What is a Self-Directed Individual Retirement Account (IRA)

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What is a Self-Directed Individual Retirement Account (IRA)

A Self-Directed IRA (SDIRA) is a type of retirement savings account. It is similar to the military’s Thrift Savings Plan, in that it is a tax-advantaged retirement plan. The major difference is that an SDIRA allows you to invest in nearly any type of asset you want, as opposed to being limited to stock market funds. 

In an SDIRA, almost any type of investment is on the table from real estate and private lending to intellectual property or livestock.

The law that governs Individual Retirement Accounts does not recognize a difference between conventional and self-directed IRAs. There is no difference in the way these accounts are governed, so they have the same tax benefits and styles as your TSP might.

  • All IRA tax benefits apply equally to conventional IRAs and self-directed IRAs
  • All types of IRAs (traditional, Roth, SEP, etc.) are available in both “conventional” and “self-directed” varieties
  • The same contribution limits and withdrawal rules apply equally to conventional and self-directed IRAs
  • The wonderful estate planning (inheritance) features of IRAs work identically for self-directed and conventional IRAs
  • The asset protection (protection from lawsuits) is the same for self-directed and for conventional IRAs.

Another difference between self-directed and conventional is in the IRA company, or custodian, you choose to use. The majority of IRA custodians in the U.S. choose to invest in securities like stocks and bonds. That is the conventional asset of choice for IRAs like the Thrift Savings Plan. A Self-Directed IRA is simply an IRA opened with a SDIRA custodian. They fall under the same laws, but the custodian has chosen to allow investment in more asset classes. 

In a conventional IRA, you can buy stock in a company like Tyson that sells meat products. 

In an SDIRA on the other hand, you could:

  • Buy real estate on which to raise chicken
  • Own trucks or equipment that is leased to farmers and others in the supply chain
  • Invest in research and development… and license your patents to meat processing plants
  • And you could also just buy stock in a company like Tyson, if you wish

Ultimately, your imagination is the biggest limiting factor with a self-directed IRA.

Why You Should or Should Not Use A Self-Directed IRA

A self-directed IRA might be the right choice for you if you are looking to invest your retirement account in asset classes other than stocks and bonds. It might also be right for you if you are a savvy investor, who is knowledgeable about various investing strategies. 

A SDIRA might not be the right choice for you if you are going to take unnecessary risks with the money in your IRA. It might not be right for you depending on the amount of money you will be penalized for rolling your money into the new SDIRA custodian, or if you want a hands-off approach to investing your IRA. With an SDIRA, you will need to have a better pulse on what your money is doing, as opposed to the TSP where you can just set it and forget it. 

Ultimately, if you are nervous about the risk an SDIRA presents because you are the person directing which assets it buys, perhaps you should stick with a conventional IRA. If you are not willing to accept the responsibility of finding your own investments and managing your portfolio personally, I would stick with a conventional IRA.

Don’t use an SDIRA unless you have a clear idea where you’ll invest it. 

Bryant Ellis says that these three little questions can help you ensure you don’t break the guidelines for investing with your SDIRA. 

“Before every transaction in your self-directed IRA, call an IRA attorney and ask these things:

  1. Is any part of this transaction prohibited or taxable?
  2. Are there any danger zones that would take my IRA out of compliance?
  3. At what milestones should I have you review the transaction again?

That’s it.  Ask those three questions to a good IRA attorney before every transaction, follow their advice, and you’ll be solid. (source)”

What Can You Buy In a SDIRA

There are a ton of assets you can purchase in your self-directed IRA. Here are just a few examples to get the creative juices flowing:

  • Real Estate
  • Pre-IPO companies
  • Promissory notes (private lending)
  • Cryptocurrencies
  • Precious Metals
  • Patents, Copyrights, Trademarks
  • Heavy Equipment
  • Intellectual Property
  • Private Businesses
  • Hedge Funds
  • Private Equity
  • Tax Lien Certificates
  • Livestock
  • And the list goes on…

The law only prohibits two specific asset classes: 

  • Life Insurance
  • Collectibles (art, antiques, stamps, coins, etc.)
    • Certain other tangible personal property

The tangible personal property bullet that the IRS listed under collectibles means that they can add to the list, which is all the more reason to consult an attorney before you purchase tangible items in your SDIRA.

Outside of those two asset classes, you can self-direct your IRA funds into a myriad of investments!

If you’re a creative individual like I am, this should get you excited. However, I must reiterate that you shouldn’t buy assets you don’t understand. 

Disqualified Persons

The one rule that renders all other considerations invalid is that your IRA’s assets must never be used to benefit a “disqualified person.” If your IRA transacts business with or indirectly benefits a disqualified person then it is guilty of what is known as a “prohibited transaction.”

Prohibited transactions can be (and usually are) catastrophic for an IRA, so don’t make this mistake. A prohibited transaction, even accidental, can eliminate your IRA. Yes, it is that serious!

For this reason, you must avoid any transaction with a disqualified person. As always, consulting a good IRA attorney is a smart move before making a transaction. 

“Disqualified persons” include: 

  1. You – the owner of the IRA
  2. Related Entities – any business or organization in which you or a family member has a substantive ownership or influence
  3. Most of Your Family – your ancestors or descendants and their spouses
  4. IRA Account Professionals – your account custodian or anyone providing services connected to the IRA

You must never use your IRA in a way that brings any of these individuals personal benefit!

