As investors grow more weary of the ups and downs of the stock market, and have seen retirement funds be decimated by the Great Recession of 2008 (and earlier economic woes after 9/11), many savvy investors are turning to self-directed retirement plans. These plans and their alternative investment options have been around since the inception of the IRA in the mid-1970s; but with more people looking to get off the investment roller coaster ride of the last decade, self-direction has been a growing trend in retirement wealth building.
Unlike typical retirement accounts offered by banks and brokerage houses, which limit the types of assets you may invest in (usually restricted to what the financial institution sells—stocks, bonds, mutual funds), self-directed accounts allow for a very broad array of nontraditional investments, such as real estate, precious metals, hedge funds, commodities, private placements, and much more. In addition, account holders make all their own investment decisions, usually based on assets they already know and understand. This allows investors to build a potentially more lucrative and more aggressive retirement portfolio but carries with it the responsibility of becoming educated about what is allowed and not allowed through self-directed retirement plans.
Self-direction is growing in popularity, which makes it so important that investors truly understand the many options and benefits—and a few restrictions—related to these supercharged retirement plans.
With self-direction, the investor makes all his or her own investment decisions, so make sure you truly understand what you’re getting into. Because of the breadth of allowed investments, it is vital that you do your due diligence before instructing your account administrator about sending or receiving payments or filing related paperwork. Although the third-party administrator might provide guidance or discuss potential legal pitfalls about your intended investment with you, the final decision and consequences are all on you. You may also choose to work with an ERISA attorney or accountant who can provide even more guidance on these plans.
There is vast leeway in terms of allowed investments within self-directed retirement plans; these alternative investments include commercial and residential real estate, precious metals, private placements, loans, mortgages, hedge funds, commodities, and much more. However, there are several restrictions the IRS places on self-directed accounts regarding what is a prohibited transaction and who is a disqualified person. Under the Employee Retirement Income Security Act (ERISA) and IRS codes, only two types of investments are excluded from self-directed retirement accounts: life insurance and collectibles (art, rugs, jewelry, etc.); and you, your ascendants, or descendants may not personally benefit from the investment.
Self-directed retirement accounts must be opened with a neutral third-party administrator who provides full account administration and transaction support to investors. It is important that you select a self-directed IRA administrator who is knowledgeable about all the paperwork that must be filed in relation to your transactions as well as mandated IRS reporting. In addition, your account administrator should demonstrate knowledge of IRS regulations regarding prohibited and allowed transactions as well as disqualified individuals.
Although account administrators do not offer investment advice, reputable firms will offer guidance regarding your intended transactions to help you make sure you are investing within the limits of the law.
The bottom line is that everything the IRA engages in must be for the exclusive benefit of the self-directed retirement account, not the individual. In addition to life insurance and collectibles being excluded, there are also certain “prohibited transactions” (defined in IRC § 4975 and IRS Publication 590) and “disqualified persons” (addressed in IRC § 4975) that would disallow a transaction.
Disqualified persons include the investor, spouse, ascendants, descendants and their spouses, business partners, fiduciaries, and anyone providing a service to the retirement account. Any entity or business the disqualified person owns or controls is also considered disqualified.
Violation of these rules could result in the entire IRA losing its tax-deferred or tax-free status and incurring taxes, early withdrawal penalties, and other penalties; therefore we strongly recommend that investors consult tax and financial advisors who know the requirements and procedures needed to avoid jeopardizing the account’s tax-advantaged status.
It is extremely important that account holders abide by IRS regulations, so ask a lot of questions. Even the most knowledgeable investors will have questions about certain types of self-directed transactions. Your account administrator is there to answer them all—from determining whether or not a certain investment is an allowed transaction to helping avoid potential (and unintentional) fraud.
The options and benefits of self-direction are abundant, and putting nontraditional assets in your self-directed IRA can be a lucrative way to build your retirement portfolio. However, the IRS does have certain regulations regarding these accounts and yes—you will get caught if you try to invest in a prohibited transaction or benefit disqualified individuals. The penalties can be steep in terms of tax liabilities. These laws are in place to reduce conflicts of interest and self-dealing.
Prohibited transactions are against the law, period; these restricted investments may not be included in the self-directed retirement plan and will result in your account losing its tax-advantaged status.
The list of prohibited transactions is short but it’s important to note:
- Collectibles ( artwork, coins, stamps, rugs, antiques, beverages and other personal property)
- S-Corp stock
- Gemstones and metals (except for certain U.S. coins and bullion which are allowed)
- Life insurance
- Transactions with disqualified persons and entities
With self-direction, the account holder makes all his or her own investment decisions; because of the potential for misunderstanding at best and fraudulent transactions at worst, it is important that you rely on your personal knowledge and in-depth research about the assets in question to make your investment decisions. However, if you are working with a financial planner or other trusted advisor (accountant, tax or estate planning attorney), you should certainly get that professional’s input in order to determine if your investment strategy is on track for your financial goals.
Prohibited transactions also include those in which you, your business, or certain family members will benefit. Any action or transaction that can be construed as providing you with direct use or benefit is not allowed. Remember, the self-directed IRA owns the asset and all income and expenses must flow through the IRA, for its benefit.
- Prohibited transactions include:
- Personally borrowing money from the account
- Any disqualified person or entity selling, leasing or exchanging property to the account
- Using the account as security for a loan
- Transferring plan assets, lending money, or providing good and services to disqualified persons. These are the account holder, spouse, lineal descendants, account fiduciaries, trustees, investment managers and advisers; and any corporate entity in which the account holder or other disqualified person owns or controls.
Self-direction as a retirement wealth-building strategy can be a great way for savvy investors to take control of their investments with alternative assets they already know and understand. It is crucial for account holders to do their homework before making an investment, and to work with a plan administrator who is available to answer questions and provide guidance when needed.
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