IRAs — both traditional and Roth — are powerful tools for financial, retirement, and estate planning. But what if you’re not satisfied with your IRA’s performance? One way to “turbocharge” its benefits is to use a “self-directed” IRA, which is permitted to hold alternative investments that offer higher potential returns. That’s an attractive feature, but self-directed IRAs also present some dangerous tax traps that can wreak havoc on your plans.
What are the advantages?
Traditionally, IRAs offer a limited menu of stocks, bonds or mutual funds. Self-directed IRAs — which are offered by certain financial institutions — allow you to choose from a wide variety of investments, including closely held stock, interests in partnerships and LLCs, real estate, and precious metals. By giving you greater investment flexibility, these IRAs offer greater diversification and the potential for substantially higher returns on investment.
A self-directed IRA also offers valuable estate-planning opportunities, allowing you to transfer a variety of assets, including real estate and closely held stock, to your children or other family members in a tax-advantaged manner.
Note that self-directed IRAs are not allowed to invest in certain types of assets, including S corporation stock, insurance contracts, and collectibles (such as art or coin collections).
What are the tax traps?
Self-directed IRAs are subject to several complex rules, and one misstep can quickly wipe out their benefits. The most lethal tax trap is the “prohibited transaction rules,” which restrict dealings between an IRA and “disqualified persons.” Disqualified persons include you, as account holder, the IRA’s beneficiaries, certain members of your family, businesses that you or your family control, and certain advisors and service providers to the IRA.
You and other disqualified persons are prohibited from engaging in a variety of transactions with a self-directed IRA, including:
- Selling property to or buying property from the IRA,
- Lending money to, or guaranteeing a loan to, the IRA,
- Pledging IRA assets as collateral for a loan,
- Furnishing goods or services to the IRA,
- Receiving compensation from the IRA, or
- Personally use IRA assets.
Penalties for violating the prohibited transaction rules are harsh: If you or a beneficiary engages in a prohibited transaction, the IRA is disqualified and its assets are deemed to have been distributed on the first day of the tax year in which a prohibited transaction takes place. The result: All tax benefits of the IRA are erased, plus you or your beneficiary will be hit with a bill for penalties and interest.
If a disqualified person other than you or a beneficiary violates the prohibited transaction rules, that person must undo the transaction and pay a hefty excise tax
The prohibited transaction rules make it dangerous, if not impossible, for you or your family to manage real estate or business interests held by a self-directed IRA. In other words, to avoid disqualification, you and your family would have to accept a purely passive role with regard to the IRA’s assets.
Other tax traps include:
- Unrelated business taxable income (UBTI), which can be generated by IRA investments in operating companies, and
- Unrelated debt-financed income (UDFI), which can be generated by IRA investments in mortgage- or debt-financed property.
Neither UBTI nor UDFI will disqualify an IRA, but their tax costs should be considered when evaluating the benefits of a self-directed IRA.
Consult a Professional
If you’re contemplating a self-directed IRA, please contact us. Our professionals can help you review the pros and cons and avoid the tax traps.