A Self-directed IRA: the Pros and Cons
by Shane Flait (2009)

Government rules allow use of your IRA for more types of investments than the conventional trustees - like banks and mutual fund companies - allow. But you must steer clear of violation self-dealing rules for those nonconventional IRA investments. Besides that, the taxation of IRAs obliterates the tax-advantages of some alternative investments.  

This article overviews some nonconventional investments for IRAs, the tax rules and restrictions on self-dealing that apply, and suggests reasons for and against investing in them.  

Individual Retirement Accounts (IRAs) is a government qualified retirement plan. You fund it from tax-deductible contributions or tax-free rollovers from another retirement plan. It grows tax-deferred. But when you take money out, it’s taxed as ordinary income – often high tax rates. After turning 70½ you must withdraw at least minimum required distribution yearly.  

Most people have accumulated a lot of money in qualified plans. Taking money out loses a lot to income taxation. So they often consider what other investments they can use for their IRAs besides the conventional stocks, bonds, and associated fund types.

About the only investments prohibited for IRAs are life insurance policies and collectibles such as art, rugs, antiques, metals, gems, stamps, coins and alcoholic beverages. You can buy certain gold and silver coins minted by the U.S.

 

So what are the nonconventional or alternative IRA investments?

Examples include stock from an initial public offering, closely held stock, real estate, options to buy real estate, oil and gas royalty interests, stock options, mortgages or other loans held for investment.

 

But recognize that some of these alternative investments carry tax-advantages themselves. As an example, owning real estate for rental income offers depreciation, deductible expenses including mortgage interest, and is taxed at capital gains rates. Long term capital gains tax is relatively low. And, often you can use some of your real estate income losses to shelter some of your personal income from income taxation. Those are pretty good tax-advantages without an IRA. 

These tax-advantages are lost when your real estate investment goes into your traditional IRA plan. You’re stuck with the traditional IRA taxation mentioned above which pales in comparison.

But you must also watch out for violating IRA self-dealing (prohibited transaction) rules which don’t apply to nonIRA investments. So you can’t use your IRA:

·         To buy stock or other assets from you or sell them to you,

·         To lease assets from you or to you,

·         To buy stock in a corporation in which you have a controlling interest.

·         To lend to you or borrow from you.

·         To engage in transactions with certain related parties and/or family members.

And, you can’t use your IRA to transact with certain disqualified persons. These include you as the owner of the self-directed IRA and other family members as:

·         Your spouse

·         Parents

·         Your children & their spouses

• Grandparents & grandchildren
• Grandchildren and Great-Grandchildren & their spouses

Lastly, you have to set up a self-directed IRA to invest in these alternative investments. So, you’ll need to find a trustee for your self-directed IRA investments like real estate. This directed-trustee holds your assets for you.

 

You can fund your self-directed IRA through him from rollovers from your employer plan or IRAs held by brokerage or mutual fund firms. Try to choose a trustee that’s familiar with the alternative investments you want.

Self-directed IRA or not?

In large part, the advantage of using your IRA is that you can get more funds to invest with. You either have more because you get a deduction from income to contribute funds or don’t have to withdraw money from a qualified plan that’d suffer heavy income tax. That’s the good side.

But paying what can be pretty high income tax for successful investing results within your IRA is the bad side when you take money out. And, I think, is often much too bad.

If you feel comfortable with alternative investments, try to invest in them without putting them in an IRA. Withdraw some of that IRA money and pay the income tax. Then use it for your alternative investment. The tax-advantages it carries will eventually help you out if you’re successful. If not you can take a tax loss too – which you can’t on your IRA investment.

But if you want to use your IRA, then aim for investments that’ll kick off high yearly earnings. Commercial or rental real estate can do it.  That’ll enhance your yearly compounding rates under your self-directed plans because of the tax-deferred nature of IRAs. 

Using an IRA as an investment vehicle shines best when you have high tax-deferred earnings compounding every year for many years. It’s this long term high compounding rate that can offset the eventual income tax loss at distribution times.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com