A self-directed IRA isn’t a different type of IRA. Rather, the term refers to any individual retirement account (traditional or Roth) that allows you to direct the investment of your IRA assets into nontraditional investments. For example, in addition to the usual IRA mainstays (stocks, bonds, mutual funds, and CDs), a self-directed IRA might invest in real estate, limited partnership interests, a small business, or anything else the law (and your IRA trustee/custodian) allows. In fact, the only investment you can’t have in an IRA is life insurance. Collectibles (artwork, stamps, wine, and antiques) aren’t strictly prohibited, but if your IRA purchases these items, you could suffer adverse tax consequences.
First, you’ll need to find a trustee or custodian that specializes in self-directed IRAs. Make sure you understand the expenses involved–some trustees charge transaction fees and/or asset-based fees, depending on the particular investment. You also need to be aware of the prohibited transaction rules. These rules are designed to make sure that only your IRA, and not you (or your immediate family), benefits from your IRA transactions. If you violate these rules, your account will cease to be treated as an IRA, with potentially devastating tax consequences.
Finally, you need to understand the UBIT (unrelated business income tax) rules. Even though IRA investments usually grow tax deferred (or even potentially tax free in the case of a Roth IRA), if your IRA conducts certain business activities or has debt-financed income, then your IRA could be taxed currently on all or part of the income generated.
What are prohibited transactions?
Generally, a prohibited transaction is any improper use of an IRA by you, your beneficiary, or a “disqualified person” including certain family members. The following are examples of prohibited IRA transactions:
- Selling property to, or buying property from, the IRA
- Borrowing money from it
- Receiving unreasonable compensation for managing it
- Using it as security for a loan
- Buying property for personal use (present or future) with IRA funds
The IRS has warned: “IRAs that include, or consist of, non-marketable securities and/or closely held investments, in which the IRA owner effectively controls the underlying assets of such securities or investments, have a greater potential for resulting in a prohibited transaction.” (Source: IRS Instructions to Form 1099-R, 2015)
Consequences of engaging in a prohibited transaction
Generally, if you (or your beneficiary after your death) engage in a prohibited transaction at any time during the year, the account stops being an IRA as of the first day of that year. The account is also treated as distributing all its assets to you at their fair market values on the first day of the year. For a traditional IRA, if the total of those values exceeds your basis in the IRA, you’ll have taxable income that’s included in your income. If you’re not yet age 59½, the 10% premature distribution penalty tax may also apply.
The IRS hasn’t yet provided specific guidance describing how these rules apply to Roth IRAs. However, it’s likely that if you’ve satisfied the requirements for a qualified distribution, the distribution will still be tax free. A nonqualified distribution from a Roth IRA will result in taxable income to the extent the distribution exceeds your Roth IRA contributions (and again, the premature distribution penalty tax may apply if you haven’t yet reached age 59½).
What is UBIT?
UBIT, as noted earlier, stands for “unrelated business income tax.” While not common, it can apply to your traditional (and Roth) IRA. In simple terms, if your IRA regularly conducts a trade or business (for example, your IRA buys and operates a bakery), then the income from that trade or business (less any expenses directly connected with carrying on the trade or business) is subject to UBIT. The IRA is taxed on the income (unrelated business taxable income, or UBTI) at trust tax rates.
The term “trade or business” has been broadly interpreted to apply even if an IRA doesn’t directly conduct a business, but instead invests in a pass-through entity, like a partnership, that conducts a trade or business. If an IRA invests in a partnership that conducts a trade or business, then the IRA must calculate its UBTI based on its share of the partnership’s gross income and deductions.
As you can see, a self-directed IRA can provide you with almost unlimited investment flexibility, but also presents some traps for the unwary. Carefully weigh the benefits and risks to determine if it’s the right choice for you.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2015