion
- There should not be an indemnification of the manager
- A successor manager should be stipulated in advance in the event the original manager dies or is incapacitated
None of these items prevent you from making suggestions to your checkbook IRA LLC manager for how to handle the assets of your IRA, not do any of these things prevent your manager from acting on your recommendation...
...But what is accomplished is establishment of legitimate independence, which is a legally necessary component to be able to argue that any prohibited transactions committed by your manager should be merely penalized rather than resulting in a partial or full distribution.
Now remember: A lot of this stuff is legally untested, because frankly, there's not a lot of case law related to self-directed IRA's. But a reading of existing statute, regulation and case law suggests to me that this strategy is a reasonable one...
...But as always, confirm with your own attorney, because I am not an attorney.
An Important Role For Your Checkbook IRA LLC...
Whether or not you use a 3rd party manager for your checkbook IRA LLC, one other position you should seriously consider including is a legal advisor.
An excellent strategy is to require the manager of the LLC - whether you or anyone else - to seek legal advice concerning any and all transactions before execution.
This is a great idea no matter whether it's an IRA LLC or a major corporation. But it's particularly relevant for a checkbook IRA LLC because of this:
Compliance with tax laws in an IRA is complicated, ever-changing and very poorly understood.
It's entirely plausible that something you didn't even know could cause a prohibited transaction...
...and for that reason, I recommend that you specify a legal advisor who must be consulted and sign off on any transactions before execution by your checkbook IRA LLC's manager.
Miscellaneous Additional Terms...
Your IRA LLC operating agreement should stipulate that bankruptcy of any member doesn't cause automatic dissolution of the LLC.
(This protects your IRA LLC in the unlikely event that your IRA custodian - who is the sole member [owner] of your LLC - goes out of business.)
You should also stipulate within the LLC that any transactions executed by the LLC that are prohibited transactions are automatically null and void.
(That last idea may or may not help you if you face audit, but the risk of including such a clause is likely quite low.)
Wrapping It Up...
This topic of checkbook I.R.A. LLC's is a huge one, and frankly, I suspect I'll be adding to this section quite a bit...
...maybe even making it into a book of its own.
In the mean time, take this advice to heart: The self-directed checkbook IRA LLC takes a thing that is already extraordinarily powerful and very risky - the self-directed IRA - and dramatically increases both the power and the risk.
This is a professional-level tool. You must have good legal counsel at the beginning and every step of the way through if you plan to use this type of tool successfully.
The Self-Directed IRA Masterclass Is A Work In Progress. Check Back For More... We've Not Even Scratched The Surface Yet!
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About The Author
I am host of Self Directed Investor Talk, which I'm told is America's #1 podcast and for affluent self-directed investors. I'm also something of an expert in self-directed IRA's, solo 401k's and 1031 exchanges. You can find more of my writing in some cool places like TheStreet.com, Entrepreneur.com, ThinkRealty and even Forbes (that was always one of my goals!). I live in metro Atlanta, Georgia with my wife and business partner Carole Ellis(she's a real business partner... not just because she's my wife... I'd want to work with her if I wasn't married to her... and I'd want to marry her, too). I also have 4 children ranging in age from 2 to 20 (yes, you read that correctly). It's my goal to be the name everybody thinks of when they think of Self-Directed IRA's and Solo 401(k)'s.