Overview
When I first learned about a Self Directed Individual Retirement Account (SDIRA) several years ago, I was amazed that I had not heard about it before. Most of us know about the regular IRA, and how we can use it to save for retirement by investing in stocks, bonds, mutual funds, and other securities. As I worked for various companies, I would save in my 401k and when I left that job I rolled my savings into my IRA. Like most other people, I relied on my financial advisor to allocate my portfolio to various securities that met a risk and growth profile based on my current age and planned retirement age.
For years, I didn’t really know any better and thought this was my only option for retirement savings. But, what I also noticed was that my advisor would make money every month on my portfolio, regardless of whether the market was up, down, or sideways. I also began to feel very uneasy about the prospects of a major downturn in the market and how that could impact my ability to enjoy a stable retirement.
The Self-Directed IRA
The Self Directed IRA (SDIRA) is a special kind of IRA that allows you to invest in alternative assets such as real estate or mortgage notes. This type of IRA is offered by custodians that specialize in managing them. The custodian is not able to provide advice or guidance about the suitability of the investment, so it is up to the individual investor to examine the suitability of the investment and perform appropriate due diligence. The investor can also work with an independent financial advisor that understands the benefits of a balanced portfolio.
Investment Options
The SDIRA is very flexible when it comes to the type of investments that are allowed. You can invest in single-family houses, real estate syndications, mortgage notes, debt, and even private companies. There are many options for what you can invest in, so it is almost easier to describe what you cannot invest in. For example, you cannot invest in life insurance and in collectibles such as artwork, rugs, antiques, metals, gems, stamps, and coins. But, as long as you stay away from these types of investments, the SDIRA offers a lot of flexibility that a traditional IRA does not. I have personally invested in syndications, mortgage note funds, agriculture and private debt in my SDIRA.
How to Establish an SDIRA
Setting up a Self Directed IRA is usually pretty simple. Perform a Google search and find the custodian that meets your needs the best. You need to be aware of the fees that each custodian charges. They don’t earn a commission on the assets under management, so they need to cover their expenses via fixed fees. Consider the types of investments you want to hold in the account and choose a custodian that best fits your needs. Most companies charge a fee for each investment you purchase in your account and then there is typically also a quarterly fee for each asset you have in the account.
Also, find a custodian that can do most of the paperwork electronically. There are often a lot of forms to complete for each transaction, so it will simplify your life if most of it can be done electronically.
Finally, some custodians offer checkbook control over the account. This can be beneficial if you do a lot of transactions or want to hold property in your account for which you may have to pay bills regularly.
Arms’ Length Transactions
The investments in your SDIRA are for retirement savings, so you cannot have any direct benefit from the investment. For example, if you own an AirBnb rental in your account you can’t use that rental for your own vacations. You also can’t personally work on or perform repairs on a property that you hold in the account.
There are also restrictions on which individuals you can transact with. Anyone you deal with must be “arm’s length” from yourself. So, you can’t enter into transactions with yourself, your spouse, any of your lineal ascendants or descendants (parents, children, grandchildren, and the spouses of children, grandchildren, etc.— including legally adopted children).
These rules are in place so you don’t have a benefit of your SDIRA until you retire and start taking distributions.
Failure to follow these rules can result in your SDIRA to be forcibly distributed and lose its tax-protected status. The account will be immediately taxable and you will owe taxes and penalties on the amount, starting from the year of the original prohibited transaction (no matter when the transaction is discovered).
UBIT Taxes
Traditionally, money in an IRA grows tax-deferred, or tax-free in the case of a Roth IRA. However, if you use debt to leverage your investments, for example by purchasing a house in the IRA or investing in a syndication, a portion of your investment may be taxable. For example, if you buy a rental property for $100,000 and $40,000 came from the IRA and $60,000 from a loan. The property is 60% leveraged and as a result, 60% of the income is not a result of the IRA’s investment, but the result of the debt invested. Because of this debt that is not retirement plan money, the IRS taxes 60% of the income. So, if there is $10K of rental income on the property then $6K would be subject to UBIT taxes.
This is a tax that a lot of SDIRA investors are not aware of and must be reported to the IRA and paid via the IRS Form 990-T.
If you have self-employment income, refer to my article on a Solo 401k which avoids this tax altogether.
Summary
The SDIRA is a great way to get access to alternative investments in your retirement account. Getting your money away from Wall Street and into Main Street can benefit your community directly and you have much more transparent investment opportunities. Just be aware of the UBIT taxes and ensure that you have the knowledge to understand the risks of the alternative investments that you pursue.
Disclaimer; This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or investment advice. You should consult your own tax, legal, and investment advisors before engaging in any transaction.
