Lessons Learned Part One: Self-Directed IRAs and Tax and Legal Compliance Problems

Self-Directed IRAExperience, they say, is the best teacher. But it’s a fool who learns by no other.

That’s why we’re writing this post: A brief survey of difficult tax issues and compliance problems faced by others. Self-Directed IRAs and other retirement accounts provide a lot of advantages – but they aren’t something for rookie advisors to be dealing with. There are a number of tax and legal issues that come up that are unique to Self-Directed IRAs, 401(k)s, SEPs and the like. They shouldn’t pose a problem in the vast majority of cases, but at the margins, or for people who are careless or who receive poor advice from advisors with little or no experience in Self-Directed IRAs, seemingly small mistakes can lead to big consequences.

Unrelated Debt Income Tax and Self-Directed IRAs

When most people read about IRAs in the media, all they see is that IRAs allow you to defer income taxes on contributions and profits (for Traditional IRAs) or allow for tax-free growth (for Roth IRAs). But that’s not entirely true.

In some cases, assets in an IRA can generate something called unrelated business taxable income, or unrelated debt-financed income. Both of these are taxable.

These don’t ordinarily come up for most conventional IRA owners (that is, people who do not use Self-Directed IRAs) because Sections 512 and 514 of the U.S Code Chapter 26 exempt most securities from the requirement.

But if your IRA owns an interest in an LLC or other closely-held business that employs leverage to operate, the portion of earnings that can be attributed to debt could become taxable as unrelated debt-financed income.

In other words, it’s only earnings from your own contributions that are tax-deferred within a Self-Directed IRA, when it comes to real estate or closely-held business. Earnings attributable to other peoples’ money may be taxable, in the current year!

Many advisors don’t realize this, though, and their clients are blindsided by a tax liability.

K-1 earnings from partnerships and rental income from real estate IRAs are particularly likely to generate UDFI tax liabilities, so investors and their advisors should be on the alert to address them as they arise. That way, investors would know to file a timely IRS Form 990-T, declaring the unrelated debt-financed income, and avoid potential tax liabilities and problems.

Consequences for not understanding these compliance issues can be extreme, including penalties and taxes from the disallowance of the entire Self-Directed IRA. It’s important for taxpayers to use caution when investing and administering Self-Directed IRAs.

Furthermore, it’s vital to use advisors who have experience specific to Self-Directed IRAs. Many rookies and generalists do not have a detailed understanding of how Self-Directed IRAs work – leading to problems like the ones described above. American IRA is an administrator who has been in business for 10 years and has a team comprised of people who are both experienced investors and IRA experts. This blend of expertise ensures transactions flow smoothly as their team is uniquely qualified to communicate with professionals (advisors, CPAs, attorneys, etc.) about investments at all levels within a Self-Directed IRA. American IRA does not give investment/financial advice in relation to any investments.




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Investing in Oil and Gas in Your Self-Directed IRA

Self-Directed IRAWith radical Islamist groups overrunning Iraq, including a number of rich oil-producing areas, we could well be seeing a prolonged period of instability in oil supplies. Translation: Unless a resolution happens soon, oil prices are likely to rise and reach a baseline level higher than where they are today.

The best countermeasure – aside from a magic neutron bomb that only kills Al Qaeda/ISIS troops while leaving innocent Iraqis alone – is more investment into energy development elsewhere. And rising oil prices help make such investment more attractive.

The good news is, you can take advantage of rising oil prices, help reduce western dependency on middle-eastern oil, and profit at the same time by using your Self-Directed IRA to invest in oil and gas-related projects. Here are some of your options:

You can buy energy stocks. Obviously, you can take an equity position in companies like Exxon-Mobile and Chevron, right here in the U.S. You can also potentially buy ADRs (American Depositary Receipts) that allow you to take an ownership stake in oil companies from other regions, like Lukoil (Russia), Royal Dutch Shell (Holland), BP (Great Britain) and PetroChina (you guessed it! China!).

