Taking Advantage of the Self-Directed IRA


A world of investment opportunities is open to individual retirement accounts (IRAs), a topic I cover regularly in my newsletter, Retirement Watch.

In addition to stocks, bonds, and mutual funds, your IRA can invest in real estate, private businesses, hedge funds, mortgages, tax liens, and more.

But most IRAs can’t take advantage of the flexibility the law allows, because the custodians and trustees restrict the IRA investments.156541

In addition, the tax law creates some traps and hurdles that need to be avoided when owning non-traditional investments in IRAs. Several steps are needed to safely include non-traditional investments in your IRA.

The non-traditional IRA has been given several labels, such as: True Self-Directed IRA; Super IRA; Checkbook IRA; and LLC IRA. They all describe the same basic strategy. Let’s look at how you can include different types of investments in your IRA— and avoid the potential pitfalls.

An IRA has to have a custodian or trustee that’s been approved by the IRS, and the approved custodians and trustees are financial institutions. Many financial institutions describe their IRAs as “self-directed IRAs.” They mean you can choose how to invest the IRA in any of the investments on the approved list of the custodian.

The lists are mostly publicly traded stocks and bonds, mutual funds and some other assets. A few custodians and trustees restrict the investments to those they sponsor or manage. A wide array of investments that the law allows, however, aren’t accessible through these IRAs.

To invest your IRA in other assets, you first need to find one of the few custodians or trustees offering a true self-directed IRA, an IRA that will hold any, or almost any, legal investment. You find these custodians by typing “self-directed IRA” in the search box on your favorite Internet search engine.

self-directed-ira-nest-eggA number of the results will be for the traditional self-directed IRA custodians discussed earlier. You can refine the search further by also using one of the labels listed above: checkbook IRA, Super IRA, or LLC IRA.

Conduct careful due diligence on the different custodians and trustees. Some specialize in IRAs that invest in certain types of assets while others are more broad-based. A few firms have offered these accounts for a long time, while others are relatively new.

You’ll find these custodians charge more than the traditional IRA custodians, and there will be more types of fees. You are likely to be charged a fee for every transaction in addition to an annual fee.

Also, the assets in the IRA have to be valued each year, and the custodian likely will charge you for the valuation. The range of fees and expenses can make the true self-directed IRA impractical for low-value IRAs or those that will make a number of transactions.

That brings us to the next step in the process. After opening a true self-directed IRA, you can decrease the drag from the fees and expenses and increase your flexibility by setting up a limited liability company (LLC) with the IRA as the sole owner of the LLC. The LLC receives its funding from the IRA. Then, you execute all investment transactions through the LLC instead of directly through the IRA account.

There’s no reason to go through the custodian for each investment or transaction the IRA makes. The LLC opens its own investment accounts or engages in transactions on its own.

The LLC might incur costs and expenses for its transactions, but it won’t incur the fees the custodian imposes on each transaction. You’ll still need to have the LLC valued at the end of the year and will be charged for that.

‘Checkbook IRA’

 You can see why this sometimes is referred to as the LLC IRA. Some people call it the Checkbook IRA, because the investments and transactions essentially are being made through the LLC’s checkbook.

You have to follow all the legal requirements of setting up and operating an LLC. That means creating the organizational documents, registering with the state, paying the state registration fee annually, receiving an employer ID number from the IRS, opening up a bank account or other financial account, and filing annual income tax returns.ira-e1415741210226

There also might be local registration or tax filing requirements. The annual income tax returns shouldn’t result in a tax. The single-member LLC will have all tax results passed through to the owner, and that’s the IRA. The IRA is tax deferred and pays taxes in only a few instances, such as when it buys prohibited investments or engages in prohibited transactions.

Through the LLC you can buy any investment that is allowed for an IRA.

Keep in mind that the LLC must follow all the investment and transaction limits on IRAs. If the LLC does anything that an IRA is not allowed to do, the penalties will be imposed on the IRA as though it directly engaged in those actions.

Adding an LLC also can give you additional asset protection. An IRA has some protection under federal bankruptcy law and many state laws, but the protection isn’t complete.

