IRA Investment Types and Transactions: Q&A

Last update on: Aug 12 2021

By Bruce Miller

In my introductory IRA-investment-types-and-transactions/">article about investment types and transaction restrictions, I provided a general indication about which types of investments are permitted in IRAs and which types of investments are not permitted, Additionally, I touched briefly on transactions that would immediately make the entire IRA value considered a distribution, which has tax implications.

To better understand some of these potentially complex and hazardous rules, here is how you should handle few real-life situations that actual investors have encountered.

Q. I dislike trying to pick investments for my IRA. So, I responded to an advertisement for a variable annuity that promises to pay me a minimum amount each year on my investment – even in an IRA. With constant market fluctuations, this seems almost too good to be true. Should I consider this?

A. Possibly. Most informed investors will stay clear of insurance investment products, such as the many types of deferred annuities. These products come with high annual fees, high expenses and many restrictions. Additionally, IRAs are already tax deferred and part of the cost of a deferred annuity is that it is tax deferred or “tax sheltered”. Therefore, by purchasing a deferred annuity, the IRA owner would be paying extra for something that is already included in the IRA. An insurer can not take your contributed dollars and go out into the same investment markets you and I can access and – after all the annual expenses of the insurance annuity – get a better investment return than you or I can. Remember, the first rule of the marketplace is that no one knows what the markets will do in the future. This includes insurance companies.

However, there are some investors who simply do not want to deal with investment decision making and do not wish to watch the value of their savings fluctuate. For these investors, a low cost deferred fixed annuity might be suitable. IRAs can invest up to 100% of assets in deferred or immediate annuities. However, a variable deferred annuity will require making investment choices and avoiding these choices might be the sole reason for considering the deferred annuity in the first place. Most of today’s large IRA custodians, such as Fidelity, Vanguard or T. Rowe Price, offer consumer-oriented investments that are easy to understand, carry very low annual fees and provide free online or toll-free phone investment assistance services that are typically well received by consumers, including those who know very little about investing.

Q. I have read that I can hold gold coins in my IRA. I like this idea to avoid the fluctuations of the stock market and as a protection from a potential stock market collapse. If a market collapse occurred, at least I would have the gold coins. Can you comment?

A. Yes, holding gold, silver or platinum coins issued by the U.S. Treasury or individual states is possible. However, you must be careful. Holding precious metal coins – or bullion – in an IRA is tricky. If you are not aware of all the rules, you run the risk of an IRS audit and having your gold holdings disallowed and treated as a distribution from your IRA with commensurate back taxes and penalties. Some self-directed IRA web sites promote this, but you will be far better served to get another option from a tax accountant or Certified Financial Planner (CFP) before you act.

While you can hold precious metal coins or bullion in your IRA, keep in mind that prices of precious metals fluctuate just like the stock market does. Gold is no more immune from sharp drops in valuation than any shares of stock. While the gold will hold its value if the market sharply declines and is often held as a hedge to this risk, you should hold only a small portion of your assets in precious metals. Most advisors recommended generally around 5% – but no more than 10% – of the overall portfolio value. You must also consider that the cost of holding such an illiquid investment can be very high. A typical managed mutual fund will cost between 1% and 1.5% of the value of your holding each year. Exchange-Traded Index funds will typically cost 0.1% to 0.5% per year. However, due to the strict rules of the IRS on how gold must be held, the cost of holding gold coins or billion can run 2% to 4% per year. This difference might seem small, but compounded over the long run, it can make a significant difference in your total return.

Q. I live in a rural community with a community bank owned by its account holders through a subchapter S-Corporation. The bank would like to expand but needs to get a loan to do so, and the interest rates on such a loan are very high. Can I loan the community bank the money it needs from my TIRA?

A. Probably not, since such a loan would conflict with the prohibited transaction rules that do not allow you – an S-Corporation shareholder – to derive a direct benefit from your IRA or to take indirect loans from the IRA. Also, S-Corporation shareholders must be individuals or certain trusts and your TIRA is neither. Therefore, the S-Corporation would be running the risk of disqualifying itself. This is a complicated area beyond the scope of this quick guide. You should seek the advice of an attorney or tax accountant who is familiar with handling issues like this one.

Q. I was contacted by an advisor who told me that I should consider investing a sizable portion of my TIRA in private reits to provide good and steady income as I begin my retirement years. His main selling points are that these shares will not go up and down with the stock market and will pay a steady 7% dividend. This sounds very enticing to me. Where is the catch?

A. You are very wise to ask that question. Your “advisor” has failed to tell you about a big catch. Real Estate Investment Trusts (REITs) have been around since the REIT Act of 1960. These trusts have done exactly what this original Act intended – provide low cost capital to America’s commercial real estate market, while providing the individual investor with reliable income by requiring that REITs pay out at least 90% of their profit to shareholders to maintain their tax-exempt status.

But here is the catch. In the 1990s, some REITs were formed that are registered publicly traded securities, but they are not traded on any of the organized stock exchanges. Instead, the shares are sold through “advisors,” who generate large commissions for each sale. The mere act of taking these public – not private – shares of REIT stocks off the stock exchanges and sell directly to investors creates a whole new ballgame. The “unlisted” or “non-traded” REIT shares held in your IRA are perfectly legitimate investments, but they have proven to be complete disasters to the shareholders. These shares are illiquid, meaning it is almost impossible to sell the shares to anyone else without taking a considerable loss on the sale. Management of these REIT shares has been abysmal, because the management has no incentive to manage the REIT profitably. Most of these unlisted REIT managers have simply mismanaged the REIT holdings, driving down the price of the unlisted REIT shares by 20%, 30% and some down 90%, with most dividends suspended and no way to get rid of the shares. You can just Google something like “unlisted REIT risks” and you will see page after page of information that will confirm my doubts about the viability of these REITs as sound investments.

To choose investments for your IRA, you should stick with investments that trade on the major stock exchanges, such as the New York Stock Exchange or the NASDQ exchange. Going off “the grid” with public or private investments using your IRA carries a significant risk that you must fully understand. Otherwise, you are highly likely to suffer the same consequences as those who were talked into buying unlisted REITs that your “advisor” suggests.

Q. I have a retired friend who purchased a duplex in his IRA that he manages himself. He does this by holding the duplex in an LLC within the IRA. Is this legal?

A. Your friend’s situation is not so much a question of legality. The larger concern is whether the IRS will consider such an arrangement to be a prohibited transaction. If it does, the entire IRA balance will be deemed to have been distributed on Jan. 1 of the year the LLC and the IRA owner began to manage the rental property. The prohibited transaction in such an arrangement is “providing service” or self-dealing and the IRA owner is doing exactly that by being his own landlord. The IRA custodian and IRA owner will claim that they do not provide any service and that the LLC is the entity servicing the property as granted by the IRA custodian. While that point is fine, conservative IRA advisors will avoid it as it is clearly a work-around the prohibited transaction. However, a Tax Court case – T.L. Ellis, TC Memo. 2013-245, Dec. 59,674(M), October 29, 2013 – complicated this situation a bit. The Tax Court found that the formation of an LLC to manage IRA investments is not a prohibited transaction. This seems to provide a more definitive answer to the question of LLC ownership of IRA investments and self-management of these investments. However, the IRA owner should evaluate all implications and determine whether this approach is something worth pursuing.

Hopefully, my answers to these actual customer questions provided some clarification regarding rules that govern IRA transactions and the types of investments that can be held in an IRA. The next item that I will discuss are rules and conditions for elective withdrawals from Traditional IRAs.