30 January 2012
Last week the Minneapolis paper, StarTribune, had an article about a local man who lost some of his retirement money in a self-directed IRA to a Ponzi scheme. There may be more variables to this story, but it highlighted the flexibility of the self-directed IRA; and with flexibility comes responsibility.
A self-directed IRA is similar to a traditional IRA. In a traditional IRA you will invest your money in mutual funds, stocks, bonds, cash or other marketable securities offered by your brokerage firm/financial advisor. In this scenario, some of the due diligence has been done for you to make sure that the investments are generally sound. But the IRS does allow you to invest in other investments like privately held stock, real estate or certain precious metals within a self-directed IRA. "Self-directed" means just that—you are doing the due diligence and making all the decisions, so you really need to understand the rules.
There are too many rules and warnings to review in a short blog, but let me review a couple that trip people up the most:
- Prohibited Transactions. "Self-dealing" is a big term in self-directed IRAs; in essence, you cannot conduct a transaction that benefits you personally. For example, you could not use your IRA money to invest in a cabin that you or a family member (disqualified individuals—include direct descendants like children and grandchildren; or ancestors like parents or grandparents) was going to use. Real estate must be for investment purposes only. Similarly, you cannot invest in your (or disqualified individuals') own business or make loans to yourself (or disqualified individuals).
- Stepped Transactions. Trying to circumvent prohibited transactions by creating more steps to the process still disqualifies the transaction. For example, you cannot loan money to a friend, who then gives the money to another friend, who then loans it back to you. The IRS looks for these multiple "steps" and can assess a penalty.
- Assets. While there are many things you can invest in, the ones to stay away from include collectibles (art, antiques—see IRS Publication 590 for the full list), life insurance and Sub-Chapter S Corporations.
- Administration. This is not a rule, just a suggestion on my part. Investing in something outside the norm takes a lot of time and effort. Doing the proper due diligence and then monitoring it constantly is needed, but often ignored. I would suggest that if you do not expect returns higher than average stock market returns, then a self-directed IRA might not be worth the effort. For example, if you do invest in a piece of real estate, you must make sure the IRA pays all the bills like insurance, property taxes, and maintenance—this adds a level of detail that needs to be monitored so that you do not disqualify your IRA.
All this brings me to the painful point of what happens when you make a mistake in any of the above, and you disqualify your IRA from tax-deferred standing. If a mistake is made, the entire IRA can be considered taxable and taxes/penalties will be owed immediately. While I often suggest people watch their investment expenses closely, this is one area where paying a little more for good advice is worth it. Outside of a custodian that knows how to do this, include your attorney and/or accountant from the beginning.
Self-directed IRAs can be a great tool for diversifying a portfolio. But like anything, do so with a small chunk of assets, not everything. And know the rules, since tripping up in this area can be very expensive.
About Jon T. Meyer, CFP®
