A Self-Directed IRA allows you more investment flexibility than many other retirement plans, but it is of the utmost importance that individuals adhere to self-directed IRA rules. Below, you’ll find 5 Self-Directed IRA Rules every investor should know.
Rule #1: Certain Assets are Considered Prohibited Investments
Self-Directed IRAs grant access to a world of investment opportunities away from the traditional marketplace of stocks, bonds, and mutual funds. Indeed, investors can choose from a myriad of alternatives like real estate, LLCs, timber, oil & gas, notes, precious metals, and many others. Additionally, with the emergence of Bitcoin, Ethereum, and other cryptocurrencies, investors are able to diversify into options never seen before.
The IRS only identifies a handful of assets that are prohibited within an IRA. Those items are:
- Collectibles – This includes, works of art, rugs or antiques, certain metals, gems, stamps and certain coins, alcoholic beverages, and any other tangible personal property that is a “collectible” under IRC Section 408.
- Life insurance – Per the Internal Revenue Code 408 (a)(3) for an individual retirement account, an IRA cannot invest in life insurance.
- S-Corporations – Trusts that qualify as an IRA are not eligible to be shareholders of an S-Corporation. (See Revenue Ruling 92-73)
Rule #2: IRAs Shouldn’t Interact with Disqualified Persons
Like Prohibited Investments listed above, IRAs also have rules regarding the people you may do business with. These prohibited individuals are referred to as Disqualified Persons. Engaging in direct or indirect transactions between your retirement plan and a disqualified person may cause your IRA to be disqualified, leading to potential taxes, penalties, and may include mandatory distributions from your IRA funds.
Per the IRS, the following people are considered Disqualified Persons for the purpose of your self-directed IRA:
- You, the account owner
- A beneficiary of the IRA
- Your spouse
- Your lineal ascendants
- Your lineal descendants (and their spouses)
- Plan service providers and fiduciaries (including advisors, custodians, and administrators)
- Entities (corporation, estate, partnership, etc.) in which you own at least 50% of the voting stock, directly or indirectly.
- An officer, director, or a 10% or more shareholder or partner.
While transactions involving brothers, sisters, aunts, uncles, nieces, or nephews, including in-laws, are not expressly prohibited, it’s best to use caution when engaging in business with these individuals.
For more information regarding Disqualified Persons, please refer to IRS Section 4975.
Rule #3: IRAs Should Avoid Prohibited Transactions
According to the IRS, a prohibited transaction is any improper use of your IRA by you, your beneficiary, or any disqualified person. Additionally, transacting with a Disqualified Person or committing a prohibited transaction will most likely void the tax protection of your account, which may lead to costly and serious tax consequences.
Additionally, should a prohibited transaction in connection with an IRA account occur at any time, the IRA will then be considered to have distributed all its assets to the IRA owner (at their fair market values). If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that should be included in his or her income.
Here are a few examples of Prohibited Transactions. You cannot use your self-directed IRA to:
- Sell, exchange, or lease, property you already own to your IRA as an investment
- Transfer IRA income, assets, or investment to a Disqualified Person
- Lend IRA money or extend IRA credit to Disqualified Person
- Supply goods, services, or facilities to Disqualified Person
- Allow fiduciaries to obtain or use the IRA’s income or investment(s) for their own interest
Lastly, per IRS regulations, you cannot have “indirect benefits” from assets owned by your self-directed IRA. For example, using a vacation home that you’ve purchased with your Self-Directed IRA is considered a prohibited transaction.
For more information regarding Prohibited Transactions, please refer to IRS Section 4975.
Rule #4: Annual Fair Market Valuations Are Typically Required
The Internal Revenue Service (IRS) requires that Self-Directed IRA Custodians/Administrators report the value of the assets in their accounts, annually.
For traditional assets it’s relatively straight forward, as investors have public exchanges to identify their asset’s value. For alternative assets where there is no easily accessible marketplace, individuals must use a Fair Market Valuation (FMV) to assign or change the value of an asset.
Valuation of the assets in your self-directed account must be provided to your IRA Custodian/Administrator on a yearly basis (typically prior to December 31st), to ensure accurate and proper tax reporting with the IRS.
Additionally, an FMV is also required when there is a taxable event, such as:
- Taking a distribution from your IRA (including “In-Kind” distributions)
- Demonstrating an asset no longer has value; or
- Converting assets held in a tax-deferred account to a post-tax account (E.g. Traditional to Roth)
In general, precious metals and publicly traded assets (stocks, bonds, etc.) typically do not require your submission of a fair market valuation because these investment values are determined by the market. However, it is helpful to contact your IRA Custodian/Administrator to verify their individual requirements.
Rule #5: Certain Account Types Have Required Minimum Distributions
For Traditional IRA holders who reach age 72, the IRS requires that those individuals begin taking distributions from their IRA. These types of distributions are referred to as Required Minimum Distributions (RMDs). Individuals with a Roth IRA are not required to take mandatory distributions from their Roth IRA.
The amount required to withdraw each year varies based on several factors, most notably account value. If you have multiple accounts, you will usually need to calculate the RMD for each separately, to determine the required amount. You may then take a full distribution from one account or take an RMD from each. The important thing to remember is that the total RMD amount across all applicable IRAs needs to be withdrawn to avoid tax consequences. It is always wise to confirm your individual needs by using the latest calculation worksheets, which can be found on the IRS website.
There are two methods of distribution from an IRA:
- Cash Distributions – When an IRA holder requests a cash amount to be distributed from the account and sent via check, ACH or wire directly into their hands.
- ‘In-kind’ Distributions – Used to distribute non-cash assets from an IRA without selling these assets. This method of distribution changes the ownership of the asset from the IRA’s name to the name of the IRA holder. This type of withdrawal is typically used for illiquid assets like real estate, promissory notes, and private placements. The Fair Market Value (FMV) of the asset is used to report to the IRS the dollar value of the distribution.
Your IRA Custodian/Administrator reports all distributions (as of December 31st of the tax year) to the IRS and the account holder using IRS Form 1099-R.
Being aware of the few things that aren’t allowed in your IRA is essential when it comes to protecting yourself and your account. Which is why we recommend that every investor consult with a qualified financial advisor or tax attorney before making any significant financial decision.
Whether you’re just getting started or you’ve been investing with a self-directed account for decades, it’s helpful to know the basics. If you have questions about how the Self-Directed IRA process works, our experts are here to help. Call us today at (800) 777-9878 or email us at [email protected].