Last week, the Minneapolis newspaper, the StarTribune, published an article about a local man who lost some of his retirement money in a self-directed IRA due to a Ponzi scheme. There may be more variables to this story, but he highlighted the flexibility of the self-directed IRA; And with flexibility comes responsibility.
A self-directed IRA is similar to a traditional IRA. In a traditional IRA, you’ll invest your money in mutual funds, stocks, bonds, cash, or other marketable securities offered by your brokerage/financial advisor firm. In this scenario, some due diligence has been done to make sure that the investments are generally sound. But the IRS allows you to invest in other investments like private stocks, real estate, or certain precious metals within a self-directed IRA. “Self-directed” means exactly that: you’re doing your due diligence and making all the decisions, so you really need to understand the rules.
There are too many rules and caveats to review in a short blog, but let me review a couple of the ones that trip people up the most:
- Prohibited Transactions. “Self-dealing” is an important term in self-directed IRAs; in essence, you cannot make a transaction that benefits you personally. For example, you could not use money from your IRA to invest in a cabin that you or a member of your family (disqualified individuals, including direct descendants such as children and grandchildren, or ancestors such as parents or grandparents) were going to use. Real estate must be for investment purposes only. Similarly, you may not invest in your own business (or that of disqualified persons) or make loans to yourself (or disqualified persons).
- Staggered transactions. Attempting to circumvent prohibited transactions by creating more steps in the process still disqualifies the transaction. For example, you can’t lend money to a friend, who then gives the money to another friend, who then lends it to you. The IRS looks for these multiple “steps” and may assess a penalty.
- Assets. While there are many things you can invest in, things to avoid include collectibles (art, antiques – see IRS Publication 590 for the full list), life insurance, and Subchapter S corporations.
- Administration. This is not a rule, just a suggestion from me. Investing in something out of the ordinary takes a lot of time and effort. Proper due diligence needs to be done and then constantly monitored, but it is often ignored. I would suggest that if you don’t expect returns in excess of average stock market returns, then a self-directed IRA might not be worth it. For example, if you invest in real estate, you need to make sure the IRA pays all the bills, such as insurance, property taxes, and maintenance; this adds a level of detail that needs to be controlled so you don’t get it disqualified. his anger.
All of this brings me to the sore point of what happens when you make a mistake in any of the above and disqualify your IRA from tax-deferred status. If a mistake is made, the complete The IRA may be considered taxable and taxes/penalties will be due immediately. While I often suggest that people keep a close eye on their investment spending, this is one area where it’s worth paying a little extra for good advice. Aside from a custodian who knows how to do this, include your lawyer and/or accountant from the start.
Self-directed IRAs can be a great tool for diversifying a portfolio. But like everything, do it with a small part of the assets, not with everything. And know the rules, as tripping in this area can be very expensive.