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Investing for Retirement Using a Self-directed IRA

Last Updated: May 21, 2010

A Self-Directed Individual Retirement Account (SDIRA) is an IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. IRS regulations require that either a qualified trustee, or custodian hold the IRA assets on behalf of the IRA owner. Generally the trustee/custodian will maintain the assets and all transaction 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.

Self-directed IRA accounts are typically not limited to a select group of asset types (e.g., stocks, bonds, and mutual funds), and most truly self-directed IRA custodians will permit their clients to engage in most investments, if not all, of the IRS permitted investment types (an almost unlimited array of possibilities including foreign real estate). Some of the additional investment options permitted under the regulations include, but are not limited to, real estate, stocks, mortgages, franchises, partnerships, private equity and tax liens.

What Are Prohibited Transactions?

You cannot invest in Collectibles, S Corporations or Life Insurance Contracts. There are also certain transactions in which you cannot participate when using IRA funds, designated as "prohibited transactions". Prohibited Transactions are defined in IRC § 4975(c)(1) and IRS Publication 590. These transactions were established to maintain that everything the IRA engages in is for the exclusive benefit of the retirement plan. Sometimes professionals refer to these as “self-dealing” transactions. Self-dealing occurs when an IRA owner uses their individual retirement funds for their personal benefit instead of benefiting the IRA. If you violate these rules, your entire IRA could loose its tax-deferred or tax-free status. There is more detail on prohibited transactions at the end of this article.

Selecting and Setting Up a Self-directed IRA

Creating a self-directed IRA is easy. In order to own these special assets in a retirement account, you'll have to find a firm that offers a self-directed IRA. You can't buy real estate or other special assets with a basic IRA, so the first step will be to open a self-directed IRA. A number of financial institutions such as banks, insurance companies and brokerages can assist you in opening a self-directed IRA, but most likely your investment options will be limited to the products they sell and service. To buy these special assets with your IRA you will most likely have to find an independent administrator to serve as a trustee or custodian, and you must do your homework in this selection as well. Here is an explanation of the different types of administrators that you may encounter:

• Fee-based administrators. A set fee is charged for each transaction you request the administrator to perform.

• Asset-based administrators. A set percentage of your total asset value is charged annually regardless of the tasks performed. The percentage will typically be 1.5% or lower, contingent on total asset value, the commission percentage decreasing as asset value increases.

• Hybrid-based administrator. This type of management involves a combination of asset and fee, and seems to be the most predominant method used currently according to our research.

Some examples of well-known established companies that handle this sort of IRA include Entrust, Equity Trust, Guidant Financial or Pensco Trust. When selecting a company to administer the IRA, consider that experience is key. You'll want to ensure you fully understand the fees involved, but ask hard questions to ensure they are well-versed in the requirements involving the type of investment you plan to utilize. Many companies/administrators do not even take on real estate contracts, as the complexities are numerous. For a sample list of the questions you might to interview potential custodians for your new self-directed or real estate IRA, click here.

Decide on the Type and Funding of the Account

You can either setup a new account and deposit the IRA contribution limit or you can rollover an existing IRA, 401k or other qualified retirement plan. You do not have to rollover all of your existing IRA or retirement account. For example, you may want to experiment with this method by moving a portion of your retirement into a self-directed plan. Decide on the type of account that will work best for your needs. An example would be a Roth IRA, traditional IRA, solo 401k or others. Your administrator should be able to assist you in choosing the appropriate type of account.

Contribution Limits and Types of Self-Directed IRAs

• Contributions limits for 2010 are $5,000 (or $6,000 for those age 50 and above.)
• A traditional IRA comes in two flavors: deductible and nondeductible.
• To qualify for a deductible IRA, which lets you deduct all or part of your contributions from your taxable income, use the following guidelines: If you have no retirement plan at work and you're under 70-1/2, you can invest in a deductible IRA and deduct the entire amount from your taxes. If you have a 401(k) or other retirement plan at work, you may fully or partially deduct your contribution only if your adjusted gross income (AGI) qualifies. In 2010, your AGI cannot exceed $65,000 if you're single or head of household, or $109,000 if you're married and filing jointly. If you're not covered by a retirement plan, but your spouse is, you may qualify for a full or partial deduction if you file jointly and your AGI is below $177,000. (The same rule applies if you're a non-working spouse of someone covered by a retirement plan at work.)
• If you're not eligible to contribute to a deductible IRA, you may be eligible to contribute to a Roth IRA if your AGI is below $120,000 if you're single or $177,000 if you're married filing jointly.
• Starting in 2010, the $100,000 modified AGI limit for conversions to Roth IRAs has been eliminated. This means that married couples filing separate returns can now convert amounts to a Roth IRA.
• The above contribution limits can be found in Publication 590 at www.irs.gov.

I've Set Up My Self-directed IRA- What Next?

You've selected an administrator to act as the trustee of your account and facilitate investments on your behalf. They keep the books, disburse money, and collect profits for the IRA, but they may not give investment advice. So now comes the real work: you must go out and find the asset to invest in. You are competely responsible for the due diligence involved; once you've selected the property, business or asset, your administrator can assist you in the transaction. The key is, all income or proceeds from the investment are returned to the IRA. Transactions that can be interpreted as providing immediate financial gain to self-directed account or other disqualified persons holders are not allowed.

A disqualified person in accordance with (IRC 4975(e)(2)) is defined as:

• The IRA owner
• The spouse of the IRA owner
• Lineal Descendents (such as daughters, sons, grandchildren)
• Spouses of Lineal Descendents (such as a son or daughter-in-law)
• Lineal Ancestors (Mother, Father, Grandparents)
• Fiduciaries (those providing services to the plan)
• Investment advisors
• Any business entity in which any of the disqualified persons as defined above has a 50% or greater interest.

Prohibited Transactions: Defined in IRC 4975(c)(1) and IRS Publication 590, these rules were established to maintain that everything the IRA engages in is for the "exclusive benefit of the retirement plan". Often referred to as "self dealing" transactions, this section of the code identifies prohibited transactions to include the following (either direct or indirect):

• Lending money or other extension of credit between a plan and a disqualified person. For example, you cannot personally guarantee a loan for a real estate purchase by your IRA.
• Selling, exchanging, or leasing, any property between a plan and a disqualified person. For example, your IRA cannot buy property you currently own from you.
• Dealing with income or assets of a plan by a disqualified person who is a fiduciary acting in his own interest or for his own account. For example, you should not loan money to your Financial Advisor.
• Furnishing goods, services, or facilities between a plan and a disqualified person. For example, you cannot use furniture from your primary residence to furnish your IRAs rental property.
• Transferring or using by or for the benefit of, a disqualified person the income or assets of a plan. For example, your IRA cannot buy a timeshare condo you or your family intends to use.
• Receiving any consideration for his or her personal account by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. For example, you cannot pay yourself income from profits generated from your IRAs rental property.

For a complete explanation of the requirements, refer to the IRS publication 590.

In summary, the use of a self-directed IRA is an excellent method to diversify your retirement accounts, if you do your due diligence effectively as well as utilize informed, effective advisors. Real estate and other special investments have a potential higher rate of return through the combination of cash flow and appreciation, potentially accelerating the value of the IRA quicker than some traditional methods. Due to the complexities of the IRS rules and regulations regarding this type of investment vehicle, it is also a necessity to be diligent and informed. Following this advice, the self-directed IRA as an investment can be a very good choice.