Self-Directed IRA's: The Definitive Guide [2017 edition]
The self-directed IRA is a beautiful, dangerous, powerful, horrifying, wonderful financial tool.
I’m going to tell you everything you want to know about self-directed IRA’s… along with all of the things you actually need to know, even though you may not yet realize it.
What you’ll read on this page is likely very different than what you’ll see described on the websites of self-directed IRA custodians. That’s ok. They have their viewpoint, and you and I have ours as investors.
This guide is written from the vantage point of the investor, which is sometimes quite opposite the interests of custodians.
That’s enough introductory yammer. Let’s begin:
What is a Self-Directed IRA?
Let’s break that down into “what is an IRA” and what is “self-directed”.
An IRA – “individual retirement arrangement” – (you thought the “A” stood for “Account”, didn’t you? Nope) is Uncle Sam’s way of motivating you to save and invest for retirement.
The basic idea is this: You put money into an account, and the IRS gives you an income tax deduction for that deposit. Then you invest and reinvest that money, presumably making it grow and grow until retirement. As long as the money stays in the account, you don’t pay taxes on it, but the IRS gets their pound of flesh once you begin making withdrawals during retirement.
That’s the IRA in a nutshell.
(Yes, I know that the other kind of IRA – the Roth IRA – is taxed differently. But the point is the same: To use tax benefits to motivate you to save and invest for retirement. We’ll cover Roth IRA’s later.)
But what about the “self-directed” part of the equation? That part is easy. It just means that you get to choose whatever you want for your IRA. If you want to buy stocks, that's fine. If you want to buy real estate, have at it. If you want to buy a herd of alpacas, may the force be with you.
Surely There's SOMETHING That's Prohibited In An IRA, Right?...
Your shiny new self-directed IRA is nearly without limit in terms of the types of assets that you're allowed to purchase using your IRA funds.
In fact, the law that created IRA's - ERISA - doesn't say what you can buy in your IRA, only what you can't buy in your IRA. What are those things?
Fortunately for you and me, there are only 2 things on the "no-no" list for IRA's:
- IRA’s aren’t allowed to purchase life insurance
- IRA’s aren’t allowed to purchase collectibles
(Purchases of these assets in an IRA will cause the amount of money used for that purchase to be classified as a "distribution", likely bringing with it a financial burden for the rule-breaking IRA owner in the form of taxes, penalties and interest.)
There are certainly other restrictions for your IRA that must be honored – such as the prohibition against any transaction that benefits a so-called “disqualified person” – but where asset class-based restrictions are concerned, if an asset is neither Insurance nor a Collectible, it’s quite likely fair game for your self-directed IRA.
There is one other type of asset that's commonly thought to be prohibited for ownership in IRA's, but it really isn't. That asset class is "S-corporation" shares. Unlike assets that are actually prohibited - like life insurance or collectibles - purchasing shares of an S-corporation doesn't automatically trigger a distribution from your IRA. But there can be some very bad tax ramifications for the S corporation itself and the other shareholders, so tread lightly here. More information about S-corporations in a self-directed IRA is here
So the words "self-directed" before the word IRA just means that you, as the owner of the IRA, get to decide how the money in your IRA is invested, and nothing - except for the law itself - will constrain your choices.
A self-directed IRA is the best kind of IRA to have.
Which is why it may surprise you to know that...
If an IRA is not Self-Directed, What Is It?
An IRA is an IRA, period.
The term "self-directed" isn't a legal term, it's a marketing term. In other words, the phrase "self directed IRA" doesn't appear in the law anywhere.
Still, we've got to have an alternative adjective to describe IRA's that are not self-directed, and I think the best term to use is "captive", as in "she upgraded from a captive IRA to a self-directed IRA".
Here's why I use the term "captive" to describe non-self-directed IRA's:
Hypothetically, imagine that you open a checking account at a bank. In every way, it works like a checking account should: You get a checkbook, a debit card and monthly statements. There are tellers and ATM’s and local branches.
But there’s one catch: When you opened the checking account, there was a stipulation in the paperwork that forces you to spend all of the money you put into that account there at the bank.
Fortunately for you, this bank has a small grocery store built into it. It also has a small clothing store, and even a few doctors have set up shop inside of this bank.
And it’s a good thing they did, because otherwise, you couldn’t get medical care or clothing or food, because your money is captive to that bank. You can spend your money however you want, as long as you spend it right there inside the bank.