You can do so via your Self-Directed IRA or any other retirement account quite easily, and of course you can place orders with your broker in a taxable account.

There are also a number of energy-focused ETFs and closed-end funds you can buy that may directly or indirectly reflect gains from increased crude oil prices.

For American investors, though, buying such publicly-traded stocks and funds can be problematic. That’s because publicly-traded stocks are generally C-corporations. As such, they present the investor with the problem of double-taxation: Because American companies cannot deduct the income they pay to investors in the form of dividends, every dollar the investor receives has already been taxed – at the incredible rate of 40 percent.

This means that the investor is only receiving 60 cents on the dollar of total income – and then gets taxed again on that, sooner or later – either that same tax year in a taxable account, or when the investor withdraws any dividends received from a retirement account.

Fortunately, your Self-Directed IRA – and most other types of tax-advantaged retirement savings vehicles – is flexible enough to let you explore other options, including:

o   Limited partnerships

o   Master limited partnerships

o   Closely-held c-corporations and LLCs

Many oil and gas and other energy investments generate income – commonly offset by substantial deductions for depreciation and depletion. These deductions become generally irrelevant when the interest is held in an IRA, but the general tax benefits of the Self-Directed IRA – deferral of income taxes and capital gains taxes on assets held within traditional IRAs, and generally tax-free income and growth in IRAs, still holds true.

Note: It is very common for partnership entities in these industries to use leverage. This could subject your Self-Directed IRA to a special tax called the Unrelated Business Income Tax, or UDIT.

There are a number of highly situation-dependent tax considerations when investing in limited partnerships and MLPs, both in and outside of Self-Directed IRAs. We recommend making these investments in close consultation with an experienced tax advisor. American IRA, LLC, does not provide tax advice.

Of course, if you are interested in energy investments in general, you aren’t limited to oil and gas development. You can also invest in pipelines and refineries, solar energy, windmills/wind energy and wind farms, coal, transport, storage and battery technology, and a nearly infinite variety of other opportunities. The sky’s the limit, and you are in control.



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How to Minimize Retirement Plan Expenses by Using Self-Directed IRAs

"Non"-Self-Directed IRAsYou’ve heard it said that compound interest is the investor’s best friend. This is true. But it’s not just returns that compound: Investment expenses, in your typical, off-the-shelf non-Self-Directed IRA or other conventional retirement account also compound over time. And these compounding costs can be a very nasty enemy as far as your long-term returns are concerned.

For example, a recent study, published by the Center for American Progress, calculated that investment and other fees of just 1 percent per year – an amount commonly reached in 401(k) plans, especially at smaller companies – average out to as much as $70,000 in costs over the average workers’ working career.

“”The corrosive effect of high fees in many of these retirement accounts forces many Americans to work years longer than necessary or than planned,” concluded the authors of the report. Indeed, most workers would have to work between three and five more years, saving aggressively, to make up the shortfall by contributing to a 401(k).

The study mentioned above was just released in April of 2014. But here at American IRA, we’ve been concerned for a long time that needless or excessive fees were taking too big a chunk out of our clients’ retirement returns. We frequently review our own fee structures with this in mind. Indeed, last year, in May of 2013, we significantly lowered our fees to a low set annual fee.

Our approach is very different from the norm in the financial services industry. To see how we’re different, click here (video at the link).

What are the fees?

As we mentioned above, we rely on a low set annual fee, rather than a percentage of the assets under management. Unfortunately, that’s the exception in the financial services industry, rather than the norm.

In most cases, the lions’ share of the fees are wrapped up in the expense ratios of mutual funds inside 401(k) plans, which can range as high as 1 to 1.3 percent, and even higher in some smaller 401(k) plans. This is one thing in an equity fund when stocks are zooming at 10-15 percent per year or more, but it is unconscionable in, say, a bond mutual fund when interest rates – and therefore long-term expected returns – are closer to five or six percent per year. In this case, you’re giving up a fifth of your profits right back to the investment house.