For example, you cannot live in a house that is owned by your IRA, sell assets to your IRA, buy assets from your IRA, use your IRA as collateral for a loan, etc.

There are a lot of weird ways you could end up triggering the “prohibited transaction” designation. Bottom line is that you should absolutely consult an expert SDIRA attorney before engaging in any transaction.

Prohibited Transactions in Your Self-Directed IRA

Now that you understand what types of assets you can and cannot purchase and the people or entities that must not be allowed to benefit from your IRA or its assets, let’s discuss what happens when you commit a prohibited transaction.

There are actually three different possible results you could receive from a prohibited transaction:

  • Prohibited Asset Penalties
  • Prohibited Transaction Penalties
  • Fiduciary/3rd Party Penalties

Any one of these penalties could be catastrophic, but prohibited transaction penalties are the most common…and the worst.

Prohibited Asset Penalties

Basically, if your SDIRA purchases any prohibited assets, it will be subjected to a mandatory partial distribution. Basically, the IRS will force you to distribute (read withdraw) an amount of money equal to the size of the transaction. 

That means you will be forced to pay income taxes, early withdrawal penalties, and interest on this money, assuming you are below 59 ½ years of age. You could easily end up with a tax bill for over 40% of the amount you spent on the prohibited asset. 

Don’t purchase a prohibited asset! 

SDIRA Prohibited Transaction Penalties

If you commit a prohibited transaction, which generally means your IRA is working too closely with a disqualified person, the IRS will crush you with a mandatory full distribution.

The mandatory full distribution is every bit as bad as it sounds. If you get hit with this penalty, it will effectively eradicate your IRA. Some of the penalties you can be expected to pay are:

  • Federal and state income taxes 
  • Withdrawal penalties 
  • Failure to pay penalties 
  • You will also owe the IRS interest between when the event occurred, and when they discover it. The IRS interest rate is the federal short-term rate plus 3%. Currently it is around 4%, which adds up quickly if the IRS doesn’t notice your prohibited transaction until three years later.  

To make matters worse, your IRA will no longer be an IRA which means:

  1. Your former IRA will no longer be conveyed to your choice of beneficiaries
  2. Your former IRA is no longer protected by the laws that keep IRAs away from creditors

For this reason, creditors have ample motivation to try and prove you committed a prohibited transaction if they believe you owe them money.

Fiduciary/3rd Party Penalties

If you turn over your IRA to a financial advisor or another 3rd party that commits a prohibited transaction, there is still a penalty. Granted, this penalty isn’t as bad as if you commit the prohibited transaction yourself, but it still carries some penalties:

  1. Payment of a 15% penalty of the amount of money involved
  2. Account must be returned to condition before the prohibited transaction occurred. For example, if they purchased a property in a prohibited transaction, you would need to sell it and return the capital to the IRA.

This still sucks but is much better than if you made the mistake personally. 

SDIRA Custodians

You need to ensure that the custodian you choose to use for your SDIRA is competent. An incompetent custodian could be devastating for your account. There is a lot that goes into choosing a custodian, but that is beyond the scope of this article. 

Know that your custodian is not able to help you find deals or give legal advice. The custodian is simply the trustee on your account that helps facilitate fund transfers with the IRA. 

Checkbook IRAs

Checkbook IRAs give you checkbook control over your IRA funds. This can be good or bad. 

Checkbook IRAs are extremely simple to invest with. You can literally write a check from your IRA, and boom!

That means your activities are hidden from and not subject to the approval of your self-directed IRA custodian. All of the previously discussed rules still apply though. A checkbook IRA means that you eliminate a layer of defense against making a prohibited transaction because your custodian doesn’t have to (or get to) review your transactions. Again, this is not their job, but it is a nice bonus if they happen to notice you’re about to do something unwise.

On the flip side, a checkbook IRA could help protect you from a bad custodian or 3rd party penalty!

The best things about checkbook IRAs are that they: 

  1. Have lower fees
  2. Provide independence from your self-directed IRA custodian
  3. Allow you instant access to your capital
  4. Can substantially reduce the effect of prohibited transactions

As with anything though, there are some disadvantages to a checkbook IRA. If you use a checkbook IRA, you will be on the hook for keeping your own records, insurance, asset protection, etc., that a non-checkbook SDIRA custodian might do. This can be good or bad, depending on your situation and knowledge level.

You need to hire an experienced IRA attorney in order to set up your checkbook IRA and the LLC that it will own. This is complex, and adding or omitting the wrong clause when establishing the operating agreement for your LLC could have you operating with prohibited transactions from day one…not ideal.

Hire an experienced IRA attorney to set this up for you.

Ultimately, the checkbook IRA is very powerful and very risky. I definitely don’t recommend it unless you are extremely well-versed in this strategy and have a specific need for it. 

Self-Directed IRAs allow you to invest your retirement savings in practically anything…

Ultimately, a self-directed IRA requires more attention from you than the Thrift Savings Plan. You will need to pay more attention to your SDIRA, and it is entirely possible that you could have money sitting in your SDIRA without earning interest. 

As with everything, there are pros and cons, so make sure you do your homework. A self-directed individual retirement account could be very powerful if used correctly.

Check out this article for more information on self-directed IRAs and checkbook IRAs.

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David Pere

David Pere

David is an active duty Marine, who devotes his free time to teaching personal finance and real estate investing for service members, and the working class!

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