Owning Nontraditional IRA Investments
More and more IRA owners are considering investments other than traditional stocks, bonds, and mutual funds. It’s not surprising. The Federal Reserve’s zero interest rate policy boosted returns of stocks and bonds the last few years but probably pulled forward a lot of future returns into those years. For the next five or 10 years, returns from traditional investments are likely to be less than historic averages.
The tax law allows your IRA to be invested in a range of vehicles other than publicly-traded stocks, bonds, and mutual funds. There are some obstacles you must navigate, but doing so could allow you to invest in unconventional and profitable investments. The most popular unconventional IRA investments probably are real estate and privately-traded stock. Other frequent investments are making loans and mortgages and owning some precious metals.
It’s the IRA custodians who limit most investments. Your IRA must have an approved custodian or trustee, and most of them are traditional financial institutions that restrict IRA investments to traditional vehicles.
To own non-traditional investments in an IRA, you need a custodian or trustee that allows a true self-directed IRA, one that allows you to invest in any asset permitted by the tax law. (In fact, some let you invest in assets not permitted by the tax law. It’s up to you to know the rules and be responsible for any penalties the IRS imposes.) Many traditional IRA custodians and trustees say they offer self-directed IRAs, but they mean only that you can choose from among the traditional investments available on their platforms.
To find a true self-directed IRA custodian or trustee go to your favorite Internet search engine and search for “self-directed IRA.” In addition to articles about self-directed IRAs, you’ll find web sites for trustees and custodians of true self-directed IRAs. The firm that appears to have done this the longest is The Entrust Group, though I haven’t dealt with it.
To use a true self-directed IRA, you should be prepared to pay higher fees across the board. The trustee has to do more work, and there are fewer IRAs of this type so the custodian doesn’t have the scale and efficiencies of traditional IRAs. In addition to an annual fee and transaction fees, you might pay to have your IRA’s investments valued each year.
A move that might reduce fees is to form a limited liability company and have it wholly-owned by the IRA. Then, the LLC makes the investments in its name. But keep in mind the LLC can engage only in transactions allowed for an IRA directly. There will be costs to forming the LLC, and it probably will have to file an annual tax return and pay an annual license fee. So, it doesn’t eliminate all the extra costs.
Once you set up the self-directed IRA, either with or without an LLC, the next step is to be sure your investments don’t violate IRS rules, especially those against prohibited investments and transactions.
The list of prohibited investments for IRAs is short. It consists of life insurance and collectibles. Collectibles include art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS can add to the list but hasn’t. There are some exceptions. The largest is for U.S.-minted gold coins that are legal tender. An IRA is allowed to own them.
The longer and more significant list is of prohibited transactions. It’s easy to make a mistake and stumble into a prohibited transaction and its penalty. You want to avoid prohibited transactions, because the penalty is that the entire IRA will be treated as fully distributed when the prohibited transaction was made. The IRA owner must include the IRA’s full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited trans-action is penalized.
Basically, a prohibited transaction is an investment or deal between a related or disqualified person and the IRA. It doesn’t matter if the transactions are at fair market value. They are prohibited at any price.
There are six prohibited transactions between IRAs and related parties. The first four are specific, and the last two are general.
The specific prohibited transactions are:
? A sale, exchange, or lease of property;
? A loan of money;
? Furnishing goods, services, or facilities; and
? A transfer or the use of the income or assets of the IRA;
The general prohibitions are: an act in which the related party deals with the IRA income or assets as his or her own; and the receipt of any benefit for the related party’s personal account in connection with a transaction involving the IRA’s income or assets.
Stated in clear, plain English the prohibited transactions can be summarized as: No deals 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.
A related person for an IRA is the IRA owner; anyone who makes decisions for the IRA; anyone providing services to the IRA; an ancestor, spouse, or descendant of the IRA owner, of the owner’s spouse, of a decision maker for the IRA, or of anyone providing services to the IRA; a corporation, trust, partnership, or estate that is 50% or more owned by any of the above persons; an officer, director, highly compensated employee, or 10% or greater owner of any of the above; and a partner of any of the above.
Though the list of related persons sounds comprehensive, there are some gaps. Not included as related persons are brothers, sisters, step relatives, 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.
Roth IRAs don’t escape these rules. 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 appears to have gone a step further for Roth IRAs. It issued a notice stating that any transaction between a Roth IRA and a “related party” would be considered a tax shelter or an abusive transaction required to be registered with the IRS. For this notice, the IRS considered brothers and sisters as related parties. (IRS Notice 2004-8)
Though the list of prohibited transactions is long and comprehensive, the Department of Labor is allowed to grant exemptions and frequently does. It grants exemptions to specific taxpayers for specific transactions and also grants broad class exemptions that apply to anyone who matches the facts in an 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 the Department of Labor web site at www.dol.gov. Look for the “Employee Benefits Security Administration” among the department’s agencies. On the home page for the EBSA look for “Technical Guidance.” I’d give a more specific web address, but the Labor Department frequently changes its web site. You can look at the class exemptions that have been granted to see if what you want to do qualifies. You also can look at individual exemptions to see if there is something close enough to make it worth your while to apply for one.
With an individual or class exemption you might be able to use an IRA to buy real estate (including a vacation home), invest in your business, or lend money to a relative. I don’t recommend engaging in these transactions on your own. The rules are technical, and you have to comply fully with them. You should consult with an accountant or attorney who is well-versed in the rules for IRAs and retirement plans. As mentioned earlier, the penalty for mistakes is steep and should be avoided.
You can find more details about these and other rules in my report, IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments, available through the “Bob’s Library” tab on the web site at www.RetirementWatch.com.
RW July 2015.
