A Must Read Before You Set-up A Self-Directed IRA

With the market fluctuations of late, investors are growing increasingly concerned and tired of watching their portfolio holdings lose value by the day. This is causing a lot of buzz in the area of Self‐Directed IRAs. Investors feel that by having more control over their investment options, they will see their investments grow rather than dwindle.

What is a Self‐Directed IRA?

Self‐Directed IRAs are retirement accounts in which you, the investor, decide what types of assets to hold. Traditional, Roth and SEP IRAs as well as 401k plans have the ability to have self directed status. In traditional accounts of these types, you were restricted to buying securities or annuities. However, that is not the case with
Self‐Directed IRAs. Within these types, you are allowed to hold real estate, stocks, mortgages, franchises, partnerships, private equity and even tax liens. If done correctly, there should not be any adverse tax consequences to establishing and investing in a Self‐Directed IRA.

What is not allowed?

Though more flexible than traditional retirement accounts, Self‐Directed IRAs do have their limitations. They do not allow, for example, investments in life insurance and collectibles (think artwork, antiques, stamp and coin collections, etc.). The rules are also strict about what you cannot do within the IRA in what are called “Prohibited Transactions”. The following are prohibited transactions within a Self‐Directed IRA:

  • Borrowing money from it
  • Selling property to it
  • Using it as collateral
  • Buying property for personal use with the funds
  • Receiving excessive compensation for managing it

The repercussions for partaking in prohibited transactions are steep. If the account owner or beneficiary engages in a prohibited transaction, the account is treated as having been distributed at fair market value as of January 1st of the year the prohibited transaction took place. Taxes would be do as well as a 10% early withdrawal penalty for those under the age of 59 ½. In addition to prohibited transactions, self‐dealing is also not allowed. Self‐dealing
is taking advantage of one’s position in a transaction by acting in one’s own interest rather than the best interest of the benefited party. In this case, self‐dealing would include situations such as:

  • Having your IRA buy real estate that you already own or use (your primary residence or a vacation home, for example)
  • Providing a child with a mortgage to purchase his/her first home
  • Purchasing stock in a corporation where you as the account owner of the IRA have a controlling equity position in the corporation

How is it set up?

A Self‐Directed IRA is oftentimes also referred to as a Checkbook IRA because there is typically a checking account established in order for the account owner to have immediate access to funds to purchase/make investments. A Checkbook IRA can be established in the following ways:

  • Self‐Directed IRA Limited Liability Company
  • Solo 401k
  • Business Funding Plan/Self‐Directed 401k
  • Utilizing an approved Self‐Directed IRA custodian

A Self‐Directed IRA LLC is typically the business structure for investors interested in investment real estate. When establishing the LLC, you are not limited to your state of residence. Rather, you are free to establish in the state of your choice and the cost of doing so ranges from $25 to $1,000. This arrangement establishes the IRA as the owner of the LLC who will be the one transacting business on behalf of the IRA. You would then need to find a custodian that allows for Self‐Directed IRAs and establish an account with them in order to transfer your assets from the existing IRA. One should also establish a bank account in the name of the LLC in order to receive any income from and pay expenses for the investment.

For a sole practitioner/business owner who wants to start a retirement plan for his/her business, a Solo 401k is a very smart way to go. With this type of structure, the business owner is allowed to defer $17,000 (plus $5,500 if over the age of 50) to the plan as well as make a profit sharing contribution of 20% or 25% (depending on the business structure) for a total annual contribution to the plan of $55,500 (including the catch up).

Practitioners that want to invest these monies in something other than stocks or bonds can take advantage of the loan provisions allowed within Solo 401ks. The investor would withdraw funds from the account by way of a special form that allows for loan disbursement. The interest charged for this loan is deposited back into the retirement account and builds the equity back up. The funds loaned can be self‐directed for investing. In order to initially fund the plan, you are also allowed to rollover funds from Traditional IRAs, SEP Plans, previous employer 401k plans, Money Purchase plans, Profit Sharing plans, Keogh plans, Defined Benefit plans, 403(b) plans and Rollover IRAs. You would
need to establish a bank account and appoint a Trustee. If it is a Solo 401k, you are allowed to serve as your own Trustee.

For investors interested in buying a business or a franchise, a Business Funding Plan would provide the appropriate structure. In this situation, you would roll over some or all of the monies in an existing IRA to a new 401k plan that permits stock purchase. You would then create a C Corporation who will purchase the shares of stock in the business using the funds you transferred over from the IRA. For purposes of a Self‐Directed 401k, a C Corporation is the only business entity that meets the legal requirements currently in place.

Is it a good idea?

Self‐directed IRAs may be a smart choice for only a handful of the most disciplined, by the book investors out there. Sure they allow for broader investment options but their rules are very stringent and the slightest misstep could be financially detrimental (think losing tax deferred status resulting in taxes and potential penalties). Not to mention that one has to be far more involved in finding investments and managing them, sometimes on a daily basis. For individuals that buy their own business or a franchise they work in, that diversification is lost as your current source of income also becomes your nest egg for the future. If you are considering establishing a Self‐directed IRA make sure you do your homework and proceed with caution! It is far too easy to misstep when it comes to self‐directed

About the author

Ana Maria Martinetti-Katz, CFP®, CPA, MBA


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