The facts and fiction behind self-directed IRAs
[Please note that this article is about self-directed IRAs, which are very different from self-directed accounts for a 401(k) or other employer-sponsored retirement program. Azzad frequently helps clients open self-directed accounts for their employer-sponsored retirement programs, which allows them to choose their investments while still participating in their employer’s program. Read on to learn about the rules that apply to self-directed IRAs.]
Not long ago, the North American Securities Administrators Association (NASAA) issued a warning to investors about custodians who handle self-directed individual retirement accounts (IRAs). A self-directed IRA holds nontraditional investments like real estate, metals, or limited partnerships. These accounts have been the subject of growing regulatory scrutiny and punitive action. Before investing in a self-directed IRA, make sure you’re aware of the risks involved.
In its warning, NASAA dispelled 3 common myths surrounding self-directed IRAs.
1) The custodian is somehow blessing the investments available to you, performing due diligence and monitoring your account. The reality is that your custodian is not a fiduciary so it has no obligation to do so.
2) Your investment is safe because the custodian is a regulated trust company. In reality, the custodian is approved by the Internal Revenue Service, but its only real duty is to report contributions to and distributions from your account.
3) The custodian is holding your investment assets. In reality, it’s just a keeper of deposits and distributions from the account. Unfortunately, some investors have had to learn this lesson the hard way.
Two things you should know if you’re considering a self-directed IRA:
1. Prohibited transaction rules: These rules are designed to make sure that only your IRA, and not you (or your immediate family), benefits from your IRA transactions. For example, you’re prohibited from buying investments from or selling investments to your IRA. If you violate these rules, your account will cease to be treated as an IRA, with potentially devastating tax consequences.
Investing in real estate will require that you pay particular attention to the prohibited transaction rules. For example, you can’t sell property you already own to your IRA. And neither you nor certain family members can use real estate while it’s owned by your IRA. This sort of self-dealing can result in your entire IRA becoming taxable to you.
Note also that all expenses related to property owned by your self-directed IRA (maintenance, improvements, property taxes, condo fees, general bills, etc.) must be paid out of your IRA.
2. Unrelated business income tax (UBIT) rules: Even though IRA investments usually grow tax deferred (or even potentially tax free in the case of Roth IRAs), if your IRA conducts certain business activities or has debt-financed income, then your IRA could be taxed currently on all or part of the income generated.
For example, you buy and operate a bakery using IRA funds, then the income from that trade or business (less any expenses directly connected with carrying on the trade or business) is subject to UBIT. The IRA is taxed on the income (unrelated business taxable income, or UBTI) at trust tax rates.
If an IRA invests in a partnership that conducts a trade or business, then the IRA must calculate its UBTI based on its share of the partnership’s gross income and deductions. If your IRA purchases real property and finances the purchase with a mortgage, any rental income attributable to the financed portion of the property will be UBTI, even though that rental income would otherwise be exempt. This may result in double taxation as the income will be subject to tax again, under the regular IRA distribution rules, when ultimately distributed from the IRA (although qualified distributions from Roth IRAs will be tax free).
As you can see, a self-directed IRA can present some traps for the unwary. For most investors, we believe the potential benefits generally aren’t justified by the risks of a self-directed IRA. If you think otherwise, proceed with great caution.
This information presented above is for educational purposes only and should not be construed as tax, legal, or investment advice. Whenever making an investment decision, please consult with legal, tax, and accounting professionals.