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IRA Crossroads


​Over the last few months we have been asked, and have heard rumblings, of utilizing Individual Retirement Accounts (IRAs) to invest in assets such as private businesses and/or real estate. At first glance, this seems like an attractive deal – invest in a private business with potentially high returns while doing so in a tax-efficient way – yes please. However, like anything else, once you start down the rabbit hole, it becomes more clear that using an IRA to invest in “alternative” assets has as many pro’s as there are con’s. So, let’s dive into the intricacies of utilizing the sought after self-directed IRA.

What is the difference between a self-directed IRA and an IRA? The name itself is a bit misleading – it postulates not all IRAs are self-directed. When thinking of self-directed, it’s logical to assume it references the individual making the decision. However, the self-directed piece isn’t referring to investment decisions, but is a label for the type of assets you can invest in within an IRA. To help clarify, here is the Securities and Exchange Commission’s (SEC’s) explanation: “A self-directed IRA is an IRA held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians. Most IRA custodians are banks and broker-dealers that limit the holdings in IRA accounts to firm-approved stocks, bonds, mutual funds and CDs. Custodians and trustees for self-directed IRAs, however, may allow investors to invest retirement funds in other types of assets such as real estate, promissory notes, tax lien certificates, and private placement securities.”[1]

As you can see the difference between a “self-directed” IRA and a “regular” IRA is the type of assets an individual may invest in – that’s it! The tax advantages, contributions’ limits, required minimum distribution limits, etc. are all the same. The kicker is the expansion of the investable options. Lastly, self-directed IRAs can come in different forms such as a traditional IRA, Roth IRA, SEP IRA, and/or SIMPLE IRA. What are some of the nuances to a self-directed IRA?

  1. Trustee or custodian – in the quote above the SEC states most trustees or custodians only allow investors to invest in “traditional” assets such as stock, bonds, mutual funds, and/or CDs. So, large trustees or custodians like Fidelity, TD Ameritrade, and Charles Schwab don’t typically offer self-directed IRAs. Meaning, you must find a smaller trustee or custodian to work with. Now, there are firms that strictly work with self-directed IRAs, but this also creates an opportunity for negative behavior in this niche space and is something to be aware of[2]. In addition, not all custodians have the same allowable investments and their job is not to perform due diligence on your investment; rather, their purpose is geared more towards the administration of the account.

  2. Alternative investments – the reason you utilize a self-directed IRA is the ability to invest in assets such as real estate, private companies, promissory notes, etc. within a tax-advantaged investment vehicle. However, these types of assets bring other risks such as illiquidity or lack of information, and as mentioned above, the individual must perform their own due diligence.

  3. Prohibited transactions – to quote the Internal Revenue Service (IRS): “Generally, a prohibited transaction in an IRA is any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary or any disqualified person”[3] and regardless of if an IRA is self-directed or not, the IRS classification of prohibited transactions apply. Prohibited transactions[4] consist of:

a. A disqualified person’s transfer of plan income or assets to, or use of them by or for his or her benefit b. A fiduciary’s act by which he or she deals with plan income or assets in his or her own interest c. A fiduciary’s receipt of consideration for his or her own account in a transaction that involves plan income or assets from any party dealing with the plan d. Any of the following acts between the plan and a disqualified person:

  • Selling, exchanging, or leasing property

  • Lending money or extending credit

  • Furnishing goods, services or facilities

And a disqualified person[5]: a. Grandparents b. Parents c. Spouse d. Children/Adopted Children and their Spouses e. Grandchildren and their Spouses f. A Fiduciary (…) g. A person providing services to the plan, such as an CPA or Attorney h. Companies owned by disqualified parties

This is important, because as you begin to invest in alternative assets, the probability of committing a prohibited transaction increases. For example, you want to purchase a vacation property with your self-directed IRA. If you were to purchase the property and use it, it would be considered a prohibited transaction. If you commit a prohibited transaction, you lose the tax-advantaged status of the account, and depending on the situation you may be hit with ordinary income taxation and a penalty.

  1. Generated Income – income produced from the investments inside the self-directed IRA must be deposited into the IRA.

  2. Potential expenses – if any of your assets have potential expenses, you must use the assets inside the self-directed IRA to cover them. For example, you own a rental real estate property inside of your self-directed IRA and the furnace goes out. You must use funds from within the IRA to cover this expense. This can become an issue if you don’t have enough liquid assets to cover the aforementioned costs.

  3. Required Minimum Distribution (RMD) – if your self-directed IRA is a traditional IRA, SEP IRA, or SIMPLE IRA, RMD rules still apply. Meaning, at age 70 ½ you will be required to take a distribution[6]. Depending on the assets that are invested, you may have to liquidate said assets to satisfy your RMD. If you hold real estate, there is the ability to take your RMD using an in-kind distribution. This essentially allows you to transfer ownership in the real estate from your IRA to yourself. Meaning, part of your real estate would be in the IRA’s name and partly in your name only.

  4. Taxes – again, since you are investing in private companies and other types of income-generating assets, depending on the investment, you may be subject to income taxes regardless of the tax-deferred advantage of an IRA. For example, if you invest in an operating business selling goods and services and the company is structured as an LLC, the income derived from this entity may be subject to Unrelated Business Taxable Income (UBIT)[7]. And, if you purchased real estate inside your self-directed IRA and financed it with debt, you may be subject to Unrelated Debt-Financed Income (UDFI)[8].

Conclusion Unraveling a self-directed IRA begins to show its true colors – its complicated. The opportunity to hold real estate and/or a private company is attractive, but if you are unaware of the details behind this vehicle type, the potential benefits could be washed away in an instance. When asked if a self-directed IRA is a good idea or not, our answer is simple – it depends. Every individual and/or household is different from its finances to its goals. A vehicle such as a self-directed IRA is complex, and if used correctly can be beneficial and if not can cause harm. The only definitive answer we can provide – before making the decision to use your IRA to purchase alternative assets, talk to your trusted advisors, especially a CPA. They should be able to help educate you on the vehicle as well as assess if it is the right fit for you. And if you don’t have any one to talk to, we at LBW are always happy to lend a helping hand. With all of that said, we feel a quote from Rob Lowe perfectly sums up this post – “Every relationship has its complications”[9]. ​Sincerely,

LBW [1] https://www.sec.gov/investor/alerts/sdira.pdf [2] Please reference the SEC’s following document for further information https://www.sec.gov/investor/alerts/sdira.pdf [3]https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-prohibited-transactions [4]https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-prohibited-transactions [5] https://www.pensco.com/self-directed-iras/the-basics/prohibited-transactions/ [6] RMD’s are calculated based on the individual’s account balance from December 31st of the year that precedes the year of their distribution. That number is then divided by the amount indicated in the IR’s “Joint Life and Last Survivor Expectancy Table” of the “Uniform Lifetime Table”. [7] Please consult a qualified CPA for further information. [8] Please consult a qualified CPA for further information. [9] https://www.brainyquote.com/quotes/keywords/complications.html

#individualretirementaccount #selfdirectedIRA #IRA

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Madison, WI 53719

(608) 286-1321

tsbickmore@lbw-wealth.com

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