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What is a self-directed IRA? If you have invested in alternative assets for years, you may be surprised at how many IRA investors still invest only in traditional assets. Even today, it isn't surprising that millions of retirement investors don't know anything about the Self-Directed IRA.
Essentially, a self-directed IRA (SDIRA) is an individual retirement account. You know this is if you read our previous article: Self-Directed IRA LLC, How Can I Benefit. Some investors consider it the “Do it yourself” retirement account. In other words, self-directing puts you, the IRA holder, in complete control. However, you must choose the option of a self-directed IRA with checkbook control.
There is a second type of self-directed IRAs without checkbook control. This is commonly known as a custodian-consent checkbook IRA. Both IRAs allow you to invest in traditional and alternative asset investments – but there are different rules.
Many financial institutions allow you to make nontraditional investments (for example, alternative assets). However, this is in contrast to traditional financial institutions, like Fidelity and Vanguard, which primarily make commissions and fees from stocks, bonds and mutual funds, etc.
With a custodian controlled self-directed setup, the custodian generates its profits through annual valuation fees and transaction fees. So if you wondered if they charge annual fees, the answer is yes.
Not only must you consider fees, but this self-directed setup requires custodian consent before you can make a transaction. With this comes long delays as you wait for the custodian to approve your investments. They may even be cases where you don't receive consent on your desired transaction. You must also consider the custodian fees for each of these transactions, which can be steep.
Finally, it’s important to note that the IRA will be in the name of the custodian. As a result, you receive no limited liability protection.
A custodian controlled self-directed IRA is a more appealing option if you make few investments.
In the case of a true self-directed IRA, the IRA holder has full control of his/her investments. This is the self-directed IRA LLC with checkbook control. In this structure, you can make direct investments without custodian consent. There is the establishment of an LLC (limited liability company), which the IRA account owns. However, the IRA account holder (you!) manages the LLC. A passive custodian will then transfer your funds to the LLC’s bank account.
Once your funds are transferred by the passive custodian to the LLC bank account, this provides the IRA holder (again, you) with checkbook control over your IRA accounts. Now, all investment decisions are truly yours. You can buy and sell whatever you want, whenever you want. Of course, you must still consider the prohibited transaction rules, which limit you from investing in certain assets. However, these are very few.
The passive custodian provides no advice or recommendations regarding investments. They execute investment decisions by the IRA owner and perform custodial and administrative duties to maintain the tax-deferred status of an IRA. Also known as a directed IRA custodian, a passive custodian provides no advice or recommendations regarding investments. A passive custodian simply establishes and maintains IRAs. They’re in attendance to satisfy IRS regulations. As a result, it's important that you research every investment you want to make. All control of the self-directed IRA, thus all responsibility, is yours.
Self-Directed IRA LLC’s are extremely tax-efficient. The main advantage to using a self-directed IRA is that the income and gains from your investment is not subject to tax. Therefore, you don’t pay tax on your investments until you reach retirement age.
When you make self-directed investments, you must abide by the IRS rules. At IRA Financial, our expert IRA specialists provide ongoing advice to ensure you always operate according to these rules. They predominantly involve prohibited transactions, disqualified persons and allowable investments.
There are certain transactions that a retirement account cannot engage in. You can find more on this in IRC Section 4975. However, you can best understand prohibited transactions by breaking them down into three basic categories:
This is a transaction between the disqualified person (Plan participant) and the retirement account that either directly or indirectly benefits the participant. The IRS-prohibited transaction rules are primarily in place for this reason.
However, if you want to use your retirement funds for personal gains and you're under 59 ½, you must pay tax and a penalty.
To clarify the difference between the two prohibited transactions:
Direct prohibited transaction
Transactions that deal with the disqualified person and the self-directed IRA directly. These are very obvious situations, such as using your self-directed IRA to pay off your credit card bill.
Indirect prohibited transaction
Whereas indirect transactions are ones that don’t appear to benefit the disqualified person directly, but do so indirectly. Less obvious situations, such as investing in a business of which you are 10%-part owner.
A type of indirect prohibited transaction, self-dealing is a situation where you use your income or assets to further your own interests.
Let’s take a look at two examples from Self-Directed IRA in A Nutshell, an IRA book that helps IRA holders easily self-direct their accounts.
Why are these acts prohibited? In both cases, the Plan participants use their retirement income for personal interests.
According to the IRS, a disqualified person is anyone who can exercise substantial influence over the affairs of the tax-exempt organization. When the IRS refers to a disqualified person, they mean the IRA holder. That’s right: you are a disqualified person, as well as your lineal descendants.
Disqualified Persons include:
Yet another prohibited transaction is when a disqualified person has a connection with a transaction and uses the income or assets within his/her retirement funds to profit. For example, you use your retirement funds to loan money to a company that you manage, control and have a small ownership in.
You must always keep in mind that the prohibited transaction rules serve a dual purpose. The first is to encourage you to accumulate your retirement funds. However, it also prevents individuals from taking advantage of tax benefits for personal investments.
A self-directed IRA provides unlimited investment opportunities. However, if you don’t follow the rules, this may lead to severe taxation or the disqualification of the IRA.
Another key point is that the IRS doesn’t tell you what you can invest in – only what you can’t invest in. Rather than looking at self-directed IRA allowable investments, it’s much easier to review the excluded investments in a self-directed IRA account. A helpful tip is to figure out what you want to invest in, and then consult with a tax-attorney or certified public accountant (CPA) to determine if they fall under the excluded investments.
These excluded investments fall under IRC Section 4975. IRC Section 408 goes into more detail on types of metals and coins that are allowable transactions. You can also find more information on allowable transactions with Adam Bergman’s book, Self-Directed IRA In A Nutshell.
A Roth IRA and a Traditional IRA are virtually the same in that they are subject to the same rules. Tax reporting requirements are also the same. A Roth IRA, however, is after-tax. In other words, you pay your taxes now. Therefore, all the money you make on your profits are tax-free.
A Traditional IRA is pre-tax. You pay your taxes later. This also means that your profits will be taxed when you make a distribution.
Meet with an IRA specialist at IRA Financial Group today. We’ll help you set up your Self-Directed IRA with Checkbook Control.
Do you have questions regarding what a self-directed IRA is that we didn't mention in this article? Call IRA Financial Group at 800-472-0646. You can also fill out the form to speak with an IRA specialist. For more information on our services, please visit our services page.
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