If your plan includes annuities – a common feature in 403(b) plans and very frequent in IRAs as well – you encounter mortality and administration expenses, which can be even higher than those in mutual funds because of the additional cost of providing insurance out of those funds.

How Can You Avoid Fees?

There are several effective ways to avoid or minimize fees in your retirement accounts. Here are some ideas:

  1. Choose index funds. These funds don’t attempt to beat the market. Instead, they just buy everything in the market, according to the outstanding float, or market capitalization, of every security they can get their hands on. These funds can be managed by a robot for next to nothing. You aren’t paying someone to sit around and pick stocks for you. As a result, these funds can be had for a fraction of the cost of a conventional, actively-managed fund. Besides, year in and year out, most index funds soundly outperform most actively-managed funds, once you take their expenses into account. That 1 to 1.3 percent handicap is simply too large for most funds to overcome compared to mutual funds.
  2. Use Self-Directed IRAs and other retirement accounts. You can set up your own Self-Directed Solo 401(k) plan, Self-Directed SEP plan, Self-Directed IRA, Self-Directed Roth IRA, SIMPLE or even a Self-Directed Health Savings Account. You can then use these accounts to invest in nearly anything except life insurance, jewelry and gemstones, art and collectibles, and a few other items prohibited by the IRS.

Otherwise, you can invest your funds in whatever you know best: Real estate, private lending, private equity, farms, ranches, land banking, tax liens and certificates, certain forms of gold and precious metals, partnerships and LLCs, and even stocks, bonds and mutual funds (though with mutual funds you’re back to paying expense ratios).

If you partner with American IRA to run your self-directed retirement account, you only pay a small fee per transaction. Overall, your expenses are normally much lower than a typical actively-managed mutual fund. Yes, you may have internal expenses, but these are expenses that you control. You are in charge, and you don’t have to make any transactions you don’t want to (until you run into required minimum distributions in retirement, which apply to any tax-deferred retirement account, anyway).

  1. Ask your employer for lower expense options, or, if you are self-employed or you own the company, shop around for a plan provider that offers index funds. Many 401(k) plans don’t even include index funds at all. There is simply not enough money in them for them to be attractive to a 401(k) representative to set up. Not every employer is going to listen, sadly.
  2. Work with American IRA, LLC. That way, you know you’re getting the benefit of a flat administrative or set annual fee, rather than a percentage that increases the amount you have to pay out every year. A penny saved is a penny earned, and the less you pay out in fees, the more you can keep for yourself.

Need help getting started with Self-Directed IRAs? Self-directed 401(k)s? SEPs? Join us for one of our free upcoming workshops and seminars on the topic. You can choose between a general look at self-direction in general, as applied to Self-Directed IRAs, or focus in on the advantages of using real estate within a self-directed retirement account.

Or call us at 1-866-7500-IRA (472). We look forward to working with you.



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Self-Directed IRA and Traditional Retirement Savings for Your Children

Self-Directed IRARecent studies show that a large percentage of Americans feel they need to work past age 70 to be able to continue covering their living expenses. This underscores the need for individuals to improve their Self-Directed IRA and retirement-saving habits…for many this means starting to save at an early age. You can help your children by encouraging them to begin funding their retirement accounts as soon as they start earning eligible income. Consider the following when funding retirement accounts for your children.

The Child Must Have Earned Income

The required income rules that apply to adults also apply to children. A contribution cannot be made to a child’s IRA unless that child receives eligible income of at least the dollar amount of the contribution made for the year. For this purpose, eligible income includes wages, salary, and commission.

