A self-directed IRA gives you enormous freedom, and with it plenty of room for error. Here are the ten mistakes I see people make most often, grouped by where they go wrong, so you can avoid them with your own account.
Know what “self-directed” really means
1. Not understanding the “self-directed” part
Unlike traditional brokerage IRAs, self-directed IRAs come with no tax, legal or investment advice, and self-directed custodians and third-party administrators don’t offer or endorse investment products. Self-directed means just that: you find your own investments and decide how to structure them. If you make a million dollars in your self-directed IRA, all the glory is yours. If you lose everything, there’s no one to blame but yourself.
2. Investing in something you know nothing about
One of the main benefits of a self-directed IRA is that it lets you invest in what you know best, especially if that isn’t stocks, bonds, mutual funds or annuities. Some people get so excited about self-direction that they invest in something they know nothing about, which often leads to disaster. Most of my own investing mistakes came from straying from what I know how to do best.
3. Not understanding what you are investing in
This is a big one. It amazes me how some people have no understanding at all of what they’ve invested in.
A woman called the other day believing she held a note and an option agreement. In fact she held a simple option: she had paid $28,000 for an option to buy 50% of a property for $10. The deal was meant to help the owner out of foreclosure, and the homeowner had the right to buy back the option at a profit to the IRA of about $5,000.
The good news is that it worked for a while, and the homeowner stayed in the house an extra two years. The bad news is that the homeowner still wasn’t financially responsible, and the IRA lost every dime when the lien holder foreclosed. Because the IRA held only an option, not a note as she thought, she couldn’t even sue to recover some of her money. And even if she had exercised the option, her IRA would have owned only half the house.
Learn the rules that can sink your IRA
4. Not understanding disqualified persons and prohibited transactions
Disqualified persons are people considered too close to you for a transaction with your IRA to be at arm’s length. They can’t enter into transactions with your IRA or benefit from them, directly or indirectly. Prohibited transactions are the things your IRA can’t do with any disqualified person.
The penalty for a prohibited transaction is death (of the IRA, that is), along with taxes and penalties. If you have a self-directed IRA, you need a good basic understanding of these rules as they apply to your investing strategy.
5. Not understanding unrelated business income tax
An IRA can be taxed in three situations:
- It runs a business, either directly or through a non-taxed entity such as a partnership or LLC.
- It owns and rents out personal property (rent from real property is exempt from this tax).
- It owns debt-financed property, directly or through a non-taxed entity such as a partnership or LLC.
To be clear, investments that cause your IRA to pay tax aren’t necessarily bad, especially in a Roth IRA or other tax-free account. But you should understand the tax up front.
6. Trying to get around the rules instead of investing within them
Many people are tempted to use their IRA to make money or get some other benefit for themselves or other disqualified persons right now, instead of letting all the benefits go to the IRA for a comfortable retirement. To make matters worse, a lot of gurus teach how to hide rule violations instead of how to use the rules properly to your advantage.
My personal motto is: use the law to your advantage, but don’t abuse it. After all, the “R” in IRA stands for retirement. It isn’t an INA (Individual NOW Account)! To make money now, use OPI (other people’s IRAs). To make money for retirement, use your own self-directed IRA.
Get the paperwork and titling right
7. Not vesting assets correctly
Every asset in a self-directed IRA must be titled in the name of the custodian for the benefit of your IRA, in this form:
[Custodian Name] FBO [Your Name] IRA #[Account Number]
A lot of time goes into getting clients, title companies and investment providers to understand this. Common errors include:
- Leaving out the custodian or administrator entirely.
- Putting only the client’s name after “FBO,” so it looks as if the custodian holds the asset for the individual rather than for the individual’s IRA.
- Using the client’s own Social Security number instead of the IRA’s number or the custodian’s trust tax ID number.
8. Submitting incomplete paperwork
Another big time waster is chasing down improperly completed documents for opening IRAs, transferring money into them and processing transactions. It frustrates clients and staff alike. Take the time to learn how to submit paperwork properly, and allow yourself enough time to do it. It is better to ask questions in advance than to submit incorrect paperwork and cause a delay.
Protect your money before you invest it
9. Skipping due diligence and proper documentation
Here’s a hint: con men are very good at what they do. Understand what you are investing in, and do your due diligence on both the investment and the person you are investing with before you decide.
Make sure you have proper paperwork, too. I wouldn’t lend money to my own mother without proper documentation! Good paperwork protects both your IRA and the person it invests with. What would happen if either of you died? Would your heirs understand the investment? Even if you trusted the other person completely, would their heirs know about your handshake deal and honor it? Probably not.
An excellent rule of thumb: if it sounds too good to be true, it probably is. A common thread in scams is pressure to act now or miss out on an incredible opportunity. That pressure is meant to draw you in before you have time to think or do your due diligence.
10. Not following a sound strategy when lending IRA money
There are at least ten simple rules to follow when lending your IRA money (or even your personal money):
- Don’t lend on anything you wouldn’t be excited to own if the borrower defaults.
- Generally, don’t advance money for repairs until the repairs are done, and inspect them before advancing the funds.
- Don’t lend to anyone you’d be uncomfortable foreclosing on.
- If the loan goes into default, don’t delay. Take action immediately.
- Collect interest monthly so you’ll know if the borrower is getting into trouble.
- If you’re unsure about a loan, hire a professional to help evaluate the deal (at the borrower’s cost, of course).
- Get title insurance on the loan. Done at closing, the extra cost to the borrower is very small.
- Verify that hazard and, if needed, flood and wind insurance are in place, naming your IRA as an additional insured.
- Insist on proof that taxes, homeowners association dues and hazard insurance are paid when due during the loan.
- Get a personal guarantee when lending to a non-individual borrower or a weak borrower.
