Self Directed IRA Rules
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.
Rule #1 – Opening a Self Directed IRA
All IRA accounts must be held by a qualified Custodian. 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 account 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 that utilizes an IRA LLC. (An IRA LLC gives investors checkbook control for their IRA.) The LLC has to be specially formulated to adhere to all pertinent IRS 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 that are mandated off-limits by ERISA are collectibles 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, you’ll never have to pay 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 competition 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. You can read more about UBIT here.
Rule #4 – Prohibited Transactions in a Self Directed IRA
Prohibited Transactions are perhaps the most well known of the Self Directed IRA rules. Simply stated, the account holder or their close relations may not give or receive any benefit to the IRA account. An account holder may manage the IRA in a complimentary role but may not donate anything more tangible. 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. Find out more about Prohibited Transactions here.
Rule #5 – How To Make a Contribution In a Self Directed IRA
Contributions are made by writing a check and filling out a Deposit Information form. This is true for both the custodial 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, rather they have to be deposited with the Custodian.
Rule #6 – RMDs in a Self Directed IRA
RMDs – Required Minimum Distributions – are a part of every retirement account. The IRS has legislated that at a certain age account holders must start drawing on their retirement funds and pay the relevant taxes. The amount can be calculated using the IRS’s RMD calculator, or you can just ask your accountant. In a Self Directed IRA, this process can be a little more involved than in a standard IRA. The reason for this is that stocks can be cashed out immediately, while alternative assets like real estate have to go through a sale or distribution process. Because of this added layer, Self Directed IRA account holders have to prepare in advance for this rule. They can sell the asset outright and then take a cash distribution. Alternatively, they can do an in-kind distribution where the ownership of the asset is redistributed between the IRA account and the IRA account holder.
Rule #7 – Financing in a Self Directed IRA
In a standard IRA, financing is rarely an issue. The brokerage you invest with usually add your money to a bigger pot and you get returns in an exact percentage. With a Self Directed IRA, that scenario no longer applies. Since you will often be investing in an asset as an individual, you need to be able to purchase that asset with the funds available. In the case of a property, it could be that the one that makes sense for your goals has a purchase price that exceeds your available retirement funds. Alternatively, you may be able to cover the price but you prefer to diversify your retirement account and not sink it all in one asset. In both cases, you will need to secure a loan to finance the property acquisition. One of the important Self Directed IRA rules is that this loan has to be non-recourse. That means the loan will only be secured by the specific asset that it is acquiring.