An Individual Retirement Account (IRA) is a fantastic tool to sock away money for retirement.
Contributions are tax-deductible, and the growth of the assets in an IRA is generally completely tax deferred. An IRA is also protected against creditors in bankruptcy (up to a limit of around a $1.3 million). Outside of bankruptcy, most states protect the entire value (or at least most of the value) in an IRA against ordinary creditors.
IRAs are also relatively simple and don’t cost a fortune in fees and maintenance.
An IRA can hold nearly any type of investment, other than those prohibited by the Tax Code. However, IRA custodians may impose additional restrictions on investments. Because it’s more work for them, many IRA custodians prohibit investments in non-traditional assets such as real estate, precious metals, or non-US investments.
Plus, with a traditional IRA, you have very little control, because your custodian must approve every investment you make.
The only way to avoid these restrictions and target investments prohibited by an IRA custodian is to create a self-directed IRA. For the greatest flexibility, your IRA can create an entity to hold the investments you wish to make. Ordinarily, this is a domestic LLC that is owned 100% by the IRA. This arrangement is often called a checkbook IRA.
The biggest benefit of a checkbook IRA is that it frees you from needing your IRA custodian to approve every investment you make. The custodian must approve only the ownership of the LLC by the plan. It need not approve each individual investment.
The Hidden Danger of Prohibited Transactions in Your IRA
Not having each investment approved by the custodian, though, makes checkbook IRAs vulnerable to noncompliance of IRS “prohibited transaction” rules. A prohibited transaction could result in a deemed distribution of the entire IRA, resulting in:
- The end of tax deferral
- Federal tax liability on the entire value of the IRA, up to a top rate of 43.8%
- State tax liability on the entire value of the IRA if you live in a state that imposes an income tax
- A 10% early distribution penalty if you’re under 59½
- A substantial underpayment penalty of up to 20% of the tax due
In other words, if your IRA makes a prohibited transaction, you could easily wind up paying two-thirds or more of its value in taxes and penalties.
Simply for making a single mistake.
With a traditional IRA, the rules defining prohibited transactions don’t come into play. The investments and relationships involved rarely (if ever) involve anything on the prohibited list.
But the more esoteric your IRA gets, the more likely you are to violate regulations. When you call the shots, you can invalidate your entire plan without even knowing it.
Indeed, an article in the prestigious Journal of Accountancy estimates that more than 50% of investors with self-directed IRAs are noncompliant. And while not all of the issues the article highlights will blow up your IRA in a prohibited transaction, many will.
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Examples of Prohibited Transactions
Most prohibited transactions boil down to some type of self-dealing with your IRA. A prohibited transaction is any improper use of your IRA by you, your beneficiaries, or any “disqualified person.”
One example of a prohibited transaction is depositing a contribution to your IRA directly into a checking account that your checkbook LLC holds. Your contributions to the IRA must still be made through your custodian. This simple mistake can actually terminate your IRA and result in a deemed distribution of all of it!
Another example is selling your personal property to your IRA. You also can’t personally lend your IRA money nor can you co-sign a loan made to your IRA.
The IRS considers you a disqualified person with respect to your IRA for this category of prohibited transactions. But it’s not just you. Other disqualified persons include:
- Your spouse
- Your parents, grandparents, and their spouses
- Your children and their spouses
- Your IRA administrator, manager, or custodian
- An IRA “fiduciary” (e.g., you or your advisor)
- Any entity in which you own at least a 50% share
Among other consequences, this means that you and your spouse can’t jointly make an investment using your respective IRAs. That’s because you and your spouse are disqualified persons with respect to each other.
Confusing? Yes, it is. And the lines get even blurrier when we look at the investment assets themselves.
Let’s say you instruct your IRA to purchase a rental property. Avoiding personal interactions with real estate is tricky. Here are just a few common interactions that would trigger a prohibited transaction:
- Using your personal funds as a deposit to secure the sale. The IRA must secure and buy the property.
- Accepting a check from a tenant payable to your personal account. Even if you transfer the funds from your personal account straight to your IRA, this is prohibited.
- Furnishing the property with items purchased with your personal funds. Again, the IRA must purchase the furniture.
- Using personal funds to repair or upgrade the property. The repairs must be paid for by the IRA.
- Performing repairs or routine maintenance yourself. Your IRA must instead hire someone who is not a disqualified person to do the work. You can’t even lend your personally owned tools to someone else to do the work.
- Paying yourself a salary for managing the IRA’s investments. This isn’t prohibited outright, but the salary must be related to matters concerning the IRA administration itself, not its investments. If this sounds like splitting hairs, it is. But in 2015, this mistake (among others) resulted in the deemed distribution of a $321,000 checkbook IRA.
Are You Scared Yet?
To conclude, I want to emphasize that I heartily endorse the checkbook IRA concept. But before you start investing with it, you must take the time to understand the prohibited transaction rules.
Incidentally, I recently wrote a two-part article for our Offshore Freedom Inner Circle service about creative ways to use a checkbook IRA without breaking the prohibited transaction rules. Inner Circle members can access Part I here. If you’re not a member of the Inner Circle and want to learn more, follow this link.
