It’s true: sign up for a Self-Directed IRA and you will experience a lot of financial freedom. You will be able to use a tax-protected account for investing in a wider range of retirement assets, including precious metals, real estate, and even private companies. You will be able to call your own shots. But there are limits to tax-protected accounts—and these limits can be serious if you want to avoid penalties and fees. With any retirement account, you need to know what constitutes a prohibited transaction. But even more, you need to avoid getting caught up in mistakes that could lead to you paying taxes and fees you did not anticipate. Here’s how.
Avoid Working with “Disqualified Persons” Using a Self-Directed IRA
If you use personal funds for investing, then you are used to a lot of freedom. You could, for example, use personal funds to invest in a piece of property, rent that property out to a son or a daughter, and enjoy a mutually beneficial financial relationship. There’s nothing wrong with that. However, problems arise when you do something similar with a “disqualified person” with your Self-Directed IRA.
Why is it the case? First, let’s look at who a disqualified person may be. The IRS considers “disqualified persons” to be your lineal family (so parents/grandparents, children/grandchildren, and their spouses) as well as your spouse. For example, you could not use your Self-Directed IRA to make a loan to your spouse; this would yield an immediate personal benefit, which is essentially the same thing as taking an early withdrawal from a retirement account. After all, retirement accounts are for long-term benefits, and that’s why they enjoy tax protections. The tax protections are in place to incentivize you to keep that money in retirement savings. When you use your Self-Directed IRA to create a personal benefit you can enjoy now, it’s essentially an early withdrawal. For that reason, the IRS could expect taxes and penalties on these prohibited transactions.
Understand what Constitutes a Prohibited Transaction
Any time you enter into an investment transaction between a disqualified person and your Self-Directed IRA, you will experience the possibility that you’re carrying out a prohibited transaction. Though there is still a possibility for your IRA to partner with a disqualified person, it must be structured a very specific way. Keep in mind, however, even if you don’t partner with a disqualified person, there is still a possibility of unknowingly entering a prohibited transaction. Most important thing here is to avoid the list of prohibited assets within a retirement account. You cannot invest in:
- Life insurance.
- Alcoholic beverages.
- Specific kinds of precious metals.
- Using the Self-Directed IRA or assets within it as collateral for a loan, unless you are using a non-recourse loan within the IRA.
This means that even if you avoid the first mistake—carrying out transactions with disqualified persons—there are still ways you could run afoul of the rules. Part of using a Self-Directed IRA is understanding your limits. The better you understand those limits, the better you will be able to explore the other freedoms that a Self-Directed IRA can give you.
Using the Self-Directed IRA in the Right Way
It’s true: using a Self-Directed IRA does provide you with a lot of freedom. But that freedom comes with new responsibilities because you are now the one in the driver’s seat. You might not have experienced these issues in the past because you weren’t directing your own accounts; you were simply making limited choices in a retirement account. With more choices and power, however, comes the responsibility to know where that power ends.