WHAT IS A SELF-DIRECTED IRA?
A self-directed IRA is not a special type of IRA.
The term self-directed simply refers to the way the account is administered and the greater choice of investment options available to the account owner. More conventional retirement accounts are managed on behalf of the client. Self-directed IRAs are invested solely at the discretion of the owner of that account who directs the account administrator (such as Midland Trust) to purchase assets they have completed their own due diligence on. Accounts that can be self-directed include: Traditional, Roth, SEP and SIMPLE IRAs, as well as educational plans, health savings plans, and 401(k)s.
WHO SHOULD CONSIDER A SELF-DIRECTED IRA?
Anyone who wants to take control of his/her retirement investments, or who is unhappy with their current retirement plan returns, should consider a self-directed account. Typical IRA custodians only allow you to invest in the products they sell which often do not include alternative investments.
The IRS perm its investments into a wide variety of assets, but each custodian decides which assets it is wilIing to hold. Midland IRA does not selI products or offer financial advice, and therefore, does not limit your investment decisions. In fact we exist as an IRA administrator to encourage people to take control and self-direct their retirement accounts.
Examples of common alternative investments purchased within a self-directed account include:
- Real estate
- Notes and mortgages
- Private placements and private stock
- Single-member LLCs (checkbook IRAs)
- Futures, foreign exchange (forex), and brokerage accounts
- Precious metals and more
THE ADVANTAGES OF INVESTING WITH IRA FUNDS
There are three primary reasons people invest with self-directed IRAs:
1. Alternate source of funding
When you are considering investments in real estate, private loans, private companies, etc., you may not reaIize that IRA funds can facilitate those investments. You may simply look to your personal savings accounts to acquire these assets. However, you are allowed to use funds from a self-directed IRA to make these investments and more. By doing so, you may find a potentially large source of additional monies to make these different types of investments.
2. Looking for higher returns
Most retirement funds (close to 95 percent) are invested in accounts through a brokerage firm or bank, which offers limited investment choices. Most people have been conditioned to think that only securitized investments like stocks, bonds, and mutual funds are the only options for investing their retirement dollars. Individuals who are unsatisfied with the returns these accounts earn often look for alternative investments, leading them to discover the self-directed IRA. AdditionaIly, individuals learn that, by using self-directed IRAs, they can invest in other types of assets they possibly understand much better than those offered at more traditionaI institutions. Investing in what you know and understand can lead to higher returns within the retirement account.
3. Tax-free or tax-deferred growth (time value of money)
The time value of money simplified is the assumption that at the present time, money is worth more than the same amount will be worth in the future. Why would you want to pay the IRS capital gain taxes after each investment sale when you have the ability through an IRA to pay taxes later? The money you save in taxes can be invested to create even higher wealth. By choosing to invest in alternative assets, an IRA owner can potentially earn greater returns through these assets that may help the IRA grow at a fast pace, resulting in higher account values within a shorter time frame.
WHICH ACCOUNT TYPES ARE AVAILABLE FOR SELF-DIRECTION?
A tax-deferred retirement savings plan for individuals. Contributions and earnings are only taxed when distributions are taken. Former employer plans can be directly rolled into a traditional IRA without tax consequences.
A retirement savings plan for individuals based on tax contributions, not tax-deferred contributions. The earnings are tax-free once distributions begin provided the IRA owner is over the age of 59 1/2 and has had a Roth IRA for at least five years. Learn more about Roth IRAs.
Simplified Employee Pension (SEP) IRA
A SEP IRA allows an employer (typically a small business or self-employed individual) to make larger retirement plan contributions into a traditional IRA established in the employee’s name.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
The SIMPLE IRA is available to employers with 100 or fewer employees and allows for both employer and employee contributions, similar to a 401(k) plan.
Qualified plans, such as profit sharing plans or individual 401(k) accounts for the self-employed, can be self-directed in many cases. Click here to learn the benefits of investing with an Individual (k) plan.
Health Savings Account (HSA)
An HSA is the only type of savings plan that offers three tax advantages: a deduction for contributions, tax-free earnings, and tax-free withdrawals. Click here to find out which expenses qualify for HSAs.
Educational Savings Account (ESA)
ESAs are savings accounts for your child’s (or grandchild’s) higher education. The money you put into this account is taxed but the earnings are not taxed. Click here for a comparison of 529 plans to ESAs.
