You wouldn’t believe how many people ask me these questions. Especially number 1 on our list. I can promise you that by the end of this article, you’re guaranteed to walk away (or should I say click away?) with new knowledge regardless of your IRA experience level.
Let’s dive right into it shall we!
What is a self-directed IRA?
A self-directed IRA is an IRA where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments include: real estate, stock, gold and cryptocurrency, just to name a few.
If you haven’t heard about self-directed IRA’s before, that’s understandable. The main reason most people haven’t is large financial institutions who administer most U.S. retirement accounts don’t think it’s a good idea to hold real estate or non publicly traded assets in retirement plans.
Can I rollover or transfer my existing retirement account to a self-directed IRA?
I can’t blame you for wanting to know, now can I?
The answer to this question is that depends. The chart below can help you determine the answer.
|I have a 401k or other company plan with a current employer.||No, in most instances your current employer’s plan will make it impossible until you reach retirement age.|
|I inherited an IRA and keep the account with a brokerage or bank as an inherited IRA.||Yes, you can transfer to a self-directed inherited IRA.|
|I have a Traditional IRA with a bank or brokerage.||Yes, you can transfer to a self-directed IRA.|
|I have a Roth IRA with a bank or brokerage.||Yes, you can transfer to a self-directed Roth IRA.|
|I have a 403(b) account with a former employer.||Yes, you can roll-over to a self-directed IRA.|
|I have a 401k account with a former employer.||Yes, you can rollover to a self-directed IRA. If it is a Traditional 401k, it will be a self-directed IRA. If it is a Roth 401k, it will be a self-directed Roth IRA.|
What can a self-directed IRA invest in?
The most popular self-directed retirement account investments include:
- Rental real estate;
- Secured loans to others for real estate (trust deed lending);
- Private small business stock or LLC interest; and
- Precious metals, such as gold or silver.
Under current law, a retirement account is only restricted from investing in the following:
- Collectibles such as: Art, stamps, coins, alcoholic beverages, or antiques (IRC 408(m)
- Life insurance (IRC 408(a)(3)
- S-corporation stock, (IRS Letter Ruling 199929029, April 27, 1999, IRC § 1361 (b)(1)(B)
- Any investment owned by someone in your close family (parents, grandparents, spouse, children).
What restrictions are there on using a self-directed IRA?
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with.
The prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes: The account owner, their spouse, children, parents, and certain business partners.
So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as they are not disqualified persons.
Can my self-directed IRA invest in my personal business, company, or deal?
No, it would violate the prohibited transaction rules if your IRA transacted with you personally (or with a company you own).
What is a checkbook-control IRA or IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC (aka “checkbook-control IRA”) as the vehicle to hold their retirement account assets.
An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner, and the IRA owner then directs the LLC investments and the LLC to take title to the assets. Which pay the expenses to the investment, and receive the income from the investment.
However, there are many restrictions against the IRA owner being the manager (such as not receiving compensation or personal benefit) and many laws to consider. You definitely want to consult with your attorney before establishing an IRA/LLC.
Can my IRA invest cash and can I get a loan to buy real estate with my IRA?
Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan.
A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Also, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).
Are there any tax traps? (UBIT/UBTI)
The Unrelated Business Income tax (UBIT) applies when your IRA receives “unrelated business income.” However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income exempt from UBIT includes the following.
- Real Estate Rental Income: Rent from real estate is investment income and is exempt from UBIT.
- Interest Income: Interest and points made from money lending is investment income and is exempt from UBIT.
- Capital Gain Income: The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
- Dividend Income: Dividend income from a C-Corp where the company paid corporate tax is investment income and exempt from UBIT.
- Royalty Income: Royalty income derived from intangible property rights, such as intellectual property, and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.
So, make sure your IRA receives investment income as opposed to “business income”.
What is unrelated debt financed income (UDFI)?
If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as “unrelated debt financed income” (UDFI), and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan.
For example, let’s say an IRA buys a rental property for $100,000, and that $40,000 came from the IRA and $60,000 came from a non-recourse loan. The property is now 60% leveraged, and as a result, 60% of the income is not a result of the IRAs investment, but the result of the debt invested.
Because this debt is not retirement plan money, your friends at the IRS require tax to be paid on 60% of the income. So, if there is $10,000 of net rental income on the property then $6000 would be subject to UBIT taxes.
Should I use an individual 401k instead of a self-directed IRA?
This is where things get interesting!
An individual 401k is a great self-directed account option, and can be used instead of an IRA for persons who are self-employed with no other employees (other than business owners and spouses). If you are not self-employed, then the individual 401k will not work in your situation.
An individual 401k is generally a better option for someone who is self-employed and still trying to maximize contributions, as the individual 401k has much higher contribution amounts ($54,000 annually versus $5,500 annually for an IRA).
On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts which can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.
Another consideration in deciding between an individual 401k and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a individual 401k over an IRA as individual 401ks are exempt from UDFI tax on leveraged real estate.
Congratulations! You made it to the end of this article!
That sure was a lot of information wasn’t it? Hopefully this article helped you, and if you have any questions please don’t hesitate to ask them.