Your IRA investment universe is greatly expanded when you set up a true self-directed IRA, as we discussed last month. But to reap the benefits, you need to avoid some key pitfalls and traps in the tax law.
Also known as the Checkbook IRA, LLC IRA, Super IRA and other names, the true self-directed IRA can invest in assets other than mutual funds and publicly traded stocks and bonds. While this type of IRA has greatly expanded investment options, the tax code doesn’t allow unlimited investment choices. This month we discuss the prohibited investments and transactions for IRAs.
It is your job to be sure you don’t cross any of the lines as the IRA custodian isn’t required to monitor your activities and keep you from violating the tax rules. The custodian also doesn’t give tax or investment advice. That’s why you should know the rules and consider working with a tax advisor who is familiar with true self-directed IRAs.
The prohibited investment and transaction rules apply to LLC IRAs, because an LLC or other entity that’s owned by an IRA must follow the rules imposed on IRAs.
The list of prohibited IRA investments is short: life insurance and collectibles. These aren’t allowed in IRAs at all.
The tax code defines collectibles as art, antiques, rugs, stamps, coins, metals, gems and alcoholic beverages (such as fine wine). Although the IRS can add “certain other tangible property” to the list through regulations or rulings, it hasn’t.
An exception allows IRAs to own certain types of coins and metals. The allowed coins must be legal tender gold and silver coins that are minted by the U.S. Treasury. These generally are the American Eagle coins. Rare and numismatic coins aren’t allowed. Some platinum coins also are allowed.
An IRA also can own gold, silver, platinum, and palladium bars that meet certain minimum fineness requirements in the tax code. You cannot control and store any coins or bullion owned by the IRA.
The IRS requires that the assets stay in the possession of the custodian or trustee. Some people argue that the LLC in an LLC IRA can buy the coins or bullion and you can store them in your home or a safe deposit box. An IRS official told The Wall Street Journal that is incorrect. An approved IRA custodian must have possession of the physical assets.
When an IRA buys a prohibited investment, the investment is treated as a distribution to the IRA owner. The owner must include in gross income the amount of the investment as of the day of the investment. There’s no provision in the tax code to reverse or correct the transaction. If you’re under age 59½, a 10% early distribution penalty also might be imposed.
Prohibited transactions are a much broader category than prohibited investments.
Prohibited transactions also have a more severe penalty. The IRA loses its exempt status. That means the entire balance of the IRA is treated as having been distributed to the owner on the first day of the year the prohibited transaction was made. Even if only a portion of the IRA was used to engage in the transaction, the entire IRA is disqualified. There also is no provision for reversing the transaction or otherwise correcting the error. Other IRAs you own aren’t affected by a prohibited transaction in one IRA.
Here’s my plain English summary of the prohibited transaction rules: A prohibited transaction is any investment or transaction between a related, or disqualified, person and the IRA. Another way to phrase it is: No transactions are allowed involving the IRA and its owner or a person related to the IRA or its owner. Persons include entities, such as trusts, corporations, LLCs and others
It doesn’t matter if the transaction was at fair market value.
Let’s look at some details of the rules. The tax code lists four specific prohibited transactions:
The code also lists two general prohibitions. One of them is an act in which the related party deals with the IRA income or assets as his or her own. The other general prohibition is the receipt of any benefit for the related party’s personal account in connection with a transaction involving the IRA’s income or assets.
A key to the prohibited transaction rules is the definition of a related person.
A related person is the IRA’s owner; anyone who makes decisions for the IRA; anyone providing services to the IRA; an ancestor, spouse, or descendant of the IRA’s owner, of the owner’s spouse, of a decision maker for the IRA, or of anyone providing services to the IRA.
Related persons also include entities, such as a corporation, a trust, a partnership, or an estate that is 50% or more owned by any of the above persons. A partner of any entity that is on that list is a related person, as is any officer, director, highly-compensated employee, or 10% or greater owner of any of those entities.
The list of related persons is broad, but there are some exceptions that can provide useful planning opportunities. Not included as related persons are
brothers, sisters, step relatives, and nieces and nephews of the IRA owner. Also not included are friends and neighbors of the owner. A “significant other” to whom the IRA owner is not married also is not a related person.
You need to review the prohibited transaction rules carefully before taking any actions with an IRA. They are very broad, and I recommend that you not try to get too close to the line between prohibited and allowed transactions.
Here’s an example of how the rules can trap someone with a true self-directed IRA.
Suppose an IRA buys or invests in a private business. The IRA owner has a job with the business. A prohibited transaction occurs when the IRA owner draws a salary from the business or even provides services to the business without payment.
The prohibition of debt also frequently catches people. The true self-directed IRA can own real estate. But it’s difficult to structure a real estate transaction with a mortgage that doesn’t run afoul of the prohibition against debt. Any real estate purchase should be with cash that’s in the IRA.
A Roth IRA is subject to the same rules as traditional IRAs and other qualified retirement plans unless specifically exempted. There isn’t an exemption to the prohibited investment and transaction rules for Roth IRAs.
In addition, the IRS has gone a step further by issuing a notice stating that any transaction between a Roth IRA and a “related party” would be considered a tax shelter or an abusive transaction that is required to be registered with the IRS. For this notice, the IRS considers brothers and sisters as related parties. (IRS Notice 2004-8)
When you want to engage in a transaction, one option is to ask the IRS for a private letter ruling allowing the transaction. But this can be expensive, and it can take months or longer to receive a response.
The Department of Labor is allowed to grant exemptions to the prohibited transaction rules. It grants both exemptions to specific taxpayers for specific transactions and broad “class exemptions” that apply to anyone who matches the facts in a published exemption. Under these exemptions, IRAs and owners have been allowed to engage in transactions involving real estate, stock, loans and more.
To find details on the exemptions, go to the Department of Labor website at www.dol.gov. Look for the “Employee Benefits Security Administration” (EBSA) among the department’s agencies. On the home page for EBSA, look for “Technical Guidance” or “Guidance.” The website is frequently revised, so I can’t be more specific. You’ll be able to review both the class exemptions and individual exemptions.
I recommend that unless you’re engaging in a plain vanilla transaction, to work with a consultant or tax advisor who has expertise in the prohibited transaction and investment rules. The rules can be technical, and it’s important that all the details of a transaction are correct.
I discuss prohibited investments and transactions and other IRA investment pitfalls in my report, “IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments.” It’s available through “Bob’s Library” under the “About Bob Carlson” tab on the web site at www.Retirement-Watch.com