Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Unconventional Investments in Your IRAs: Pros, Cons and Risks

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IRAs are among today’s most misunderstood investments.

For example, did you know there’s a “backdoor” way to create a Roth IRA, even if your income exceeds the limit?  (For more on that, visit last week’s story here.)

Today we’ll cover three more aspects of IRAs you may not have considered already…

1. Unconventional Investments in IRAs

You can own a wide range of investments in an IRA, if the custodian allows it.

Most custodians allow only publicly traded assets, such as exchange-listed stocks, bonds and mutual funds.

But others offer true self-directed IRAs that allow investments in real estate, mortgages, small businesses, hedge funds and more.

Yet, there are tax risks in holding unconventional investments in IRAs.

One risk is crossing the line into a prohibited investment or transaction.

For example, an IRA may own real estate, but a mortgage or other debt can’t be involved. The IRA has to own the real estate outright.

You also can’t do deals with the IRA, even indirectly. If the IRA owns a small business and you draw a salary from that business, you have likely engaged in a prohibited transaction.

Those are only a couple of examples.

With unconventional IRA investments, there are many simple actions most people take for granted that could cross the line. You need to know the tax rules and follow them closely.

Another risk is running afoul of the RMD (required minimum distribution) rules.

After age 70½, you have to take RMDs, even if the IRA holds illiquid assets such as real estate.

One option is to take an in-kind distribution: have the IRA transfer to you a portion of legal title to the asset (which can be expensive).

If the IRA owns real estate, for example, an attorney might have to prepare a deed and have it recorded in the public record each year.

Another option is to retain enough cash in the IRA to make RMDs in cash.

The IRS changed the reporting requirements recently to make it easier for it to catch people who aren’t taking their full RMDs.

The IRS believes IRAs with unconventional assets often assign low values to assets, reducing the RMDs.

Now, reports from custodians flag IRAs with illiquid and unconventional assets, and the IRS is using that information to set audit targets.

It’s another risk of owning unconventional investments in an IRA.

2. Roth IRAs for All Ages

A rule of thumb among many financial advisers is that Roth IRAs and 401(k)s are good only for people in their 20s and 30s.

The rule says older people can’t benefit from a Roth account unless they expect much lower tax rates in retirement.

That advice is refuted by a study from T. Rowe Price, as well as research I’ve done over the years.

The fact is that the benefits of a tax-free Roth IRA are so good that, after crunching the numbers, many people of different ages will find they would benefit.

The Roth IRA doesn’t require RMDs during your lifetime, avoiding the potential for pushing you into a higher tax bracket or triggering the Stealth Taxes.

Also, distributions from a traditional IRA or 401(k) are taxed as ordinary income, while Roth distributions are tax-free.

The answer isn’t the same for everyone, but more people would benefit from Roth accounts than the conventional wisdom recognizes.

Instead of relying on a rule of thumb, crunch the numbers for your situation or have a financial planner help with the analysis.

3. The 5-Year Waiting Period

Distributions of income and gains from a Roth IRA are tax-free only after a five-year waiting period.

But the rule and its impact are different than many people realize.

For a distribution of income and gains from a Roth IRA to be tax-free, it must be made after the owner’s turning age 59½ and when the owner has had the Roth IRA for at least five years.

For distributions from contributory Roth IRAs, the five-year period is met for all contributory Roth IRAs of the owner when any Roth IRA of the owner has been opened for more than five years.

For converted Roth IRAs, however, there is a separate five-year period for each conversion.

If you converted a traditional IRA to a Roth IRA in 2017, you have to wait five years before taking the first tax-free distribution of income and gains, even if you are over 59½ and had a regular Roth IRA for more than five years, or converted other Roth IRA funds more than five years ago.

But the five-year rule might not matter to you. Only income and gains distributions are taxable, not distributions of principal.

Roth IRAs have “ordering rules.” Distributions of less than the entire IRA are assumed to be taken in a certain order.

Regular contributions are distributed first, and converted amounts are distributed second.

Only after regular contributions and converted amounts are distributed are earnings distributed.

The ordering rules are important, because only distributions of earnings are taxed. Distributions of regular and conversion contributions are not taxed.

For more insights on IRAs, please read Part 1 of our story: 6 Misunderstood IRA Rules & Strategies.

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