In this series of articles about Individual Retirement Accounts (IRAs), I have discussed so far rules and regulations that govern IRA contributions, withdrawals and distributions and now I will discuss investment types allowed in IRAs.
However, investors must be aware of additional rules, which define the types of investments that are permitted in IRAs, the types of investments that are prohibited from inclusion in IRAs and the types of transactions that are allowed to take place between the account owner, beneficiaries and all other actors involved in the process.
An IRA may hold just about any investment as a taxable account, if the IRA custodian offers all the same types of investments. However, there are some restrictions on certain investment types and on certain account activities.
Investments that an IRA may not hold are:
If the IRA holds any of the disallowed investment types, the IRS will consider the invested amount of those holdings to be a distribution for that year. The investor must remove those investment types from the account that year. Otherwise, the IRS will consider the amount to be an excess contribution, which is subject to a 6% annual tax if not removed from the account prior to Oct. 15 of the following year.
Prohibited transactions are transactions between an IRA owner or a so-called disqualified person. A disqualified person can be the IRA owner, a beneficiary, an immediate linear family member or a business entity in which the IRA owner has a stake of 50% or more. Any such prohibited transaction will deem the entire value of the IRA as distributed on Jan. 1 of the prohibited transaction year. These prohibited transactions are commonly referred to as Self-Dealing transactions.
A prohibited transaction is deemed to have occurred when the IRA owner or a disqualified person…
Another IRA subcategory is referred to as Self-Directed IRAs, which are IRAs held by custodians that offer more extensive investment options than conventional IRA custodians. This is generally treated as a special or alternative investment course for an IRA owner, as the rules governing such transactions are less well defined and many consider these transactions to be riskier.
Examples of self-directed IRAs include direct holdings of rental real estate, holdings of tax liens, indirect holdings of gold bullion, private equities and other alternative investments. Custodians usually charge more – sometimes considerably more – to oversee and manage the assets held by self-directed IRAs. The IRA owner and the custodian must take great care to avoid “prohibited transactions.” The custodian must provide all services to the investments held by the IRA – not the IRA owner. For example, if the IRA owner wishes to purchase a condominium owned by the IRA for rental income, this is certainly acceptable. However, the finding of renters, collecting of rents, all maintenance and any capital improvements…all of these things must be done or coordinated through the IRA custodian. The IRA owner may not do any of these, or any other, property management functions. For the IRA owner to do so would be deemed ‘self dealing’ and would make the full value of the IRA distributed and taxed to the owner that year. Also, the IRA owner may not personally use the property, not any member of the owner’s family, as this too would represent a prohibited transaction.
Another IRA variation features Limited Liability Company, or LLC IRAs, also called checkbook IRAs. Under this arrangement, the IRA custodian is essentially replaced by a pass-through – non-taxed – Limited Liability Company with the IRA owner as the sole owner. This allows the IRA owner to make transactions and management actions that are executed by the LLC, which the IRS does not consider to be a “disqualified person.” Therefore, this is an indirect method of providing services to one’s IRA that, presumably, the IRS has not considered self-dealing… so far. This is a potential minefield of rules and procedures that, if violated and discovered by the IRS, would result in a prohibited transaction. My suggestion would be that part-time and novice investors steer clear and stick with the simpler and more conventional IRA variations.
These are just some basic points that apply generally to all IRAs. However, detailed rules and investor-specific circumstances dictate specific responses. Therefore, I will use a few examples in an upcoming article and attempt to illustrate and clarify practical application of these rules to real-life situations.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.