That’s exactly how nearly all IRA custodians work. They restrict your investments to those that are offered by the custodian themselves. And that’s why I refer to non-self-directed IRA’s as Captive IRA’s.
What's the REAL Difference Between "Captive" and "Self Directed" IRA's?
The answer comes down to 2 words: Your custodian.
ERISA requires IRA assets to be held under the care of a 3rd party custodian, ostensibly to assure safekeeping of those assets.
I think there’s a much bigger and more sinister reason for this, but I digress…
The distinction between self-directed IRA’s and captive IRA’s boils down to your choice of custodians, and the amount of flexibility they'll allow you to exercise.
ERISA only places two explicit constraints on you where IRA assets are concerned: You can't buy life insurance or collectibles within your IRA. Everything else is totally on the table under the law.
But while ERISA imposes almost no restrictions on the type of assets that your IRA can purchase, it also imposes no requirement on custodians to facilitate the full range of assets that IRA’s can handle. So your custodian can choose to let you buy anything the law allows... or they could choose to restrict you to a narrow range of assets. It's totally the choice of each custodian.
As a result, nearly every kind of financial firm imaginable began offering IRA’s… banks, brokerages, insurance companies, mutual fund companies, etc. Why would they do it?
Just think about it: Wouldn't you like to have a bunch of people who must invest their capital into the asset that you offer, whether they want to do that or not? That's exactly the scenario that captive IRA custodians create for themselves... and it's done completely on purpose.
A Brief Warning About Self-Directed IRA’s that Aren’t…
If you'd like to invest your IRA savings into real estate, tax liens or any other alternative asset, be very careful when choosing your custodian. Many very conventional IRA providers - like e-Trade, Charles Schwab & Co, etc. - offer IRA's that they publicize as being self-directed.
Are they actually self-directed? Yes. Sort of.
Here's the deal: Between the major markets and "pink sheet" stocks, there are about 15,000 publicly traded companies in the U.S. alone. There are also nearly 10,000 distinct mutual funds in the United States. And chances are, your "self-directed" IRA from a conventional broker will empower you to invest your IRA funds into practically any of them.
But once you try to buy any asset that is not offered by Wall Street, you'll quickly discover the limits of the "self-directed" capabilities of the IRA's offered by conventional custodians.
Want to invest in real estate, intellectual property or an LLC? With these "self-directed" IRA's from conventional custodians, you're out of luck.
The bottom line is that no matter how many investment choices a custodian provides to you, if they impose limits on the way your funds can be invested that are beyond the limits imposed by law, then what you're dealing with is a captive IRA, and you should find a good self-directed IRA custodian instead.
Which brings us to one of the seminal questions for all prospective self-directed IRA owners:
Which Self Directed IRA Custodian Is The Best?
Before you can know the "best", you need to know your options. A rather thorough list of self-directed IRA custodians is available here.
Picking the right custodian for your self-directed IRA is a vitally important decision. It's particularly critical if you plan to invest in real estate or any other asset that requires formal title work for conveyance, because those assets are much harder to transfer to a different custodian if you don't like the service you're receiving.
As you make this decision, keep this fact in mind: There's no obligation on you to use one and only one self directed IRA custodian. In fact, there are some circumstances when it actually makes a lot of sense to have multiple distinct IRA's. I'll get into that a bit later.
Here are 7 key considerations for selecting a self-directed IRA custodian:
1. Quality of Service: It would shock you to know how many times I've encountered custodians who have made major mistakes in their client accounts. The worst one I've seen (and I've seen it repeatedly) was a major custodian who totally failed to record a real estate deed for a property purchased in an IRA. This can be a real disaster.
2. Speed of Service: This matters more for some people than others. If you're buying real estate at a foreclosure auction, you need a way to get access to cash quickly, so you'll need to find a custodian who can commit to that.
3. Experience with Your Asset Class: If you're going to invest in real estate, choose a custodian that has a lot of experience with real estate investments. Seems obvious... but many people don't even ask.
4. Experience with Your Specific Strategy: Let's return to the example of investing in real estate. What does it mean - in your specific case - that you want to "invest in real estate"? If it means buying a plot of land and holding it, then nearly any self directed custodian can handle that for you. But if "real estate investing" to you means that you buy a house, renovate it, resell it via owner financing, and then resell the note in stages via separate partial transactions... well, clearly that strategy is very, very different from merely buying and holding real estate. Work with a custodian who understands precisely what you're doing so that you're not impeded when opportunities arise.
