There is a lot of confusion about self-directed IRAs and what is and isn’t possible with them. This lesson takes on ten of the most common myths. Contribution and income limits quoted here are those at the time of writing (2008); they change most years, so check current IRS figures before relying on any number.
What an IRA can and can’t invest in
Myth: Anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA
Truth: The only investments the Internal Revenue Code prohibits for IRAs are life insurance contracts and “collectibles.” Collectibles include any work of art, rug or antique; any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion); any stamp or coin (with certain exceptions for gold, silver or platinum coins issued by the United States or under state law); any alcoholic beverage; and any other tangible personal property the Secretary of the Treasury specifies. At the time of writing, no other property had been specified.
With so few restrictions in the law, almost anything else that can be documented can be bought in your IRA. A self-directed IRA allows any investment the law doesn’t expressly prohibit. Common choices include domestic and foreign real estate, options, secured and unsecured notes (including first and second liens on real estate), C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.
Myth: An IRA can’t own a business
Truth: A self-directed IRA is an amazingly flexible wealth-building tool and can own almost anything, including a business. But because of the conflict-of-interest rules, you can’t work for a business your IRA owns and get paid.
Some companies offer a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) and buy employer stock to effectively start a new business. That isn’t a direct investment by the IRA in the business, and it is fairly expensive to set up.
Also, if your IRA owns an interest in a business, directly or through a non-taxed entity such as an LLC or partnership, it may owe unrelated business income tax (UBIT) on the profits. One solution may be to have the business owned by a C corporation or another taxable entity.
Which accounts can be self-directed
Myth: Only Roth IRAs can be self-directed
Truth: Because tax-free wealth building in a self-directed Roth IRA is so powerful, many articles focus on using a Roth for non-traditional investments. As a result, many people believe the Roth is the only account that can be self-directed. In fact, seven types of accounts can be:
- Roth IRA
- Traditional IRA
- SEP IRA
- SIMPLE IRA
- Individual 401(k), including the Roth 401(k)
- Coverdell Education Savings Account (ESA, formerly the Education IRA)
- Health Savings Account (HSA)
All of these accounts can hold non-traditional investments, and they can be combined to buy a single investment.
Who can open and fund a self-directed account
Myth: I don’t qualify because I have a plan at work or earn too much
Truth: Almost anyone can have a self-directed account of some type.
- Roth IRA. There are income limits for contributing (in 2008, $169,000 for married couples filing jointly and $116,000 for single filers or heads of household). But having a plan at work doesn’t affect your ability to contribute, and there is no age limit.
- Traditional IRA. A plan at work (yours or your spouse’s) affects whether your contribution is deductible, but at the time of writing anyone with earned income under age 70½ could contribute. There are no upper income limits, and a Traditional IRA can receive funds from a former employer’s 401(k) or other qualified plan.
- Coverdell ESA. You may be able to contribute for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.
- HSA. If you have the right type of health insurance, a High Deductible Health Plan, you can contribute regardless of income. Contributions are deductible and qualified distributions are tax-free forever, the best of both worlds.
All of this is in addition to any retirement plan you have at your job or for your self-employed business.
Myth: I can’t have a self-directed plan because I’m self-employed and file Schedule C
Truth: You can have a self-directed SEP IRA, SIMPLE IRA or 401(k) plan even if you are self-employed and report your income on Schedule C. At the time of writing (2008):
- SEP IRA. You could contribute up to 20% of your net earnings from self-employment (net Schedule C profit minus half your self-employment tax) or 25% of wages from an employer, up to $46,000.
- SIMPLE IRA. You could defer up to the first $10,500 of net earnings from self-employment (net Schedule C income multiplied by 0.9235 for SIMPLE purposes), plus $2,500 more if you were 50 or older by year-end, plus an employer contribution of 3% of net earnings.
