CARL WATTS & ASSOCIATES

October 08, 2012

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Self-Directed IRAs
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Business investments may include partnerships, joint ventures, and private stock. This can be a platform to fund a start-up business or other for-profit venture that is managed by someone other than the account owner of the IRA.

Other alternative investments include: commodities, hedge funds, commercial paper, foreign stock, royalty rights, equipment & leases, American depository receipts, and U.S. T-bill.

As a self-directed IRA investor you can choose to employ a self-directed IRA LLC structure. With such a structure you, as the account holder, can direct your IRA custodian to invest into a limited liability company that you manage yourself. You can then execute transactions on the LLC level without the involvement of the IRA custodian, thus reducing fees and eliminating custodian transactional fees and delays. The profits of the LLC pass through to the IRA with nearly identical tax favorable treatment.

Holders of self-directed IRA/LLCs are free to invest in alternative as well as traditional assets. Those who want to add securities to their portfolio can open a brokerage account in the name of the LLC at a brokerage house of their choice.

All rules and regulations that apply to an IRA also apply to an IRA/LLC; so the use of the LLC does not exempt the IRA from making prohibited investments and transactions.

Prohibited investments include life insurance and collectibles like artworks, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages and certain other tangible personal property.
Prohibited transactions are, in a nutshell, all direct and indirect transactions between the IRA and a disqualified person. Prohibited transactions with an IRA include: borrowing money from it; selling property to it; receiving unreasonable compensation for managing it; using it as security for a loan; buying property for personal use (present or future) with IRA funds.

Disqualified persons are:

The IRA owner;

The IRA owner's spouse;

Ancestors (parents, grandparents);

Lineal descendants (daughters, sons, grandchildren);

Spouses of lineal descendants (son- or daughter-in-law);

Investment advisors;

Fiduciaries – those providing services to the plan;

Any business entity (LLC, Corp, Trust or Partnership) in which any of the disqualified persons mentioned above has a 50% or greater interest.

If you are found guilty of prohibited investments/transactions, you will have to pay a penalty on the amount of money that you made from those investments. This could ultimately lead to forfeiting the money in your account.
Also worth mentioning is that self-directed IRAs (which are tax exempt entities) were created for long-term investing, and when they purchase an asset that produces income unrelated to the intent of the "plan" by operating a business, acquiring or improving property through debt financing, or certain partnerships in which the plan owns an interest, then that income is subject to taxation. 

The Unrelated Business Taxable Income (UBTI) is subject to Unrelated Business Income Tax (UBIT), which is a very steep and complicated form of taxation. Much like Federal Income Tax, UBIT is set to a laddered schedule and it is compressed on much tighter levels for trusts such as an IRA. Professional help is undoubtedly required to help you through tax calculations.
You may benefit from consulting a tax adviser before opening an IRA and a financial adviser before choosing investments. You may incur unnecessary taxes and IRS penalties if you don't follow contribution, distribution and investment rules.

If you are only going to invest in traditional assets (such as stocks, bonds, mutual funds, and CDs) you are better off with a mainstream IRA. Self directed IRA fees will almost always be higher than those charged for mainstream IRA accounts.

You have the option to make your self-directed IRA a traditional IRA or a Roth IRA. Traditional IRAs grow tax-deferred. When money is withdrawn, the distribution is added to the adjusted gross income.

Roth IRAs are funded from post-tax money, meaning there is no tax deduction and the owner of the self-directed IRA can withdraw money tax-free, provided that he holds the IRA for a minimum of five years.

Self-directed IRAs can be transferred to other people under special circumstances. In the event of death a spouse can become the beneficiary and be allowed to take over the self-directed IRA. This allows the widow(er) to continue to use the money while gaining tax benefits by not having to automatically liquidate the entire account upon death.

In the event of a divorce, if the IRA is required to be split among the couple as part of the divorce court order, the IRA can be transferred into an (ex)spousal IRA.

So, a self-directed IRA isn't quite as simple as just opening an account, many investors may feel more comfortable sticking with stocks, bonds, and mutual funds that most IRAs hold. But if you have an entrepreneurial spirit and want to tap your retirement accounts for financing, a self-directed IRA can open the door to a bright future.

All in all, managing a self-directed IRA requires a certain level of skills, knowledge and experience, therefore help and guidance from specialized professionals is essential to your success.