5. Asset Titling Options: How legal title to your assets is held by your IRA is a question that almost nobody considers until it's far too late. I have another article here that goes much deeper into this topic, but the basic summary is this: The way that most custodians hold title to assets builds a substantial dependency on that custodian for you. In other words, if your assets are titled incorrectly, it could be very difficult and expensive to change custodians if it was ever necessary. Read the article about IRA Asset Titling and be sure to select a custodian who will give you the flexibility you need
6. Personal Representative: When possible, use a custodian who assigns a personal representative to your account. It can be very helpful to have a personal relationship with a specific person.
7. Fees: Most self directed IRA custodians charge some combination of a flat annual fee along with a per-transaction fee. A few of them charge a flat percentage based on the size of the account... and usually, those are more expensive. It hasn't been my observation that there's an real correlation between the size of fees paid to a custodian versus the quality of their service, so aim to minimize fees.
I don't believe there is a single self directed ira custodian that is fundamentally the right choice for everyone. The best way to find the right custodian is to seek out the opinion of trusted colleagues. If you know me personally and want my opinion, give me a call 🙂
Which Kind of Self Directed IRA Should You Open?
There are several kinds of IRA's, and of course it's important that you pick the right one.
But we're not going to let this get complicated. First, for those of you who like a lot of details, here's a list of all of the types of IRA's from which you can select. Each is linked to a page with lots of information about that type of account. But FYI - if you're interested primarily in picking the right account for you, just skip this list and go to the next paragraph:
To simplify a complex issue, the simple reality is there's a 95% chance that you'll select the traditional IRA, the Roth IRA or the SEP IRA. So here's a quick description of the distinction among those kinds of accounts:
- The Traditional and Roth IRA are both very easy to qualify for, so nearly anybody can have these account types. The primary difference is a tax matter, with the Traditional IRA offering near-term benefits and the Roth IRA offering long-term benefits. Contribution limits are relatively low, at $5,500 per year (add $1,000 to that if you're 50 or older).
- The SEP IRA is basically the same as a Traditional IRA, but the contribution limit is much higher (around $54,000 per year). But the SEP IRA is generally only available to self-employed people, and while the contribution limit is very high, it's actually more difficult to contribute to it because the SEP is a profit sharing plan and not a salary deferral plan (like the iRA or 401k).
Also, if you qualify for the SEP IRA, then chances are good you also qualify for a different kind of self-directed retirement account called the Solo 401(k). A discussion of the distinction between the SEP IRA and the Solo 401k is available here and summarized below, but here's my firm belief: If you qualify for a Solo 401(k), you should use that, period. It's better than the SEP IRA, or any IRA, in every substantive category.
SEP IRA vs Solo 401(k) -- A Clear Winner
Enjoy Episode #245 of Self Directed Investor Talk, where I focus exclusively on the question of "SEP IRA vs Solo 401(k)":
Listen up, you self-employed people. If you’ve ever wondered: What’s right for me: A SEP IRA or a Solo 401(k)… I’ve got the CRYSTAL-CLEAR answer for you right now. I’m Bryan Ellis. This is Episode #245 of Self Directed Investor Talk.
Hello, SDI Nation! Welcome to the podcast of record for savvy self-directed investors like you! This is the show where the BEST stock is the one you liquidate so you can buy into REAL assets; this is the show where the only GOOD tax is the one you don’t pay; this is the show where we agree with Warren Buffet’s assessment that diversification is for the IGNORANT!
Yes, yes, yes… Buffett absolutely did say that. If you’d like to see the actual quote and context, stop by today’s show notes page at SDITalk.com/245 for that link… and for plenty of other EXTRAORDINARY resources you’ll absolutely love.
Quick question, folks: Do you want to have access to from $50,000 to $250,000 of cash credit for which you pay – say it with me – ZERO INTEREST? Then check out SDITalk.com/credit for a free webinar training that will tell you precisely how to make that happen. SDITalk.com/credit.
Ok… you people know good and well that we are believers in TAKING CONTROL of your investing… particularly your retirement investing… and self-directed retirement accounts like IRA’s and 401k’s are extraordinarily useful for that.
But you people who are self-employed face an additional choice, and I regret to say that it’s one most of you get WRONG, because you’re getting advice from people who are either uninformed or have conflicts of interest.
