Results of a recent Gallup Poll shows that Americans are still split about whether their taxes are too high. Since profits within a self directed IRA can be either “tax deferred” or “tax free”, American IRA is getting flooded with questions from investors seeking to lesson their tax burden by using a self-directed IRA. The question American IRA is most frequently asked “Can I Safely Use A Self-Directed IRA?”.
Investments in a self-directed IRA are not intrinsically more or less risky than investments in taxable accounts. Their own tolerance for risk and their techniques for mitigating risk are totally up to them. That’s one of the great things about self-directed IRAs: They are in the driver’s seat. They can use their IRA to hold very safe, risk-free assets, such as FDIC-insured money markets and fixed annuities… or they can stretch out on the risk continuum and own an entire business of their own – with all the risks that owning a small business entails.
While they can put risk-free investments in an IRA, there is nothing about IRAs themselves that make investment risk go away.
There’s no legal risk in using a self-directed IRA, either. It is perfectly legal to own gold, silver, real estate, farms, land, or any other asset not specifically prohibited by law in an IRA.
The one element of risk that is unique to self-directed IRAs (as well as self-directed SEP IRAs and self-directed solo 401(k) plans is technical risk: The risk that a mishandling or oversight – either on their part or that of their advisor could cause their IRA to run afoul of prohibited transaction rules. If this happens, the IRS will consider they have essentially voided their IRA, and charge taxes and penalties not on the amount involved in the prohibited transaction itself, but on the entire account.
Because of the size of many of these self-directed IRAs, the severity of the prohibited transaction penalties, and the complexity of this specialized area of financial planning, it is imperative to use an advisor who specializes in self-directed IRA investing. Most generalists simply aren’t familiar enough with the specifics and ins and outs of self-directed IRAs to provide reliable advice. This is a field for the most experienced, or specialized advisors in the financial services industry.
When Congress granted the terrific tax advantages to IRAs in 1974 (and to Roth IRAs in 1996), they also enacted measures to prevent people from circumventing the rules and avoiding taxation of IRA withdrawals and penalties. Specifically, they cannot use their IRA engage in the following activities, by law:
- You cannot sell property to your IRA.
- You cannot buy property from your IRA.
- You cannot lend property to your IRA.
- You cannot borrow money from your IRA.
- You cannot let your IRA engage in any of the above transactions with a member of your immediate family.
- You cannot have your IRA purchase goods or services from a company you or an immediate family member owns.
- You cannot pledge your IRA as collateral for a loan.
- You cannot use your IRA to buy the following assets:
- Alcoholic beverages
- Life insurance
If any of the above occurs, they risk triggering the IRS penalty for prohibited transactions.