Individual Retirement Account (IRA) is a term known to all Americans, but even smart real estate investors we work with don't always understand how they work.
It all starts with understanding the role of the Self-Directed IRA custodian.
An IRA must be established by a bank, financial institution, or authorized trust company. Which means only banks such as Bank of America or financial institutions such as Fidelity are authorized to establish and administer IRAs. And not all of these IRA "custodians" allow your IRA to invest in alternative assets, such as real estate.
You may know that the IRA was designed by Congress to encourage people to save for retirement.
You of course know that you can contribute a certain amount of income each year to an IRA account for investment.
You also need to understand the concept of tax deferral and that retirement funds don't have to be invested only through Wall Street. See our article about Reasons To Form a Self Directed IRA to learn more.
It’s not in the financial interests of the traditional institutional investment companies, such as Bank of America, Vanguard, or Scottrade to encourage you to make alternative investments using retirement funds.
Why? Because they make money when you invest in their financial products and keep your money there for a long time. They make money off of highly profitable trading commissions or by leveraging the power of your savings.
On the other hand, they make no money when you use your money to invest in alternative or nontraditional investments, such as a plot of land or a private business.
They get no commissions and lose access to your money when you don't invest through them. They have no reason to tell you about other forms of investing that wouldn't be in their best interest.
The IRS has permitted non-traditional/alternative investments since 1974. It says so right on the IRS website.
And what's the best way to make those non-traditional investments? Why, with a Self-Directed IRA of course!
So what do you need for a Self-Directed IRA? Money, for one thing. And a custodian who can help you invest it correctly. Which brings us back to the main point...
The majority of all Self-Directed IRA custodians are non-bank trust companies for the reasons outlined above.
The Self-Directed IRA custodian or trust company will typically have a banking relationship with a bank who will hold the IRA funds in a special account called an omnibus account, offering each Self-Directed IRA client FDIC protection of IRA funds up to $250,000 held in the account.
The following are the roles and responsibilities of a Self-Directed IRA custodian:
All IRA custodians, banks, financial institutions, and approved trust companies are regulated and are authorized by the IRS to act as IRA custodians.
But since actual custodians are directly approved by the IRS, they are the only ones in this group that’s allowed to physically hold retirement assets. IRA custodians are needed in order to make investments with IRA funds.
Whereas, an IRA administrator is not able to hold IRA assets and is not approved or overseen by the IRS or any state banking regulators. IRA administrators essentially act as intermediaries between the IRA owner and a partner custodian.
IRA administrators are not subject to any IRS or state audit or reviews. Which means they have less "motivation" to do their job perfectly.
An IRA custodian is subject to quarterly state banking division audits and reviews, as well as IRS audits, helping keep your IRA safe from prohibited transactions and fraud.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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