Self-Directed IRA

Rules

Self-Directed IRA Rules and Guidelines

When you're considering a Self-Directed IRA, these accounts' rules need to be followed closely in order to avoid any penalties. Fortunately, the rules for opening and using a Self-Directed IRA are fairly simple. They are the same rules that apply to standard IRA accounts and 401(k) plans. The only difference is the opportunity for application. In a standard IRA, the account holder won't be doing any investing personally; rather, their involvement will be limited to funding the account while the bank or brokerage manages the investing. Consequently, the account holder will almost never face a situation where they would have to apply the rules. With a Self-Directed IRA, the situation is different. Since the account holder will be taking a more active role in investing, they need to make sure they are familiar with the Self-Directed IRA rules and guidelines.

So what are the rules for a Self-Directed IRA?

Rule #1
Opening a Self-Directed IRA

The Internal Revenue Code (IRC) Section 408 details that all IRAs must be held by a custodian, such as a bank or a trust company. For a Self-Directed IRA, you will choose a custodian who specializes in holding alternative assets. Whichever custodian you choose will already have the necessary paperwork and account structure that facilitates alternative assets. Although it is possible to set up a Self-Directed IRA on your own with the help of an accountant, it will usually end up costing more and involve a lot more trial and error.

This rule also applies to a Self-Directed IRA LLC. An IRA LLC gives investors checkbook control for their IRA. The LLC has to be specially formed to adhere to all pertinent Self-Directed IRA IRS rules and regulations. One of the most frequently asked questions for this kind of account is whether or not a preexisting LLC may be used. The answer is no. The IRS requires certain elements in an IRA LLC, and these are not found in a standard business LLC.

Rule #2
Permissible Assets in a Self-Directed IRA

Theoretically, a Self-Directed IRA has very few rules about what it can invest in. The only assets mandated off-limits by ERISA are collectibles, S Corporation stock, and life insurance settlements. Practically, this would mean that an investor cannot purchase art or antiques, even if they feel they are getting a great deal. Other assets are generally acceptable, although some might have qualifying requirements.

Rule #3
Paying Taxes in a Self-Directed IRA

With most assets in a Self-Directed IRA, the tax rules allow you to avoid paying any taxes until you take a distribution. That's the whole point of a retirement account. You get a modified tax break as an incentive to save for retirement. However, there are two situations where taxes may have to be paid even while the funds are being actively invested.

The first is UBIT: Unrelated Business Income Tax. If your IRA is running an active business, it could conceivably have an unfair advantage over the competition if it got a private tax break. To remedy this situation and maintain a level playing field in the commercial world at large, UBIT was enacted.
The second potential tax is UDFI - Unrelated Debt Financed Income. If you use your Self-Directed IRA to invest in a company or property and also use a loan to help finance the investment, then you will be required to pay UDFI. The part of the investment that is financed by the loan does not receive the IRA tax incentives and therefore has to pay its percentage of the tax.

Rule #4
Prohibited Transactions in a Self-Directed IRA

Prohibited transactions are perhaps the most well-known of the Self-Directed IRA rules and guidelines. Simply stated, the account holder or their close relations may not give or receive any benefit to the IRA account. An account holder acts as the non-compensated manager. Common examples of Prohibited Transactions include the account holder mowing the lawn of an IRA property, the account holder's parents offering a personal loan to the IRA, or a child of the account holder living on the property.

Rule #5
How To Make A Contribution in a Self-Directed IRA

When an IRA is Self-Directed, rules state that contributions can be made by writing a check and filling out a Deposit Information Form. This is true for both the Self-Directed IRA and the IRA LLC. In an IRA LLC, one has to be careful with this. Contributions cannot be made directly into the LLC checking account for your Self-Directed IRA; the accounts' rules dictate that contributions have to be deposited with the custodian.

Rule #6
RMDs in a Self-Directed IRA

Required minimum distributions, or RMDs, are a part of every tax-deferred retirement account and, as such, fall within the Self-Directed IRA withdrawal rules. An RMD is a minimum amount the IRS requires that you withdraw from your IRA each year once you reach a certain age. The required amount does change from year to year, so it’s important to refer to a Self-Directed IRA custodian like Madison Trust, who can guide you through taking out RMDs.

Rule #7
Financing in a Self-Directed IRA

Since you will most likely be the only one investing in your asset, you need to have enough funds available in your Self-Directed IRA to purchase your asset.

If you do not have enough funds available, you may want to consider a non-recourse loan.

For example, let’s say you’re interested in a real estate investment that you need $100,000 to purchase, but your Self-Directed IRA has $75,000. You can use a non-recourse loan to cover the additional $25,000 needed to purchase the investment.

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