There are many banks, insurance companies, and other financial entities that offer IRA accounts – and of these, there are a large number that state that their IRA accounts are self-directed. However, their version of a self-directed IRA and a truly self-directed IRA account are oftentimes different.
While you may see “self-directed” IRA accounts advertised by traditional financial services companies, these accounts are often only self-directed in that you, the account holder, can only choose from a very short list of traditional financial vehicles to buy and sell within your IRA account.
- Mutual Funds
Yet, while there are numerous choices even within each of these options, the self-directed IRAs that are offered through traditional financial firms really only allow you to “direct” your investment choices in terms of these companies’ offerings. Rather, a truly self-directed IRA can offer you the ability to invest in an almost unlimited number of assets. These include both tangible and intangible items.
In addition, when you own a truly self-directed IRA account, you will possess other benefits, too, such as having more control of how your account is managed, and more control over the performance and return of many of the assets themselves.
Types of IRA Accounts – An Overview
Although the term IRA – or Individual Retirement Account – is sometimes used universally, there are actually several different types of retirement accounts that are available to investors today. These can include versions for individuals, as well as for business owners and employees of certain types of businesses.
When it comes to individual IRA accounts, there are two primary types, or categories. These include the traditional and the Roth IRA. While each of these accounts offers some similarities, there are also a number of key differences between the two.
Traditional IRA accounts have been in existence for more than 40 years. As previously discussed, these accounts can allow you a way to save for retirement that provides you with a number of tax-related advantages.
For example, the contributions that you make into a traditional IRA may be either fully or partially deductible from you annual taxable income. This means that, if you are able to fully deduct your contribution, you will not have to pay income tax for the amount of that year’s contribution.
The funds that are inside of your traditional IRA account are allowed to grow on a tax-deferred basis, meaning that any of the gain that takes place in the account will not be taxed until the time of withdrawal.
In the case of a traditional IRA account – provided that all of your contributions go in on a pre-tax basis – 100% of the money that is withdrawn will be taxed at your then-current income tax rate.
For some investors, the income tax rate in retirement will be lower than the rate they paid during their working years – and if that is the case, it could mean that you’ll benefit even more from a tax perspective.
There are certain rules that must be followed with a regular, traditional IRA. These include:
- Depositing only up to the maximum annual contribution amount. (In 2017, this is $5,500 if you are under age 50, and $6,500 if you are age 50 or older);
- Taking out the required minimum distribution amount each year, once you have turned age 70 1/2. (At that time, you also may not make any additional contributions into the account).
Roth IRA accounts came into existence in 1997. With a regular Roth IRA, the contributions will go into the account after the funds have been taxed. However, the money that is inside of a Roth IRA are allowed to grow tax-free—and, at the time they are withdrawn, funds can also come out of a Roth IRA free of taxation. This can allow an investor / retiree to use 100% of the money that is withdrawn.
As with the traditional IRA, there is an annual maximum contribution that can be deposited into a Roth IRA account. This, too, in 2017, is $5,500 for investors who are under the age of 50, and $6,500 for those who are age 50 and above.
*Note: If an investor owns both a traditional and a Roth IRA, the total amount of yearly contribution (for 2017) is $5,500 or $6,500, depending on your age. Therefore, an investor may not contribute these dollar amounts into both IRA accounts).
Unlike a traditional IRA, there is no requirement to start making any withdrawals when a Roth IRA account holder turns age 70 1/2. In addition, contributions into a Roth IRA can still continue to be made – in turn, allowing the tax-free growth of funds for a longer period of time.
In the case of either a traditional or a Roth IRA, most withdrawals from the account may incur an “early withdrawal” penalty of 10% by the IRS (Internal Revenue Service) if taken out before the account owner is age 59 1/2.
There are, however, some exceptions to the age 59 1/2 rule, such as:
- If the IRA owner becomes totally and permanently disabled
- If the funds being used for qualified higher education expenses
- If the money is taken out as a series of substantially equal payments
- If the money is for a first-time home purchase – up to $10,000 – for qualified individuals
- If the IRS has levied the plan
- If funds are used for unreimbursed medical expenses – up to 10% of the individual’s adjusted gross income
- If it is used for health insurance premiums that are paid while the investor is unemployed
- If the money is used for certain distributions to qualified military reservists who are called into active duty.
In terms of the contribution amount, as well as the tax-related benefits, a regular traditional and Roth IRA account are similar to truly self-directed IRA accounts. However, a truly self-directed IRA account will offer a list of other key benefits.
For example, first, the list of assets that are allowed to be included in a self-directed IRA account is nearly endless—and more choices mean more flexibility for the account owner, as well as more diversification and control.
In terms of its basic structure – as well as the tax advantages that are offered—a self-directed IRA account is technically no different than other IRA accounts. This means that there is both a traditional and a Roth self-directed IRA account option for investors.
In addition to being able to invest in all of the financial vehicles that are allowed in regular IRAs – such as stocks, bonds, mutual funds, and certificates of deposit – there is also a fairly wide array of other items that can also be held
within a truly self-directed IRA. These include the following:
- Residential real estate
- Commercial real estate
- Mortgages and deeds
- Second mortgages
- Private notes and loans
- Private placements
- Commercial paper
- Limited Liability Companies
- Limited Partnerships
- Raw land
- Mobile homes
In fact, contrary to what many people may believe, the Internal Revenue Service (IRS) does not put very many limits at all on the types of assets in which a self-directed IRA account holder may invest.
In addition to the longer list of acceptable investments, truly self-directed IRA accounts can differ in other ways, too, when compared to regular IRA accounts. For example, a self-directed IRA is held by a trustee, or custodian, that permits the investment into these broader set of assets.