Everybody knows what an Individual Retirement Account (IRA) is, but just for the sake of the subject of this newsletter, let us outline that an IRA is an investing tool used by individuals to set aside money for retirement each year, with earnings tax-deferred until withdrawals begin at age 59 ½ or later. 

IRAs are attractive because they provide methods of allowing money that would have been otherwise paid in taxes to grow.
Money in this type of investment can earn nearly twice as much as if it were held in a taxable account where state and federal taxes eat up a large portion of earnings. With a Roth IRA, the savings can be even greater because the money can be taken tax free at retirement.

As you know, there are several types of IRAs: traditional IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs.

Many taxpayers have IRAs set up through an employer. IRAs are regulated by IRS rules that govern how much an investor can contribute, what he can invest in, and what transactions are prohibited. Most IRAs invest in bank or brokerage investments (stocks, bonds and mutual funds).

Because of the tax-preferred status given to IRAs, the IRC (Internal Revenue Code) and ERISA (Employee Retirement Income Security Act) limit the types of investments available to these accounts to ensure that investors are using the money for their future retirement and not for immediate personal gain.

If you want more control over the investment strategy of your retirement funds, and are comfortable with taking on that responsibility, a self-directed IRA is the right choice.

A Self-Directed IRA is an IRA that allows and even requires you as the account owner to make investment decisions and investments on behalf of the retirement plan.

Investors who choose a self-directed IRA over a regular IRA usually do so in the hopes that the inclusion of unconventional assets will yield higher rates of return; accordingly, the self-directed IRA is considered more risk prone. While regular IRAs generally include more conservative investments, a self-directed IRA can include more aggressive assets including real estate, IPOs (Initial Public Offering), trust deeds and alternative investment opportunities.

Before you can get involved in a self-directed IRA, you must find a custodian/trustee to work with. The custodian acts as the middleman between you and your money. When shopping around for a custodian, you must pay attention to the fees that are offered by the custodian. Most custodians charge a fee to set up the account and then charge a fee for each transaction. Find out what the fee is and make sure that it is in line with what other custodians charge for this service.

The self-directed IRA is opened in the same manner as a standard IRA, namely through a bank or trust that allows for alternative assets to be held within the IRA. Some brokerage firms or bank will offer self-directed IRA services for certain clients, though in some cases there may be a separate fee for the “privilege” of the self-direction aspect of the account.

In order to set up a self-directed IRA you need to make sure the account passes all of the rules or tests the IRS has set up for any IRA, which are summarized below:

The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee custodian.  This list includes a stockbroker's account.

The trustee or custodian agrees not to accept more than the allowable annual contribution limits for an IRA.

All contributions, except for IRA rollovers, must be in cash.

The account must offer you a non-forfeitable right to your money at all times.

The money in the account cannot be used to purchase life insurance.

The assets in your IRA account cannot be combined with your other investment assets.

Finally, you need to abide by all of the minimum required distribution rules that apply to IRAs.

The custodian will send you two forms. One form is a basic IRA application, which is similar to the one you've completed when setting up an IRA account in the past.
The second form is one that needs to be sent to your existing IRA custodian to inform of your decision. Basically, the IRS has set up a system of "custodians" that are charged with taking care of your retirement money. Money passes (rolls over) from one custodian to the next, no taxes applied.

What the custodian generally does is to maintain the assets and all transactions and other records pertaining to them, file required IRS reports, issue client statements, assist in helping clients understand the rules and regulations pertaining to certain prohibited transactions, and perform other administrative duties on behalf of the self-directed IRA owner for the life of the IRA account.

The custodian usually offers a selection of standard asset types that the account owner can select to invest in. The range of permissible investments is broad, however, the IRS placed limits on the types of assets that may be invested in and on the types of transactions that may be carried out.

Some of the additional investment options permitted with a self-directed IRA include real estate, stocks, mortgages, franchises, partnerships, private equity and tax liens.

Real estate investments may include residential and commercial properties (U.S. & International), farmland, raw land, new construction, property renovation, development, and passive rental income. Real estate purchased in a self-directed IRA can have a mortgage placed against the property, thus lowering the amount of total cash needed for a purchase; however, neither the IRA nor the account owner of the IRA can have personal liability on the mortgage.