Last month I explained how you can create a Super IRA, also called an LLC IRA. You learned how to find a custodian for a true self-directed IRA, one that allows you to invest the IRA in real estate, private companies, and a host of other assets.
Now, let’s look at exactly how to exploit your Super IRA. This month we’ll examine what the law says you are and are not allowed to do with an IRA.
There are only two types of assets that are defined as prohibited investments for IRAs.
One prohibited investment is life insurance. Since life insurance already has tax benefits, Congress doesn’t want pre-tax dollars paying the premiums. You can buy annuities with your IRA, though that rarely is a good idea, but not life insurance.
The other prohibited investment is collectibles. Collectibles include works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. Other items might be considered collectibles by the IRS, but these are the items specifically defined in the law as collectibles.
Any IRA money used to purchase a prohibited investment will be treated as a taxable distribution.
In addition, the tax law defines prohibited transactions for IRAs and other qualified retirement plans.
An IRA cannot engage in a prohibited transaction with a related party. If it does, the penalty is that the entire IRA will be considered to be fully distributed when the prohibited transaction is made. That means the entire IRA is included in gross income. But only an IRA that engages in the prohibited transaction is treated as distributed. Any other IRAs of the same owner are not penalized.
There are six prohibited transactions between IRAs and related parties. The first four are specific, and the last two are general.
The specific prohibitions are: a sale, exchange, or lease of property; a loan of money; furnishing goods, services, or facilities; a transfer to or the use of the income or assets of the IRA; and the transfer to or 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 income or assets of the IRA.
The list basically can be summed at as, “no deals involving the IRA and the owner or a related person.” That sounds rather restrictive, but you’ll learn shortly why that isn’t always true. It is possible to engage legally in prohibited transactions.
A related person 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, spouse, decision maker, or 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.
Not included as related persons are brothers, sisters, step relatives, nieces, and nephews. Also not included are friends and neighbors. A significant other to whom you are not married also is not a related person.
What about Roth IRAs? They are subject to the same rules as traditional IRAs and other qualified retirement plans. In addition, the IRS issued a notice in 2003 in which it stated that any transaction between a Roth IRA and a “related party” would be considered a tax shelter or an abusive transaction, and that requires registration with the IRS. For this notice, the IRS considered brothers and sisters as related parties. (IRS Notice 2004-8)
Here’s an example of what you can do without a penalty once an LLC IRA is created.
Suppose you have a stepchild who is ready for college. Your LLC IRA can lend the tuition money to the stepchild. Over time the stepchild pays back the IRA with interest (perhaps using annual gifts from you). The loan plus interest goes back into your IRA, tax deferred. In addition, the interest might be deductible by the stepchild. This is how your LLC IRA can be used both to earn money and help a loved one. The transaction also works for brothers, sisters, nieces, and nephews.
Or suppose you help someone buy a home or other property by having your IRA write the mortgage. The person gets a loan. Your IRA earns interest income as mortgage payments are received. The loan is secured by the property, protecting your nest egg. And the borrower gets to deduct the interest payments.
These are just the tip of the iceberg. There are many other interesting and profitable transactions IRAs are allowed to make.
The law requires the Department of Labor to create a procedure for obtaining exemptions from the prohibited transactions rule. This has been done, and the Department grants a number of exemptions each year. Here is a sample of exemptions granted in recent years:
§ An IRA owner sold real estate to his IRA.
§ An IRA owner sold stock to his IRA.
§ An IRA owner purchased stock from his IRA.
§ An IRA owner purchased real estate from his IRA.
§ An IRA owner lent money to a corporation of which he was the sole owner. That means when the loan was repaid, the corporation paid tax deductible interest to the IRA.
The Department of Labor, through its Employee Benefits Security Agency, reviews applications for exemptions. The office also grants “class exemptions.” These are available to anyone meeting the qualifications stated in the class exemption.
To be granted an exemption, you have to show the office that a transaction is administratively feasible, is in the interest of the plan and its participants and beneficiaries, and that it protects the rights of plan participants and beneficiaries. An individual exemption is put on a fast track to approval if you show that the transaction is substantially similar to two or more exemptions granted in the last five years.
You can get full details of past exemptions at the web site www.dol.gov/ebsa/. In the right column, click on “EXPRO Exemptions,” “Individual Exemptions,” and “Class Exemptions.” For full details about exemptions and procedures, get the booklet “Exemption Procedures Under Federal Pension Law,” available at www.dol.gov/ebsa/publications/-exemption_procedures.html
The possibility of an exemption widens your financial options. For example, your IRA might be able to write the mortgage on your next home or vacation home. Instead of writing mortgage checks and paying interest to a bank or other lender, you will be making the payments to your IRA. And the interest likely will be deductible. That’s a pretty good deal.
Your IRA can be extremely flexible. An IRA is allowed to do things that most investors never consider for their IRAs.
The first step is to find a sponsor who will allow a true self-directed IRA. The next step is to set up an LLC and have the IRA invest in the LLC.
Consider if an LLC IRA is for you. If it might be, contact the sources listed in last month’s issue (now on the web site). They can help you implement the strategies we discussed this month and last for diversifying your portfolio and increasing your wealth.