So yes, I, as the SUPREME LEADER of the Self Directed Investor movement in America, will get you back on the straight and narrow.
A typical IRA – whether Traditional or Roth – has an annual contribution limit of $5,500 or $6,500 for 2017, depending on whether you’re under age 50 or not.
Let’s be honest… that’s helpful but kinda pathetic. It really needs to be much higher.
But for you self-employed people, it can be much higher, either by using the SEP IRA or by using the Self-Directed – aka “Solo” – 401k. Nearly 10X higher, in fact. For both of those plans, the limits are $54,000 per year – or $60,000 per year if you’re at least 50 years old.
Big difference. MASSIVE difference. I’ll put it to you like this: One of our favorite markets for lower-priced turnkey cash flow houses is Birmingham, Alabama, where you can actually buy an entire fully-renovated turnkey rental property and still have money left over by simply making the maximum contribution to a SEP or Solo 401k for a single year!
But then you have to wonder: If you could do either the SEP or the 401k, which is better? Surely the SEP is better sometimes and the Solo 401k is better sometimes, right?
The only time the SEP might be preferable is if you’re investing ONLY in conventional highly liquid assets, like stocks or mutual funds.
But if you’re investing in real estate or ANYTHING that could be described as an “alternative” asset, the solo 401k is better, period.
Well, that’s all I’ve got for you today, thanks for listening…
Or wait… did you want to know WHY the SEP IRA doesn’t hold a candle to the Solo 401k? Ok, got it. Here goes:
Reason #1: Both SEP’s and solo 401k’s have the same very high contribution limit – around $60 grand per year – but there’s another limitation, too: You can only deposit a max of 20-25% of your business’ net earnings. So even if your salary is $1 million dollars, you still won’t be able to deposit a single penny if your business isn’t actually profitable. But the 401k has a big carve-out… you CAN do a straight deposit of up to $24,000 per year from your salary that’s wholly unconnected to the profits of your business. But with a SEP… again… if your business isn’t profitable, you can’t contribute ANYTHING to it, no matter what your salary is. So it’s MUCH EASIER to actually qualify to make a deposit into a solo 401k than into a SEP.
Reason #2: There’s technically no such thing as a ROTH SEP! You could make a non-deductible contribution to a SEP, and then convert it into a ROTH account, but you’ve got to do that 2-step process each time, and there are restrictions about how much and whether you can actually do that. But with a properly structured solo 401k, there’s both a TRADITIONAL and a ROTH component to it. With each individual contribution, you can choose whether that contribution will be taxed as TRADITIONAL or as ROTH.
Reason #3: At the end of the day, the SEP IRA is still an IRA. That means if you mess up and commit a prohibited transaction in your SEP IRA – which is, unfortunately, easy to do with real estate transactions – you’ve got a real problem that could cost you the entire value of your account. With a solo 401k, you’ve got to follow the same rules… but it’s pretty simple and cheap to fix errors… plus, errors only affect the one asset where you messed up rather than the entire account like with an IRA, including SEP’s.
Now here’s the thing: A lot of you have bankers or financial advisors who either don’t even suggest that you consider a solo 401k, or who even suggest a SEP IRA as a superior alternative to the solo 401k.
I’m sorry, but there are only two reasons one might make such a recommendation: One is that your advisor simply doesn’t know better, and the other is that your advisor is actually receiving a commission from the investments made in your SEP IRA, but would NOT be making a commission from your solo 401k transactions. The only way to know for sure is to ASK.
So here’s the big idea for today: If you qualify for both the solo 401k and the SEP IRA, choose the solo 401k… but only if you want to make the right choice.
That’s all for today… so what’s on tap for tomorrow’s episode of Self Directed Investor Talk?
We’re going to look into solo 401k’s a little bit more. That’s because they’re NOT ALL THE SAME. If you pick any 3 solo 401k programs offered by most of the self-directed IRA custodians, they’ll all be different and offer you a different subset of the potential that the law actually provides to you.
I’ll tell you what features to look for… and which types of solo 401k’s you should completely AVOID. The link to that episode is available by clicking the red “Next Episode” link at the bottom of the page.
What do you think, my friends? Sound off! Your comments, questions, even criticisms are welcomed in the comments area below. But let’s just be honest… what’s to criticize? <g>
My friends, invest wisely today, and live well forever!