- Individual 401(k). Since 2002, self-employed people can have their own 401(k), and since 2006 a Roth 401(k) lets even high earners put after-tax dollars into an account with tax-free qualified distributions. You could defer up to $15,500 (2007 and 2008) of net earnings, plus $5,000 more at age 50 or older, plus up to $30,500 more based on 20% of net earnings (or 25% of wages). That meant a self-employed person 50 or older could contribute up to $51,000 for 2008.
Investing with a small account
Myth: My IRA is too small to be worth self-directing
Truth: Even small accounts can take part in non-traditional investing by co-investing with larger accounts you own, or even accounts owned by other people. One recent hard money loan we funded had 10 accounts participating. The smallest put in only $1,827.
There are at least four ways to invest in real estate even with a small IRA:
- Wholesale property. Put the contract in your IRA’s name instead of yours, with the earnest money coming from the IRA. When you assign the contract, the assignment fee goes back into your IRA. In a Roth IRA, that profit is tax-free forever.
- Buy an option. An option on real estate can be exercised, assigned to a third party or canceled for a fee.
- Use financing. Your IRA can buy property subject to existing financing or with a non-recourse loan from a bank, hard money lender, financial friend or motivated seller. Profits from debt-financed property may be subject to UBIT, however.
- Partner up. Your IRA can partner with other IRA or non-IRA investors.
Why you don’t need a checkbook-control LLC
Myth: I must set up an IRA-owned LLC before buying non-traditional investments
Truth: A very popular idea right now is to invest your IRA in an LLC that you, the IRA owner, manage. In effect you get “checkbook control” of your IRA funds. Providers often charge thousands of dollars to set these up and sometimes mislead people into thinking it’s necessary for real estate or other non-traditional investments. It simply isn’t true.
An IRA can hold title to real estate and other non-traditional investments directly through a self-directed custodian. And checkbook control through an LLC has many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups can lead to an accidental prohibited transaction, which may cause your whole IRA to be distributed to you, sometimes with substantial penalties.
That’s not to say an IRA should never invest through an LLC; it can make sense, especially for asset protection. But educate yourself thoroughly on the rules first. A checkbook-control LLC is a bit like skydiving without a parachute: it may be fun on the way down, but eventually you’re likely to go splat.
Self-dealing and how IRA assets are held
Myth: I can borrow from my IRA to buy a vacation home for myself
Truth: The Internal Revenue Code lists very few prohibited investments, but certain transactions are prohibited, and the consequences are severe. The prohibited transaction rules exist to stop disqualified persons from dealing with plan assets in a self-dealing way, directly or indirectly. Plan assets must be invested to benefit the plan, not the IRA owner (except as a beneficiary) or any other disqualified person. Transactions are supposed to be at arm’s length.
So a loan from your IRA to you, or staying at a vacation home your IRA owns, is prohibited even if you pay fair market interest or rent.
Myth: I can borrow my IRA funds to buy real estate and then put the profits back
Truth: When a self-directed IRA buys real estate or any other asset, the money never leaves the IRA. The IRA exchanges cash for the asset, just as a brokerage IRA exchanges cash for shares of stock or a mutual fund. So the asset must be held in the IRA’s name.
For example, if Max N. Vestor bought an investment house in his self-directed IRA, title would read “[Custodian Name] FBO Max N. Vestor IRA #12345-11.” Because the IRA owns the asset, the IRA must pay all its expenses, and all profit belongs to the IRA, including rents and gains from a sale.
Using debt to buy property in an IRA
Myth: An IRA must pay all cash for real estate
Truth: An IRA can own debt-financed property, directly or through a non-taxed entity such as an LLC or partnership. Any debt must be non-recourse to the IRA and to every disqualified person.
The IRA may owe unrelated debt-financed income tax (UDFIT) on profits from debt-financed property, including profits from a sale, in proportion to the debt. As a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.
That may sound terrible, but leverage can be an extremely powerful tool for building retirement wealth. The same principle applies inside or outside your IRA: you can do more with debt financing than without it. One client grew her Roth IRA from $3,000 to over $33,000 in less than four months, even after paying the tax, by taking over a property subject to its debt and selling it to another investor.
