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A self-directed Individual Retirement Arrangement is an IRA that allows the account owner to direct the account trustee to make a broader range of investments than other types of IRAs.
RS regulations require that either a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner. Generally that person/company will be the one to maintain the assets and all transactions and other records, file required IRS reports, issue client statements, assist in helping clients understand the rules and regulations pertaining to certain prohibited transactions, and perform other basic administrative duties on behalf of the self-directed IRA owner. The custodian of a self-directed IRA may offer a selection of standard asset types that the account owner can invest in, such as stocks, bonds and mutual funds; but, by definition, permits the account owner to make other types of investments. The range of permissible investments is regulated by the IRS, but it is fairly broad. There are also certain limitations on the kinds of transactions that the IRA can be involved in.
Prohibited Transaction
Self-directed IRA or 401(k) account holders are not allowed to personally benefit from the investments made with retirement plan dollars. In other words, it’s the plan that has to benefit. You are considered “disqualified” to have direct dealings with your plan, other than for making investment decisions. Certain family members and business entities that you control may also be disqualified.
A disqualified person as outlined in IRC 4975(e) (2):
- The IRA owner
- The IRA owner’s spouse
- Lineal Ancestors (Mom, Dad, grandparents)
- Lineal Descendants (daughters, sons, grandchildren)
- Spouses of Lineal Descendants (son or daughter-in-law)
- Aunts, uncles and cousins are not disqualified because they are not lineal relatives
- Investment advisors
- Fiduciaries – those providing services to the plan
- Any business entity i.e., LLC, Corp, Trust or Partnership in which any of the disqualified persons mentioned above has a majority share interest (50% or greater).
Prohibited Transactions (as defined in IRC 4975(c)(1) and IRS Publication 590) are those which occur between a retirement plan and a disqualified person. These types of transactions will result in the loss of the tax-deferred status and/or other penalties being assessed against the plan and its assets. These rules were established to insure that everything the IRA engages in is for the exclusive benefit of the retirement plan. Professionals often refer to these prohibited transactions as “self-dealing” transactions.
Generally, according to Section 4975, a plan cannot (directly or indirectly):
- Sell, exchange or lease property to a disqualified person.
- Loan money to a disqualified person.
- Furnish goods, services, or facilities to a disqualified person.
- Transfer income or assets to a disqualified person.
Allowable Investments
The rules on retirement plans come primarily from 2 places: the US tax code and the Employee Retirement Income Security Act (“ERISA”), which was the 1974 congressional act that made IRAs, 401(k)s and similar plans possible. Generally the rules only specify two kinds of assets as non-permissible investments: Life Insurance on the IRA Owner and Collectibles.
Other than the two excluded investments listed above the rules also restrict investing in the stock of an S corporation. Beyond that the Code does not specifically outline “allowable investments” since the list of possibilities is very long (IRC sections 401 and 408). In no particular order, here are a few of the more popular options for self-directed IRA investing.
- Rental Property
- Life Settlement Contracts
- Tax Liens & Deeds
- Secured & Unsecured Notes
- Real Estate
- Mortgages
- Judgements & Structured Settlements
- Accounts Receivable Factoring
- Commercial Paper