Some Dire Warnings About Your Self Directed IRA
Look, self directed IRA's are pretty exciting... who wouldn't be excited about truly tax-free profits?
But there's a harsh reality you need to understand about these accounts:
It's easy to mess up when using a self-directed IRA, and when you mess up, it can be cataclysmic.
There are fundamentally 3 ways you can screw up in an IRA:
- You can buy a prohibited asset class
- You can engage in a prohibited transaction
- You can engage in a taxable (but not prohibited) transaction
You probably saw above where I identified the two asset classes that are always 100% prohibited for an IRA. The effect of buying such an asset in your IRA anyway is called a "partial distribution". In layman's terms, the way it works is this: If you bought $100,000 worth of collectibles in your IRA, then the IRS would deem that $100,000 to be "distributed" to you, as if you'd withdrawn it from you IRA.
As a practical matter, that means a few things:
- Your IRA balance would decrease by $100,000
- You'd owe income taxes (under most cases) on the $100,000
- You'd likely owe penalties and interest too, depending on when you discover your error
This is known as a "partial distribution" of your self directed IRA, and the hit you'll take in taxes, penalties and interest could be really, really big.
But as bad as that is, it pales in comparison to the ONE THING you must be sure to avoid at all costs in your IRA, the punishment for which is much, much worse than the partial distribution triggered by prohibited assets. The one thing you must ALWAYS avoid is:
Prohibited Transactions: Armageddon in Your Self Directed IRA
Imagine you've been saving aggressively and investing successfully for decades. You've built your self directed IRA up to a value of $3,000,000 and you're ready to retire, and then it happens...
....because of a simple technicality - a little thing you did 6 years ago that you didn't even know was wrong has come back to haunt you, and the IRS says that your account is now worth only $750,000 after all of the taxes, penalties and interest for which they're going to hit you.
Think it's impossible? Think again, my friends. This is the result of a "full distribution" of your IRA, which we at SelfDirected.org lovingly refer to as "blowing up" your IRA.
Being "fully distributed" is the ramification for committing a prohibited transaction in your IRA. What is a prohibited transaction?
A very good generalization is this: A prohibited transaction is anything that benefits the IRA Owner or his/her loved ones - even if only very indirectly - rather than benefiting the IRA itself.
These loved ones - along with a few other parties - are what the IRS refers to as "disqualified persons". The core of most prohibited transactions revolves around transactions that somehow benefit - even if only indirectly - anyone deemed by the IRS to be disqualified. For that reason, it's well worth your time to fully understand what is meant by "disqualified persons".
Who are these "Disqualified Persons"?
Broadly speaking, "disqualified persons" for purposes of your self directed (or any) IRA include:
- You - the owner of the IRA
- Family - your ancestors, descendants and their spouses
- IRA Account Professionals - your account custodian or anyone providing services connected to the IRA
- Related Entities - any business or organization on which you or a family member have substantive ownership or influence
"Disqualified Persons" is a critically important consideration. By engaging in a transaction that directly (or even indirectly) benefits a disqualified person, your entire IRA will be categorized as "Fully Distributed", which is catastrophic to your IRA and nearly always irreparable.
The IRS provides more guidance about Disqualified Persons here.
Alas, there’s more… FAR MORE… than meets the eye, and it’s all legally uncharted waters.
In moving forward, keep this little tidbit in mind: The IRS lists 10 groups of people who are DISQUALIFIED from doing business with your IRA. What’s #1? That honor goes to anyone who can be described as a FIDUCIARY of the plan. And SDI Society Legal Counsel Tim Berry – the Great One, we call him – tells us that Section 4975 of the tax code defines Fiduciary as anyone who has discretionary authority over a retirement plan.
Do YOU have discretionary authority over your retirement plan? Yes, you do. Remember, it’s *SELF* directed.
But that only prohibits the IRA from doing business directly with you, right? You’d think so, but… no.
According to Tim, the examples in that regulation (26 CFR 54.4975-6 a(5)) make it arguable that the disqualification extends not just to the fiduciary, but to anyone in whom the fiduciary has an “interest” that could sway the judgment of the fiduciary. Notice the use of the vague word “interest”. It doesn’t say bloodline. It doesn’t say family relationship. It doesn’t even say “personal relationship”. It just says “interest”.
Is it arguable that you have an interest in your siblings, your aunts, your uncles, your nieces or nephews? Sure it is.