Eligibility Rules Apply

A child is subject to the same eligibility rules that apply to adults. This includes:

  1. The child’s contribution to IRAs for the year cannot exceed a total of $6,500 or 100% of eligible income, whichever is less.
  2. The child must have income within the limits for funding a Roth IRA, which means a Roth IRA contribution cannot be made for that child if his or her modified adjusted gross income (MAGI) exceeds:
  • $129,000 if single
  • $191,000 if married, and
  • $10,000 if married, filing separately
  1. If the child received benefits or contribution under an employer sponsored retirement plan, he or she might be considered an active participant and would be able to claim a tax deduction for traditional IRA contributions only if his or her MAGI does not exceed:
  • $70,000 if single
  • $116,000 if married filing jointly, or
  • $10,000 if married, filing separately

If the child is not an active participant but is married to someone who is, the MAGI limit is $191,000,

Most children will not have this issue of high income. But for those who might, it is important to pay attention to these limits to prevent tax filing and/or contribution errors.

You Can Pay Your Child a Salary – But Be Careful

If you own and operate your own business, you can pay your child a salary so that he or she is eligible to contribute to an IRA. Of course, such salaries must be done on a legitimate basis and be able to pass any IRS scrutiny. For instance, if you pay your child for providing administrative services such as filing and answering the telephone, that child must be of age to do so and you must have payroll records that satisfy statutory requirements.

Availability May Be Limited

Not all financial institution allow IRAs to be opened on behalf of children and, for those that do, the parent or legal guardian is usually required to be the authorized signatory on the IRA until the child reaches the age of majority as defined by the state of domicile. If you are the authorized signatory, you would be responsible for approving transactions such as distributions and investments. Once the child reaches the age of majority, then he or she would become eligible to be the authorized signatory on the account.

It Adds Up

Helping your child to start saving at an early age not only encourages good savings habit, it could lead to significant retirement savings. Consider that a savings of $1,000 per year for 40 years at a 4% return per year would amount to about $100,000. If the account is a Roth IRA, the entire accumulated savings would be tax-free when the child reaches age 59 ½, or sooner if it has been at least five years since the first Roth IRA was funded and he or she is withdrawing up to $10,000 for a first-time home purchase, he or she is disabled, or if the amount is being withdrawn by a beneficiary in the event of his or her death.

Professionals Can Help

Professionals can help you discover practical solutions for your child’s saving and retirement planning needs. It is never too early to start saving, but when you do, you want to start with the right type of account.


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Avoid Tax Traps for After-Tax Self-Directed IRA Funds

Self-Directed IRAGenerally, distributions and Roth Conversion amounts from your Traditional Self-Directed IRA are treated as taxable income to you. However, if you have after-tax amounts in your Traditional Self-Directed IRA, distributions and Roth conversion of these after-tax amounts should be tax-free. You could mistakenly pay income tax on these amounts if the proper tax filing and reporting is not done.

Where Do After-Tax Funds Come From?

Your Traditional Self-Directed IRA will include after-tax funds if you made contributions and did not claim a tax deduction for all or a portion of the amount on your tax return. The deduction may not have been claimed because you and/or your tax advisor simply chose not to, or because you were ineligible to claim the deduction because you received benefits under an employer plan and your income exceeded a certain amount.

Your after-tax funds may also be attributed to a rollover of after-tax amounts from an account under an employer plan, such as a 401(k) or 403(b) plan, to your Traditional IRA.

Ensuring After-Tax Funds are Not Taxed

The IRS provides Form 8606 in order to track and report after-tax funds in your Traditional Self-Directed IRA. To this end, Form 8606 must be filed for any year that you make nondeductible contributions to your Traditional IRA. Additionally, Form 8606 must be filed for any year that you take a distribution or convert funds to a Roth IRA if your Traditional IRA has after-tax funds the year that the distribution or Roth conversion is done. By accurately completing and filing Form 8606, you keep track of the after-tax balance and share the information with the IRS.

Balance Aggregated and Pro-Rated for Taxation

Distributions or Roth conversion amounts from your Traditional Self-Directed IRA will include a pro-rated amount of after-tax and pre-tax funds as long as your Traditional IRA includes an after-tax balance. As such, you cannot select only after-tax or pre-tax funds when performing such transactions. Furthermore, all of your Traditional IRAs, SEP IRAs, and SIMPLE IRAs are treated as one when determining how much of a distribution or Roth conversion amount is not taxable.

