Self-Directed IRAs: Proceed with Caution

With the poor economy, many IRA owners are desperately looking for better returns, which might prompt them to consider self-directed IRAs. But investors need to proceed with caution down the self-directed IRA path.

Self-directed IRA accounts allow IRA owners to invest their retirement assets in unique investments such as real estate, promissory notes, tax lien certificates and private placement securities. However, with the risks associated with those investments, the Securities and Exchange Commission (SEC) just published an Investor Alert directed to the owners of self-directed IRA accounts. The SEC is concerned that these owners are targeted for potentially fraudulent schemes. See www.sec.gob/investor/alerts/sdira.pdf.

The SEC's worry is that often IRA investments are set on "cruise control" and there's not much vigilance with regard to the investments they hold or the transparency of the management of those investments.

Before a self-directed IRA is used, you need to be mindful of several limitations.

Some assets are simply "off limits" in an IRA, self-directed or not, such as life insurance, collectibles like antiques, rugs, artwork, gold coins, stamps, and other coins other than U.S. minted gold, silver or platinum.

Corporate stock with an "S" election cannot be held in an IRA.

All IRA distributions are subject to ordinary income taxation. In contrast, some assets, like real estate, if held "outside" of an IRA and subsequently sold, would be subject to capital gains tax rates which are much lower than ordinary income rates.

If the IRA holds closely-held business stock, it will be subject to unrelated business income tax even though normally an IRA does not report any taxable income. Moreover, if the closely-held business is held in the IRA, it cannot be operated by the IRA owner or employ the owner or the owner's family members due to IRA "self-dealing" prohibitions. A disqualified person includes the IRA owner, their spouse, their children and their grandchildren.

A disqualified person directly interacting with a self-directed IRA investment is a prohibited transaction. If this happens, the entire IRA account is tainted and will be treated as having been distributed in its entirety to the IRA owner as taxable income and may be subject to other excise taxes.

A self-directed IRA can also cause an unrelated debt financed tax on its investment income that is derived from debt financing. If that tax is triggered, the IRA pays the tax, not the IRA owner. In addition, with such debt financed properties, the IRA owner cannot personally guaranty any loan made to the IRA as that would also constitute a prohibited transaction.

While a self-directed IRA can hold unusual assets like real estate, the challenge comes when the IRA owner reaches age 70 1/2 and is then required to begin to take required minimum distributions from their IRA. All of the IRA's assets have to be valued as of Dec. 31 of the prior year to determine the IRA's balance and thus the required minimum distribution to the owner for the next year. If the IRA holds a "strip mall," each year that "strip mall" will have to be valued – the appraisal being paid for from the IRA itself and not by the IRA owner. Also, there is a 50 percent penalty assessed if the IRA-required minimum distribution amount is not, in fact, timely paid to its owner, all of which makes hard-to-value assets in an IRA very challenging.

During a "down" market, self-directed IRAs can be enticing, but dangerous. Proceed with caution when you consider more aggressive investments to improve your retirement returns.

George Bearup is a shareholder in the Traverse City office of Smith Haughey Rice & Roegge. He can be reached directly at gbearup@shrr.com or 231-486-4510.

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