While a custodian – such as a bank, credit union, trust company, or other entity – is actually required for all IRAs, it is important that the custodian that you choose for your self-directed account allow investors to invest in vehicles other than traditional options, such as real estate, promissory notes, tax lien certificates, and other such items.
Based on IRS rules, an IRA custodian must adhere to and meet stringent requirements, and also allow for regulatory oversight and audits. The custodians that meet these IRS standards will be given the authority to hold title to assets, investments, or property, as well as to issue funds by writing checks, issuing wires, and through other viable methods.
In addition to IRA custodians, the truly self-directed IRA market place also includes many self-directed IRA administrators and promoters. These are not the same thing as an IRA custodian. For example, a self-directed IRA administrator is only responsible for the following types of activities:
- Data Entry
- Producing Statements
- Basic Financial Reporting
Therefore, in order to complete transactions within a self-directed IRA account, an administrator must establish a relationship with a self-directed IRA custodian or with a trust that is allowed to hold IRA funds and investments.
When establishing a relationship with a self-directed IRA custodian, there are some questions that should ideally be asked before moving forward with establishing an account. These include inquiring about:
- If they have a focus on, and expertise with, truly self-directed IRAs.
- How the custodian is regulated.
- How (or even if) they are insured.
- What licenses and credentials they possess.
- If there is a minimum initial investment amount.
- If they offer brokerage and / or other similar services.
- What the prices are for their services.
- Whether or not you can access your account online.
- If they have relationships established with other professional organizations in the self-directed IRA field.
- How long it will take to set up and establish a self-directed IRA account.
- What type of approach they typically take with their clients’ investments.
Ideally, investors will want to work with a self-directed IRA custodian that has expertise in the type of investing they will focus on. So, if you plan to focus on real estate transactions within your self-directed IRA, then it can be extremely beneficial to work with a custodian that has experience in property-related IRA transactions.
In addition, once you have found a custodian that deals with real estate, you will also want to inquire about the type of real estate transactions they focus on. For example, there are some custodians that may deal only with raw land investments, while others have a focus on either residential or commercial properties.
With a self-directed IRA account, you may also have “checkbook control.” This is a term that is used when a self-directed IRA account holder has complete signing authority over their retirement funds.
In order to obtain checkbook control with your self-directed IRA account, it is first necessary to establish an LLC (Limited Liability Company). This LLC will be owned by the IRA. After the LLC has been set up, a business checking
account can be opened in the IRA’s name.
This checking account will, in turn, be linked to the self-directed IRA funds. And, when the investor elects himself or herself as the LLC’s managing member, they can then control the checkbook in order to make investments for the
A self-directed IRA with checkbook control, then, can provide you with much more investment freedom, as it can allow you to manage your IRA investments with ease, as well as to purchase investments much more quickly – which, with real estate, can oftentimes make the difference between obtaining a profitable property or losing out on the deal.
Before being able to make any investments in a self-directed IRA account, the IRA must have funds available. There are actually several ways that a self-directed IRA account can be funded. These include the following:
- Cash Deposit – Just like with a regular IRA account, cash deposits can be made (up to the annual maximum contribution amount) directly into the account. Typically, IRA deposits for a particular year can be made through April 15th of the following year. For example, an investor’s 2017 IRA contribution is able to be made up until April 15th of 2018.
- Transfer – If you already have an IRA account set up, you may transfer some or all of the funds from that IRA into a self-directed IRA account. (It is important to note that, if you are transferring traditional IRA funds into a Roth IRA account, there could be tax consequences of these funds).
- Rollover – You may also be able to rollover funds from a prior 401(k) and / or other type of qualified plan balance. The self-directed IRA custodian can initiate and administer a transfer and / or the rollover of funds from a current account to a self-directed IRA. While there is no limit on the dollar amount that can be transferred, the IRS only allows investors to do this one time per year – regardless of the number of IRA accounts that are owned by the investor.
As long as the funds in an IRA transfer or IRA rollover go directly from one account to another, there are no tax consequences (unless going from a traditional to a Roth account). Likewise, there will be no early withdrawal penalty, even if the investor is under the age of 59 1/2.
One of the biggest keys to success when investing through a self-directed IRA is ensuring that the IRS rules are adhered to. There are a number of key regulations that relate to self-directed IRAs.
While each of the IRS rules will be discussed in more detail later in this guide, the primary self-directed IRA rules include the following:
- Prohibited Transactions – Based on IRS regulations, everything that the account engages in must be for the exclusive benefit of the retirement plan. Therefore, for example, an investor will not be allowed to purchase real estate using self-directed IRA funds for his or her own personal use (or even for the use of his or her family
- Disqualified Persons – As it relates to prohibited transactions, there are a number of individuals and entities that are considered to be “disqualified” in terms of benefiting from self-directed IRA investments. These include the self-directed IRA owner, as well as his or her spouse. Disqualified persons also include the IRA account owner’s ancestors (such as his or her parents and grandparents), their lineal descendants (such as children and grandchildren), and the spouses of the lineal descendants. Likewise, those who provide services to the IRA plan, such as fiduciaries, are also considered to be disqualified persons, as are any business entities that are related to the account in which any of the above-mentioned persons has a 50% or greater interest.
Although there are various rules that must be followed in terms of setting up, funding, and transacting investment sales and purchases, the benefits that can be garnered with a self-directed IRA account are many – including both tax advantages and the opportunity to grow retirement assets for the future.
A truly self-directed IRA will allow a much more broad selection of assets that can be purchased via the account as versus a regular IRA. List at least 10 assets that are not allowed in a regular IRA but can be obtained via a self-directed IRA.
• Commercial real estate
• Mortgages and deeds
• Second mortgages
• Private notes and loans
• Private placements
• Commercial paper
• Limited Liability Companies
• Limited Partnerships
• Raw land
• Mobile homes