For instance, assume that you have two Traditional Self-Directed IRAs: Traditional IRA #1 has a balance of $10,000 all of which is after-tax funds. Traditional IRA #2 has a balance of $90,000 all of which is pre-tax funds. If you take a distribution (or Roth Conversion) of $10,000 from Traditional IRA #1, only $1,000 will be tax-free and $9,000 will be taxable. This rule applies because, for IRS purposes, you took a distribution of $10,000 from an aggregate Traditional IRA balance of $100,000.

Caution: Determine Balance Formula

When determining the ratio of the taxable vs. nontaxable portion of a distribution or Roth conversion, the balance as of the end of the year in which the transaction is done is used. If the transaction is done in January when you had only Traditional Self-Directed IRA #1 with a balance of $10,000, and you rollover a pre-tax amount of $90,000 from your 401(k) to Traditional Self-Directed IRA #2 in December of the same year, your account balance used in the formula would be $100,000 (plus or minus interest or losses) .

The year-end balance is also adjusted by adding the following amounts:

  • Distributions taken from your Traditional Self-Directed IRA during the year and rolled over the next year within 60-days of receipt. For instance, if you took the distribution in December and did a rollover of the amount in January.
  • Roth IRA conversions done during the year and re-characterized the following year. Under Roth conversion rules, you can reverse a Roth conversion by doing a re-characterization of all or a portion of the amount by your tax filing deadline plus extensions.

Other distributions and Roth IRA conversions done during the year may also need to be included in the calculation.


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Annual Check Up for Your Self-Directed IRA

Self-Directed IRAYour Self-Directed IRA should be given a check-up at least once per year. A complete Self-Directed IRA check-up requires the assistance of a financial advisor who is also an expert in the Self-Directed IRA field. A Self-Directed IRA check-up process covers areas such as: estate-planning review, RMD determination, contribution error detection, conversion suitability, and whether you need to file tax forms to receive certain tax benefits for your IRA. These are highlighted below.

Estate-Planning Review

Have your professional check to make sure your Self-Directed IRA agreement and documentation are consistent with your estate-planning needs. This is especially important for beneficiary designations, and more critically so if you need to make special provisions for any of your beneficiaries.

RMD Determination

If you are at least age 70½ this year, you must take a required minimum distribution (RMD) from your IRAs. You may also need to take RMD amounts from any retirement account that you have inherited. Failure to take your RMD amount could result in you owing the IRS an excess accumulation penalty of 50% of the RMD shortfall. have your professional check to make sure that your correct RMD amount is taken from your IRA, so as to prevent you from owing this penalty.

Contribution Error Detection

If you made ineligible contributions, including ineligible rollovers, these amounts will be subject to IRS penalties and possibly double taxation unless corrected in a timely manner. Have your professional check your Self-Directed IRA activity to determine if any such errors occurred and work with you to make any necessary corrections.

Conversion Suitability

If you converted amounts from another retirement account to your Roth Self-Directed IRA last year, have your professional review the Roth conversion to determine if it should be reversed for reasons such as significant market losses. They should look at other reasons why a Roth-conversion reversal may make sense, and help you to determine if any of those reasons apply to you. The IRS allows Roth conversions for the previous year to be reversed as late as October 15 of the current year, if you meet certain requirements. If it is determined that the conversion should be reversed, have your professional work with you to have it accomplished properly and in a timely manner.

Filing Tax Forms

There are certain tax forms that may need to be filed in order for you to receive certain tax benefits, or to correct reporting done by your Self-Directed IRA custodian. Have your professional review your transactions to determine if these forms should be filed on your behalf.

Let us Help You to Take Care Of Your IRA

There are instances in which more frequent check-ups may be required. For instance, if you experience a life-changing event, such as a death of one of your beneficiaries or a marriage or birth that affects your beneficiary designation, your professional may need to conduct a review to determine if and what changes should be made.


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