Some investors prefer choices beyond mutual funds, stocks, bonds and CDs for their IRAs, and self-directed IRAs allow that freedom of choice. Real estate, bars of gold or shares of a private company are examples of allowable investments . . . but your clients need to be careful! While the IRS doesn’t spell out what kinds of investments are allowed, they do specify the kinds of investments and transactions that are prohibited, so let’s look at those rules.
IRA funds can’t be used to buy collectibles such as art, rugs, antiques, gems, stamps, coins, metals or alcoholic beverages. However, some investments in precious metals are allowed. These include coins minted by the U.S. Treasury and certain platinum, gold, silver or palladium bullion. Life insurance contracts and interests in S corporations are also prohibited.
No transactions with disqualified persons
The main guideline to keep in mind is that transactions with IRA funds or assets need to benefit the account itself, not the owner or any other disqualified person. Disqualified persons include the following:
- The IRA owner or spouse.
- Lineal descendants or ascendants and their spouses – parents, children and their spouses are disqualified persons, but brothers, sisters, aunts and uncles are not disqualified.
- Anyone providing services to the IRA, including custodians, advisors, fiduciaries or administrators.
- Any entity owned at least 50 percent by the IRA owner.
- An officer, director or 10 percent owner of an entity that is owned at least 50 percent by the IRA owner.
- The beneficiary of an IRA.
These disqualified persons are not allowed to sell property to the IRA, borrow funds from it, buy property from the IRA or use IRA funds to buy an asset that personally benefits themselves.
Examples of prohibited transactions
- Alicia has rental real estate in her IRA. She can neither hire her son nor her daughter to repair or maintain it, nor can she do the repairs herself. Her parents can’t live there, even if they pay rent and she can’t live in it herself. If it’s commercial real estate, she can’t rent it to a business if she owns more than 50 percent of that business. Alicia can’t purchase the real estate from her IRA.
- Peter’s IRA has investments in solid gold ingots. Peter cannot take possession of that gold and put it in his own safe deposit box.
- Tanya wants to use funds from her IRA to invest in a small business. She can’t invest in a small business owned by her husband or any other disqualified person. She can, however, invest IRA funds in a corporation owned by her best friend from college, or in her brother’s business.
- Gregor wants to sell his house. He cannot sell it to his IRA.
- Stacy’s mother is having financial problems. Stacy can’t lend funds from her IRA to her mother. She can, however, take a distribution from her IRA and lend those funds to her mother. She’ll have to include the distribution in her taxable income, and if she’s under the age of 59½, she’ll also pay a 10 percent penalty on that distribution.
- Phillip has multiple investment accounts with a single investment advisor, including his IRA. While it’s permissible for the investment fees for the IRA to be paid with IRA funds, the investment fees for his other accounts cannot be paid with the funds from his IRA.
- Laurie rolled her 401(k) from her last employer into an IRA. She can’t use those funds as seed money for a new venture on her own. But, she can invest the funds in a new business with other investors as long as she never owns more than 50 percent, and as long as none of the other investors are disqualified persons. Laurie should be aware that her IRA might owe taxes on income from that investment.
What are the consequences of a prohibited transaction?
Consequences for the IRA owner are especially dire. If there’s a prohibited transaction, the IRA loses its status as an IRA. The entire balance is deemed to have been distributed to the owner on January 1 of the year in which the transaction took place.
If another party is involved in the prohibited transaction, they’ll be assessed a 15 percent penalty on the amount of the transaction; and if the transaction isn’t corrected and unwound by the end of that year, the penalty jumps to 100 percent of the amount of the transaction.
If you have clients with self-directed IRAs, make sure they’re aware of these rules so they’re not caught by surprise.