Understanding Self-Directed IRAs
As many of the major U.S. equity indices recently reached all-time highs, retirement plan investors found themselves facing a “deal or no deal” quandary: take market winnings out of the markets to sit on the sideline in cash or stay invested and “let it ride.” With approximately 40 percent of US. household wealth stored in retirement accounts, many families, weary of the market crashes of 2008 and the COVID-19 crash of 2020, would welcome access to investment options that have little-to-no correlation to the general stock market.
To add another complication, most investors are not sophisticated (in terms of meeting the income or net worth requirements to satisfy the SEC’s “accredited investor” definition) enough to invest in hedge funds, private equity and other alternative investments that many wealthy and corporate insider investors have access to. So, with such investment limitations, clients may come to CPAs for assistance with evaluating options that will help to achieve this investment diversification objective.
Enter the self-directed IRA (SDIRA). Governed by IRS Code §s 408 and 408A, these IRAs allow owners to invest in an expanded offering of “alternative” investments outside of the typical cash, bonds, equities, mutual funds and ETFs typically found in broker-dealer-custodied IRAs. Except for two specific assets — investments in insurance (per IRC § 408(a)(3)) and collectibles — there is very little that an SDIRA can’t invest in. Known mostly for investments in real estate and gold, SDIRAs allow for many different investments, ranging from tax liens to racehorses.
Sounds almost too good to be true? Here are some basic considerations with respect to SDIRAs.
Dos and Don’ts of Self-Directed IRAs
- Understand IRA rules and follow them. All traditional and Roth IRA rules apply, so make sure that clients’ SDIRAs understand and comply with all contribution, rollover, distribution, timing and, if applicable, reporting requirements (e.g., Forms 5498, 1099-R).
- Understand the SDIRA structures and the responsibilities associated with them. There are SDIRAs where the owner directs the custodian who handles the receipt of and distribution of funds (often referred to as custodian IRAs) and others where the IRA owner has “checkbook control” (referred to as checkbook IRAs). This involves the creation of an IRA LLC that is owned by the SDIRA. The IRA owner acts as a non-owner manager of the LLC that directs the deployment of funds in the permissible investments. Note that when the custodian’s role is passive (as is the case with checkbook SDIRAs), the IRA owner may be faced with more responsibilities, such as recordkeeping, timely reporting and other compliance requirements.
- Be aware of custodian limitations. Even though the IRS Code may permit investors to invest in a certain asset, if the custodian is not equipped to properly handle the administrative and legal duties associated with such an asset class, the transaction can invalidate the SDIRA, potentially triggering taxes and penalties. Also, it is important to be aware of which administrative roles the custodian does or doesn’t do. Do they do periodic reporting? Do they prepare tax filings? Do they do valuations? Knowing who is responsible for what can help avoid administrative lapses that can be costly to clients.
- Understand what is deemed to be a prohibited transaction with respect to SDIRAs (IRC § 4975). This is a key area where SDIRAs draw the most scrutiny from taxing authorities. Knowing the restrictions regarding who clients can transact with as well as the type of transactions that clients can execute is critical to maintaining tax-deferred status.
- Watch out for unrelated business income tax (UBIT). Defined under IRC§ 511(b)(1), UBIT refers to the tax that is payable when a tax-advantaged vehicle such as an SDIRA earns gross income that is from an “unrelated trade or business” that is carried on for what is considered a “regular basis.” In general, UBIT as it relates to SDIRAs revolves around unrelated business income and unrelated debt-financed income.
SDIRAs can be a powerful tool in providing diversification to an investment portfolio. As trusted advisors and confidants, CPAs should 1) help clients understand their options; 2) educate clients on the ins and outs of SDIRAs — benefits, challenges, responsibilities and costs; and 3) assist clients with due diligence, vendor selection and finding appropriate council should they decide to take the plunge and utilize SDIRA structures.
Sharif A. Muhammad
Sharif Muhammad, CPA, MBA, MST, CFP, is the founder and chief executive officer of Unlimited Financial Group Inc. He is a member of numerous NJCPA committees and interest groups.
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This article appeared in the Winter 2021/22 issue of New Jersey CPA magazine. Read the full issue.