What Is Not Allowed With A Self-Directed IRA?
Sunday, September 24th 2023
Individual Retirement Accounts (IRAs) provide tax-advantaged savings and investing vehicles. One type of IRA known as a self-directed IRA (SDIRA, 1) stands out for its flexibility of investment choices; yet due to IRS regulations on what’s permissible within an SDIRA this article aims to outline both limitations and prohibited transactions that might incur penalties or even disqualify their account from participation altogether.
Let’s first address what kinds of investments are not permitted within an SDIRA account. According to IRS rules, certain classes of assets cannot be held within such an IRA account despite having greater investment options compared with traditional or Roth IRA accounts:
- Life Insurance: According to IRS rules, life insurance contracts cannot be placed within an Individual Retirement Account (IRA). This rule covers both self-directed IRAs as well as traditional ones.
- Collectibles: According to IRS rules, most forms of collectibles cannot be held within an IRA account. This category covers tangible personal property like artwork, rugs, antiques, and metal (with certain bullion exceptions), gems stamps coins (some exceptions apply), alcohol beverages and certain other tangible personal assets.
- S corporation stock: Due to S Corporations having specific rules about who can become shareholders, an SDIRA does not qualify. Therefore, it’s prohibited from holding S Corp stock within it.
In addition to investments that are prohibited under IRS guidelines, certain transactions involving an IRA or its assets also fall within its purview as prohibited transactions, known by their IRS equivalent as “prohibited transactions”. Most often these involve “disqualified persons”, including its owner (those related or disqualified by relationship), spouse of owner(s), ancestors of lineal descendants as well as any spouses associated with lineal descendants and any spouses thereof (known collectively as disqualified transactions):
- Self-dealing: Self-dealing occurs when an IRA owner uses assets within their IRA for personal gain or benefit of disqualified parties, for instance by renting out property purchased within it for noninvestment use such as living there themselves or anyone disqualified by using it solely as investment vehicles. For instance, if you own a rental property within your SDIRA, it cannot be lived in or used other than as intended for investment.
- Selling or leasing property to an IRA: In general, an IRA owner cannot sell, exchange, or lease property directly to their SDIRA account. Therefore, if you personally own any piece of real estate, you cannot transfer ownership.
- Lending money or extending credit: As a rule, an IRA owner cannot lend money or extend credit directly to their IRA account or to one owned by it – including providing guarantees such as signing on personally for loans taken out by either. In short, no guarantee can be offered by anyone other than yourself for loans made directly by or made to their IRAs or businesses owned by their IRAs.
- Furnishing goods or facilities: An individual owning an IRA must refrain from providing goods, services, or facilities directly to or for it – for instance, if your IRA owns rental properties, you cannot personally repair or maintain them yourself.
- Transfer of income or assets: Any transfer of the income or assets held within an IRA to anyone not qualified as an eligible beneficiary is illegal and involves direct as well as indirect transactions. You cannot use your IRA funds for purchasing vacation homes that will be utilized by yourself and/or family members in their use.
Penalties for Prohibited Transactions
Violating these rules can have serious tax repercussions. Should the IRS determine that an illegal transaction occurred, an entire IRA could be disqualified; its value distributed back to its owner as of the first day of the year in which the prohibited transaction took place; income tax will likely then become payable along with an early distribution penalty if their age falls under 59 1/2.
Participants (usually the IRA owner) in prohibited transactions may incur an excise tax equaling 15% of amount involved for each year (or part year) within the taxable period; should it continue without correction; tax can reach 100% of amount involved.
Correcting Blocked Transactions
If a prohibited transaction has already taken place, corrective steps are available that could help avoid paying 100% excise tax on it. Reversing as much of the transaction as possible and placing your IRA back where it would have been without this event occurring would usually suffice – should such happen, it would be wise to consult a tax professional who specializes in this area first before acting independently.
Securing Your Self-Directed IRA
Self-directed IRA investments can be an efficient and successful means of building retirement wealth; however, you must understand its limitations and restrictions to protect your account effectively. Here are a few steps you can take:
- Stay informed: Before undertaking any transaction with your SDIRA, ensure you fully comprehend its rules. Ignorance of them cannot provide an excuse against IRS penalties.
- Consult a professional: If in doubt about whether an action or transaction is legal, consult with either a tax expert or legal advisor experienced with SDIRAs for advice.
- Apply a custodian approach: All IRAs, including self-directed ones, require being held by a custodian who understands and provides guidance and support on self-directed accounts. Choose someone knowledgeable of SDIRA rules who is there for guidance and assistance during each stage.
- Keep accurate records: Maintain meticulous records for every transaction made through your SDIRA to assist the IRS should any questions arise regarding that particular trade or investment. This may come in handy should they require further explanation about one.
- Keep up to date: With IRS rules constantly shifting and evolving, staying informed on changes will allow your investments and transactions to remain compliant and legal.
Self-directed IRAs offer the potential in diversifying retirement assets over bonds, stocks and mutual funds; but their flexibility increases, but comes with greater responsibility as the IRS enforces strict rules on prohibited investments and transactions which should not be conducted - any violation can lead to serious repercussions like taxes due, and even disqualification from the IRA plan.
As you embark upon the path toward self-directed IRA ownership, keep in mind the keys to successful implementation are understanding the rules, seeking professional advice when in doubt and maintaining transparency and diligent record-keeping practices. By adhering to such protocols, you will maximize the use of your self-directed IRA while remaining compliant with IRS regulations.
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