An LLC owned by an IRA adds an additional layer of protection and has greater asset protection under most state laws. Even if a creditor wins a judgment against you that allows access to the IRA, in most states the creditor has to wait until the LLC makes a distribution to the IRA to collect. A distribution can’t be forced from the LLC to the IRA or you.

strategy-blog-picThe strategy is available to both traditional and Roth IRAs. In fact, it is available to almost any qualified retirement plan when the plan sponsor or custodian will allow your account to own an LLC or other non-traditional investment assets. Some of the custodians of true self-directed IRAs also serve as administrators or custodians of 401(k) and other qualified retirement plans.

There are three additional issues of which you need to beware.

Contribution limits, of course, apply to the IRAs, and it’s possible to unintentionally over-contribute to a true self-directed IRA. For example, suppose your self-directed IRA owns a real estate rental property. You go to the property and perform some maintenance or other service. The value of that service is a contribution to an IRA.

You also make a contribution if you pay for anything related to the property out of your personal funds instead of the LLC checkbook. To avoid these issues, you must be careful the LLC or IRA has enough cash on hand or liquid assets to pay these types of expenses, and you must pay the IRAs expenses from IRA assets, not personal assets.

Another issue is that after age 70½ the IRA must begin annual required minimum distributions (RMDs). The distributions are based on the value of all your IRAs, and the value of the assets owned by the LLC must be included. Some people put all their IRA assets in a self-directed IRA that owns real estate or other assets that aren’t easily converted to cash. They find they don’t have enough cash or liquid assets to pay the RMDs.

There are a couple of ways to deal with this problem.

You don’t have to put all your IRA assets in the self-directed IRA. You can keep some in a conventional IRA. You compute RMDs by aggregating the total value of all your IRA assets. But you can take the RMD for the year from the different IRAs in any ratio you desire. You can take all the RMDs from the conventional IRA for as long as it has assets and leave the self-directed IRA undisturbed for as long as possible.61849

Another option is to distribute property instead of cash. You can meet the RMD obligation by making an in-kind distribution of property with a value at least equal to the RMD. When the self-directed IRA owns real estate, for example, you can draw up a deed each year that transfers a portion of the property’s ownership to you as an individual. Include the fair market value of that portion of the property in your gross income.

The second option might be cumbersome and incur some extra costs, depending on the assets held in the IRA. But it is a way to avoid both selling property simply to make an RMD and penalties for failing to take RMDs.

The third issue is one I’ve mentioned but needs to be emphasized. You need to avoid transactions and investments that are prohibited for IRAs. The penalty for a prohibited transaction could be that the entire IRA loses its tax qualification, and you are treated as receiving a distribution of the entire IRA on the date of the prohibited transaction.

imagesMost people shouldn’t pursue the true self-directed IRA strategy without an advisor who is familiar with the rules for such IRAs. Some of the custodians of self-directed IRAs will offer advice or have lists of advisors to consider. There also are firms that specialize in working with owners of self-directed IRAs. You can find some to consider through a simple Internet search. Your tax accountant or estate planning attorney might be well-versed in the rules or be able to refer you to someone who is.

Interview and investigate potential advisors carefully. There have been several firms promoting themselves as self-directed IRA advisors, but they really were steering investors into questionable tax strategies or fraudulent deals. Some of the investors had to pay taxes and penalties to the IRS. Others lost their money.

The true self-directed IRA, especially one with an LLC, has many advantages for those who want to invest in non-conventional assets. With it, you can invest your IRA in real estate, mortgages, tax liens, private businesses, hedge funds and many other assets. But it isn’t for everyone. The strategy requires care to avoid triggering taxes and penalties. You need a custodian who offers the IRA, and most people need a tax advisor who can steer them through the pitfalls.

I help my subscribers walk through all aspects of their retirement planning each month in my newsletter.  Click here now to learn more about Retirement Watch.

Until next time,

Robert Carlson

Robert Carlson is editor of the monthly newsletter, Retirement Watch. In it, he provides independent, objective research covering all the financial issues of retirement and retirement planning. Carlson also is Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System and the founder of  Carlson Wealth Advisors, L.L.C.