WHAT TYPE OF INVESTMENTS QUALIFY FOR A SELF-DIRECTED IRA?
An investor can purchase vacant land, residential, and commercial property with an IRA. Income (profits from a sale or rental proceeds) flow back to the IRA, tax-deferred. Expenses (such as property taxes, association maintenance dues, etc.) are paid by the IRA.
Notes and Mortgages
Many of our clients use their IRAs to lend money to third parties. All loan payments (principal and interest) flow back into the IRA, tax-deferred. The majority of lending we see are secured loans with the property used as collateral. An IRA can also loan money using an unsecured promissory note. Secured notes are backed by collateral, such as property and deeds of trust providing the lender additional assurance of the return of the loan amount and interest. Unsecured notes are not backed by collateral, and as such, constitute a higher risk – and sometimes reward – than a secured note.
Often, individuals want to make an IRA investment in conjunction with several other investors. In many cases, the group of investors will form a partnership or LLC to make things easier to combine funds. The partnership or LLC can be formed for a number of reasons (holding real estate, making private loans, creating a private hedge fund, etc.) and the IRA can join as a partner in that entity. The IRA then shares in the profits and losses of the entity in accordance with its percentage of ownership. In most cases, the returns are not taxable to the IRA, although depending on the type and purpose of the entity, the IRA may be subject to unrelated business income tax (UBIT). Click here to read more about partnering your IRA funds.
Private Placements and Private Stock
Private or closed corporation stock offerings are not available to the public on the open market. Normally, they are made to pre-qualified individuals, referred to as “accredited investors.” Often, many community banks or start-up companies seek to raise capitaI by offering stock. IRAs can be used to purchase these shares. Recently, crowdfunding opportunities that carry less risk have become available to investors of all levels of experience who do not have to meet qualification terms to participate.
Single-Member LLCs (Checkbook IRAs)
Also known as a single-member LLC the checkbook IRA is an investment strategy by which the IRA owner elects to form an LLC to be entirely owned by his/her IRA account and the IRA owner is elected to manage that asset. This gives the IRA owner a greater deal of control over the investments held by that IRA Individual considering the checkbook control LLC are strongly encouraged to consult with legal and tax professionals on how to best form and operate the entity without running afoul of IRS rules.
Futures and Foreign Exchange (Forex) Trading
IRAs can be used to set up brokerage accounts with a futures or foreign exchange (forex) trading company. The client either makes trades himself/herself, or the client gives power of attorney to someone who specializes in trading these assets.
IRAs can be used to crowdfund, making the investment process efficient and accessible to the masses so that costs associated with larger investments are reduced.
Investors who use self-directed IRAs can use cash from the accounts to purchase shares in hedge funds. Investing in hedge funds can provide the account holders’ tax-sheltered retirement income and widespread diversity in their retirement portfolios.
Certain gold bullion, U.S. treasury coins or palladium are allowed by the IRS for IRA investments. Typically the coin or bullion must be 99.5 percent pure metal in order to qualify as an IRA investment. The IRA owner must make sure the coin’s value is not deemed collectible in nature, but instead determined by the value of the metaI on the open market.
Aside from all of the investments listed above, an IRA can invest in lease options, tax liens/certificates, real estate options, structured settlements, foreign property, oil and gas options, and much more. In fact, so many different types of investments can be made, they are not all listed. Instead, the IRS only lists the limits of IRA investments to a few different types of assets.
WHAT TYPES OF INVESTMENTS ARE NOT PERMITTED WITHIN A SELF-DIRECTED IRA?
The IRS prohibits investments made in two categories. Your self-directed IRA may not invest in Iife insurance products or collectibles, which include:
- Works of art
- Alcoholic beverages
- Metals other than certain gold, silver, and palladium
Self-directed IRAs provide a great deal of freedom, flexibility, and choice of potential investments. However, they are also governed by a set of rules self-directed investors must be aware of and follow. In addition to the prohibited investments above, there are certain transactions (and more specifically, individuals) that can disqualify an investment within your IRA. These prohibited transactions can defeat the tax benefits your IRA offers and can subject the IRA to fines and penalties, as well.
