Continuing on our theme for the month of May cautioning against early withdrawals of IRA funds – using an IRA as a “piggy bank”, as we put it – Kevin Hunter and I discussed an alternative to such a practice on the May 14 edition of The Business Forum Show, the alternative being, of course, self-directed IRAs.
A “self-directed” IRA is an IRA where the IRA owner directs how the IRA funds are invested. The IRA is administered by a custodian who handles the inflow and outflow of funds from the account. There are several companies throughout the U.S. that serve as custodians for self-directed retirement plans. These companies do not give investment advice; to do otherwise would make them fiduciaries. Instead, they recommend to their clients qualified advisors that understand self-directed investments – attorneys, CPAs and financial advisors – and who can provide the necessary advice.
Self-directed investing works best for passive investments such as real estate, and when it is done through a limited liability company (“LLC”) funded by IRA funds. A qualified attorney sets up the LLC, the custodian signs the contribution agreement on behalf of the IRA which is the owner of the LLC. Use of a LLC allows a separate bank account to be created and IRA funds to be deposited into the account. The LLC manager then can write checks for expenses related to the properties and deposit rent checks and the like. Ask most custodians and they will tell you that they prefer the use of the LLC as it eases the time and burden placed upon them for their clients’ investment activities.
Use of self-directed IRA funds, however, is not without its pitfalls. Owners must be aware of the Internal Revenue Service’s regulations on IRAs, particularly the self-dealing provisions. These rules prohibit transactions between the IRA and certain disqualified persons (the IRA owner, his/her spouse, parents, children, siblings, spouses of these persons and/or entities in which they are owners). For example, an individual cannot set up an IRA LLC and hire (and pay) a management company owned by the owner’s spouse to manage the properties.
In addition, investors who use self-directed funds are not permitted to engage in some actions that would otherwise be permitted absent the use of IRA funds. An IRA owner cannot perform work on properties which are owned through the IRA (whether they be owned directly through the IRA or by an IRA LLC). Similarly, IRA owners are prohibited from personally guaranteeing loans made to the IRA LLC.
Why all the restrictions? Because when an IRA owner takes distributions before age 59½, significant taxes and penalties are applied. The “prohibited transactions” referenced above are deemed by the IRS to be distributions and hence engaging in these types of transactions defeats the very reason why an individual would establish a self-directed IRA as an alternative to liquidation of their traditional IRA.
The use of self-directed IRA funds is not just limited to individual investors acquiring property. Multi-owner LLCs can be created which allow several investors to pool their self-directed funds to acquire larger-scale properties such as multi-unit apartment buildings.
Self-directed investing is a concept that is gaining widespread acceptance, especially in light of the current difficulty in using more traditional financing methods for acquiring real estate investment property. However, this financing method requires proper planning and careful consultation with qualified professional advisors in order to navigate the myriad of restrictions placed upon IRAs.
For more information on self-directed IRAs, you can read my e-book entitled “Alternative Investments Using Self-Directed Retirement Funds.”