A self-directed IRA isn't a different type of IRA.
Rather, the term refers to any individual retirement
account (traditional or Roth) that allows you to direct
the investment of your IRA assets into nontraditional
investments. For example, in addition to the usual
IRA mainstays (stocks, bonds, mutual funds, and
CDs), a self-directed IRA might invest in real estate,
limited partnership interests, a small business, or anything else the law
(and your IRA trustee/custodian) allows. In fact, the
only investment you can't have in an IRA is life
insurance. Collectibles (artwork, stamps, wine,
and antiques) aren't strictly prohibited, but if your IRA
purchases these items, you could suffer adverse tax
First, you'll need to find a trustee or custodian that
specializes in self-directed IRAs. Make sure you
understand the expenses involved--some trustees
charge transaction fees and/or asset-based fees,
depending on the particular investment. You also
need to be aware of the prohibited transaction rules.
These rules are designed to make sure that only your
IRA, and not you (or your immediate family), benefits
from your IRA transactions. If you violate these rules,
your account will cease to be treated as an IRA, with
potentially devastating tax consequences.
Finally, you need to understand the UBIT (unrelated
business income tax) rules. Even though IRA
investments usually grow tax deferred (or even
potentially tax free in the case of a Roth IRA), if your
IRA conducts certain business activities or has
debt-financed income, then your IRA could be taxed
currently on all or part of the income generated.
What are prohibited transactions?
Generally, a prohibited transaction is any improper
use of an IRA by you, your
beneficiary, or a "disqualified person" including certain family members.
The following are examples of prohibited IRA transactions:
- Selling property to, or buying property from, the IRA
- Borrowing money from it
- Receiving unreasonable compensation for
- Using it as security for a loan
- Buying property for personal use (present or
future) with IRA funds
The IRS has warned: "IRAs that include, or consist of, non-marketable securities and/or
closely held investments, in which the IRA owner effectively controls the underlying assets of such
securities or investments, have a greater potential for resulting in a prohibited transaction." (Source: IRS Instructions to Form 1099-R, 2015)
Consequences of engaging in a
Generally, if you (or your beneficiary after your death)
engage in a prohibited transaction at any time during
the year, the account stops being an IRA as of the
first day of that year. The account is also treated as
distributing all its assets to you at their fair market
values on the first day of the year. For a traditional
IRA, if the total of those values exceeds your basis in
the IRA, you'll have taxable income that's included in
your income. If you're not yet age 59½, the 10%
premature distribution penalty tax may also apply.
The IRS hasn't yet provided specific guidance
describing how these rules apply to Roth IRAs.
However, it's likely that if you've satisfied the
requirements for a qualified distribution, the
distribution will still be tax free. A nonqualified
distribution from a Roth IRA will result in taxable
income to the extent the distribution exceeds your Roth
IRA contributions (and again, the premature
distribution penalty tax may apply if you haven't yet
reached age 59½).
What is UBIT?
UBIT, as noted earlier, stands for "unrelated business income tax."
While not common, it can apply to your traditional
(and Roth) IRA. In simple terms, if your IRA regularly
conducts a trade or business (for example, your IRA buys
and operates a bakery), then the
income from that trade or business (less any
expenses directly connected with carrying on the
trade or business) is subject to UBIT. The IRA is
taxed on the income (unrelated business taxable
income, or UBTI) at trust tax rates.
The term "trade or business" has been broadly
interpreted to apply even if an IRA doesn't directly
conduct a business, but instead invests in a
pass-through entity, like a partnership, that conducts
a trade or business. If an IRA invests in a partnership
that conducts a trade or business, then the IRA must
calculate its UBTI based on its share of the
partnership's gross income and deductions.
As you can see, a self-directed IRA can provide you
with almost unlimited investment flexibility, but also
presents some traps for the unwary. Carefully weigh the benefits and
risks to determine if
it's the right choice for you.