Revealing the Secret Strategy of Self-Directing Your Retirement Funds
When it comes to investing the money in your IRA or other retirement plan, don’t feel trapped into using one of the menu options you get from your account custodian--you don’t have to settle for a select group of mutual funds when investing your retirement money. Instead, you can self-direct your IRA into all kinds of legal investments, including small companies, real estate, loans, or precious metals. You should seek to place your retirement account with a self-directed retirement plan custodian who will allow you to invest in any option allowed by law.
A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include real estate, promissory notes, precious metals, and private company stock. When instructing clients about self-directing, the usual reaction I hear from investors is, “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is, the large financial institutions that manage most U.S. retirement accounts don’t find it administratively feasible to hold real estate or nonpublicly traded assets in retirement plans.
The most popular self-directed retirement account investments include rental real estate, secured real estate loans to others, small-business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great choices for investors with experience in these areas. Under current law, a retirement account is only restricted from investing in the following:
- Collectibles such as art, stamps, coins, alcoholic beverages, or antiques
- Life insurance
- S corporation stock
- Any investment that constitutes a prohibited transaction (discussed below)
- Any investment not allowed under federal law (e.g., a marijuana dispensary)
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in Internal Revenue Code 4975 and the Employee Retirement Income Security Act. These rules don’t restrict what your account can invest in, but rather whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with a disqualified person.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax-advantaged accounts conducting transactions with parties who are close enough to the account owner that they could be designed to avoid or unfairly minimize tax by altering the true fair market value or price of the investment. Disqualified persons include the account owner, his or her spouse, children, parents, and certain business partners. So, for example, your retirement account couldn't buy a rental property that's owned by your father.
The IRA must hold the property strictly for investment. The property may be leased to your cousin, friend, sister, or a random unrelated third party, but it can't be leased or used by the IRA owner or the aforementioned prohibited family members or business partners. Only after the property has been distributed from the retirement account to the IRA owner may the owner or family members reside at or benefit from the property.
The IRA/LLC Structure
In a typical self-directed IRA investment, your IRA custodian holds your investment in their company name for your IRA’s benefit (e.g., property is owned as ABC Trust Company FBO John Smith IRA), receives the income, and pays the expenses for the investment at the account owner’s direction and instruction.
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/limited liability company (LLC) as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC can be managed by the IRA owner, who then directs the LLC; the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment.
There are several restrictions to the IRA owner also being the manager, such as not receiving compensation or personal benefit from the IRA/LLC. However, the ability to control the LLC and its investments, the ability to make decisions, and the money saved by not needing a custodian may outweigh the restrictions of being your IRA’s manager. There are many laws, as well as pros and cons, to consider, so please be sure to consult an attorney before establishing an IRA/LLC.
Asset Protection for Self-Directed IRAs
When analyzing asset protection for self-directed IRAs, we must consider two types of potential threats:
Outside liability. Most IRA owners know that their IRA is generally protected from their personal creditors. Various federal and state laws provide protection that prohibits a creditor from collecting or seizing the assets of an IRA or other retirement plan. For example, if an individual personally defaults on a loan in their name, then gets a judgment against them, the creditor may collect against the individual’s personal bank accounts and wages, but not their IRA. Even in the case of bankruptcy, a retirement plan is considered exempt from creditors. Because of these asset protection benefits, retirement plans are excellent places to hold assets.
Inside liability. This is the situation that shocks most IRA owners and is particularly important to self-directed IRA accounts because many hold businesses or assets that can create liability. Protections preventing a creditor of the IRA owner from seizing IRA assets will not apply if the liability arose inside the IRA. It’s not your liability; it’s the IRA’s liability. Moreover, there have been many cases where creditors came after IRA owners as the directors of the IRA, which means you may have personal liability by directing the investment. For example, if a self-directed IRA owns a rental property and the tenant in that property slips and falls, the tenant can sue the self-directed IRA and the IRA owner who owned and leased the property to the tenant. Since the IRA is a revocable trust, each investment is in fact controlled by the IRA owner, as he could terminate the IRA at any time and take ownership in his personal name.
The best solution to avoid personal liability when self-directing your IRA is to use an IRA/LLC, where you're the manager of the LLC and thus protected under its corporate veil.