So the bad news is this: The law says YOU are a fiduciary of your plan, and that you – and anyone in whom you’ve got an interest – are disqualified from doing business with your IRA. That’s a sobering thought.
The good news: Tim says he’s never seen this authority asserted by the IRS, so maybe their operating definition is narrower than what appears to be stipulated in law. Our advice: always, always, always consult qualified legal counsel before engaging in any transaction in your self directed ira. Our recommendation is to contact Tim Berry.
Prohibited transactions can be very, very subtle. For example:
- If your IRA owns real estate, allowing your granddaughter's girl scout troop to sell cookies on that land is prohibited
- If your IRA owns shares of a corporation, and you have more than a certain amount of ownership and/or influence over that corporation, that is prohibited
- If your IRA purchases real estate (or any asset) from you - even if at fair market value with no special consideration - that is prohibited
3 Tips For Avoiding Prohibited Transactions
Tip #1: Get Good Legal Advice Before The Transaction
There are questions you can ask yourself to safeguard your self directed IRA. Before each transaction, ask yourself these questions:
- Am I personally benefiting (rather than or in addition to my IRA) from this transaction in any way... even indirectly?
- Are any of my relatives benefiting directly or indirectly from this transaction?
- Are any business entities that I have any ownership of, or substantial influence over, benefiting directly or indirectly from this transaction?
- Is any money landing in my pocket, or my family's pockets, as a result of this transaction even if I'm owed the money?
- Is anyone who may be considered a disqualified person involved in this transaction?
In addition to asking yourself these question, you should enlist the assistance of experienced, qualified legal expertise, and seek their advice specifically on questions including:
- Does the asset I'm considering purchasing qualify as either life insurance or a collectible?
- Does it appear that there's involvement of any disqualified persons in this transaction?
- Do you see any indirect benefits that I'm receiving from this transaction?
- Is this transaction setting me up for any tax burden beyond that payable when I withdraw funds during retirement?
- Which parts of this transaction are most likely to be attacked by the IRS and need to be particularly well-documented?
Sequester Risky Assets
The thing that makes prohibited transactions so destructive is that any prohibited transaction, even if it involves a transaction of only $1, still results in full distribution of the IRA.
For that reason, if you're investing in assets that have a high proclivity towards prohibited transactions, such as real estate or LLC's, you would be wise to consider sequestering those assets into their own IRA accounts, like so:
- Determine the amount of capital necessary to perform the transaction in full
- Create a new self directed ira (a "sequestered account") and transfer that amount of capital into the sequestered account from the original IRA
- Never invest in any additional assets in the sequestered account
The advantage of this approach is that in the event a prohibited transaction takes place in the sequestered account, the assets in your original IRA will not be harmed. Additionally, you can create as many sequestered IRA's as you like.
Consider Using a Solo 401(k) Instead Of A Self-Directed IRA
The Solo 401(k) is another type of retirement account that provides the ability to fully self-direct its own investments, just like a self-directed IRA. However, the Solo 401(k) has several substantial advantages over the self-directed IRA, the most relevant of which for our purposes here is:
The Solo 401(k) makes it relatively simple and inexpensive to correct prohibited transactions. With Self-Directed IRA's, it's all but impossible to correct prohibited transactions.
The eligibility requirements for the Solo 401(k) are more demanding that the self-directed IRA. If you qualify, it is my advice that you seriously consider using the Solo 401(k) for your retirement investing rather than the Self-Directed IRA.
The risk of prohibited transactions can not be overstated. As leading self directed ira attorney Tim Berry says, the IRS is "not inclined to show any mercy. For an IRS agent, identifying a prohibited transaction is like Christmas morning, because it lets them tax a lifetime of savings and profits that were previously unreached by the government."
Job #1 with every transaction in a self directed IRA must always be: Avoid prohibited transactions.
While prohibited transactions are, without a doubt, the worst thing that can happen in a self directed IRA, there's one other issue which should generally be avoided, which is:
Taxable Transactions in your Self Directed IRA
What? Taxable transactions in an IRA?
Yes, I'm serious. It's a big shock to most people, who believe that IRA's are tax-exempt without exception. If only that was true!
There are 2 circumstances under which it's possible for your self directed IRA to be required to file an annual tax return and pay annual income taxes. They are:
- You're running an "active business" inside the IRA, such as a services business or a business that resells inventory
- You use debt financing (i.e., your IRA got a loan) to purchase an asset that results in a profit
These things are easy to understand, if you think about it.