Your retirement account is intended to benefit you when you retire and not before. Transactions that can be interpreted as providing immediate financial gain to account holders are not allowed. Many of these arrangements are laid out in Section 4975 of the IRS code.
For example, IRA holders may not:
- Borrow money from their IRA
- Sell, exchange or lease property to their IRA
- Receive compensation for managing property in their IRA
- Use their IRA as security for a loan
- Transfer plan income or assets to disqualified persons
- Lend money to disqualified persons
- Extend credit on their IRA to disqualified persons
- Furnish goods, services or facilities to disqualified persons
- Allow fiduciaries to obtain or use the plan’s income or assets for their own interest
For most of the disqualifying arrangements outlined, the transaction involves the IRA and a disqualified person. Therefore, it is important to understand who is considered a disqualified person for an IRA. These individuals include:
- IRA holder
- The IRA holder’s spouse
- The IRA holder’s lineal ascendants, lineal descendants, and spouses of lineal descendants
- Investment advisors and managers
- Any corporation, partnership, trust or estate in which a disqualified person has 50 percent or greater interest or in which the disqualified person maintains control as a president manager, etc.
- Anyone providing services to the IRA such as the trustee or custodian
WHAT DOCUMENTATION IS INVOLVED IN PURCHASING AN ASSET?
With real estate, the contract and all closing must be listed in the name of the IRA and signed by Midland as the administrator and custodian of the account. Title is held under “Midland Trust Company As Custodian FBO John Smith, IRA #1234567.” Prior to closing, the IRA owner is required to review and approve all closing documents. Midland Trust signs the documents on behalf of the IRA.
Notes and Mortgages
For notes and mortgages, Midland needs to see the loan documents where the lender is listed as the IRA account (Midland Trust Company As Custodian FBO John Smith, IRA #1234567). The IRA owner must read and approve the actual note as well as any mortgage or other agreement to secure collateral. If the loan is not being handled through an escrow agent (like an attorney or title company), Midland Trust must be in possession of the original, signed note prior to releasing funds.
LLC, LP, and Private Stock Investments
For closely held LLCs, generally the IRA is one of the members on the operating/partnership agreement. As Custodian, we are receiving approval.
With some LLCs, LPs, and Private Stock, there is a separate agreement which the IRA owner must fill out to purchase or subscribe to an interest in the entity. The IRA owner fills out this agreement in the name of their IRA (Midland Trust Company As Custodian FBO John Smith, IRA #1234567) and directs Midland to sign the document on behalf of the IRA.
With investments that are not listed above, Midland Trust requires paperwork or documentation proving the IRA is the owner of that particular asset. Please contact Midland Trust for any unique situations on how to ensure the title is held in the name of the IRA.
FAQS ABOUT ALTERNATIVE INVESTMENTS
Why haven’t I heard about a self-directed IRA before?
Most IRA administrators only offer products they sell, which typically involve stocks, bonds, and mutual funds. Self-directed IRA administrators allow you to choose alternative investments. When you self-direct you control your own investment choices and can potentially build wealth in your accounts by investing in what you know best.
If my IRA does not have any funds to purchase an investment outright, can I partner with my personal funds? Who else could I partner with?
If your IRA cannot afford the investment you are interested in, you have several options:
- Partner your IRA funds with your personal funds. For example, your IRA can own 50 percent and you can personally own 50 percent of the asset(s), which would make you tenants in common.
- Partner your IRA funds with funds you personally guarantee, like a home equity line of credit
- Partner your IRA funds with someone else’s personal or IRA funds. Please note: the disqualified persons rule may not apply here since you are not transacting with the individual. Therefore, it is possible to partner with your spouse, parent, or child.
How are the assets managed? How are income and expenses handled?
You manage the asset by directing Midland Trust’s actions on your behalf. For example, in regard to real estate transactions, you would find the tenants, create rental agreements, decide on improvements, etc. Income must be deposited directly into the IRA. Midland Trust, as the administrator of the account, will pay expenses related to the IRA asset from the cash held in the IRA. You cannot be reimbursed for any expenses the property may have, nor should you pay these expenses personally. You can either direct Midland Trust to make a payment from your IRA, or have a third-party property manager handle income and expenses. You can check your online statement to make sure your IRA received a payment. Midland Trust’s system also generates an automatic email when funds are deposited to the account.