For active businesses, the idea is that the IRS [reasonably] doesn't want to give tax-exempt entities like churches, non-profits and even your IRA a fundamental advantage over all other normal taxable businesses by allowing tax-exempt entities to operate without any income taxes. So they create a type of tax called "unrelated business income tax" that's charged whenever a tax-exempt entity engages in income-generating activities that are unrelated to the core purpose of the entity.
In the case of your IRA, the core business is to invest in assets which will grow in value to provide for your retirement needs. The core business of your IRA is not to serve as an income-generating business.
For debt financing, the idea is that the IRS is only willing to give you tax advantages in your IRA to the extent that it's your own money that you're using to make profit. So a good generalization is this: To whatever extent your investment is financed with debt, to that extent the profits of your transaction will be subject to taxation. The actual tax rules are more complicated than that, of course, but that's a decent generalization.
Requirements For Getting A Loan in Your IRA
Yes, it's totally legal for you to get a loan in your IRA (for the benefit of your IRA). Seems like a foreign concept to many, but it's done all of the time.
But getting a loan in your IRA is unlike getting a loan in your own name, or even in the name of a business entity.
That's because you must be aware of the issue of prohibited transactions which you'll doubtlessly recall is the worst thing that can happen in your IRA.
One type of prohibited transaction is when any disqualified person - which includes you - guarantees debt (or any obligation) on behalf of your IRA. In other words, you're not allowed to be a signer or co-signer for loans in your IRA.
A great solution to this is to get what's called a "non-recourse loan". This is a special kind of loan that empowers the lender to repossess the collateral (your investment) if the loan isn't paid, but prohibits the lender from taking legal action against the owner of the property (in this case, your IRA).
This avoids the issue with your providing a guarantee for your IRA because non-recourse loans don't require such a guarantee. But be very careful... some non-recourse lenders are very sneaky and are including provisions - called "carve-outs" that could trigger a prohibited transaction at a later time. Get good legal advice before taking one of these loans.
Conventional wisdom says that's the only option you have for getting a loan in your IRA, but conventional wisdom is WRONG.
What is prohibited is for any disqualified person to guarantee a debt for your IRA. But anybody else is allowed to do so...
...So think about it: Do you think it's possible that somebody may be willing to get a loan in their own name for the benefit of your IRA... and they are compensated by payment of a fee from your IRA? Of course! That's called a "credit partner"... and it's done all of the time!
And Now, the Good News...
I've painted a fairly grim picture of self-directed IRA's so far. That wasn't actually my intention, but it's important that you know that you're taking a substantially increased amount of responsibility when choosing to use a truly self-directed IRA.
Having said that, the things you can do with a self-directed IRA are very nearly magical. Consider just a few examples:
- You could use your self-directed IRA to acquire very low-cost, high-leverage purchase options on real estate. With these instruments, it's not uncommon to achieve cash-on-cash returns of hundreds or thousands of percent in a short time
- You could enter your self-directed IRA into strategic partnerships or joint ventures, enabling your IRA to profit by large sums of money even if you have contributed little or no capital to the transaction
- If you're using a traditional IRA, you can experience huge tax savings during retirement by withdrawing real estate using fractional interests rather than by withdrawing an equivalent amount of cash
And of course, aside from ninja-level strategies like those, the wise use of a self-directed IRA gives you something else of immeasurable value:
The ability to invest in assets that actually make sense to you.
Be honest with yourself: Do you think that the board of directors or CEO at that publicly traded company you've invested in really has your best interests at heart? No, they don't. It's not even arguable.
But with a self-directed IRA, you get control... real control... of your retirement portfolio. No longer will you be restricted to investing in stocks, mutual funds or CD's. From now on, it's all up to you.
That doesn't mean you have to step away from Wall Street assets entirely. It's all up to you... and that's the point. That's how it should have been all along. And with a self-directed IRA, that's how it can be for you... starting today.
Bryan Ellis is host of Self Directed Investor Talk, America's #1 radio show and podcast for affluent self-directed investors. He's also an expert in self-directed IRA's, solo 401k's and turnkey rental property investing... at least, that's what his wife tells him 🙂 He's a contributor to well-respected publications like TheStreet.com, Entrepreneur and ThinkRealty. Bryan lives in metro Atlanta, Georgia with Carole Ellis - his wife, business partner and best friend - and his 4 children ranging in age from 2 to 19.