While most people would opt for a regular IRA, active and financially savvy investors may choose a self directed IRA, where investing rules are not quite so constraining. However, utmost caution needs to be exercised, or the consequences can be devastating. Self directed IRA mistakes can easily be made, due to the sheer legal complexities imposed by the IRS. The most common pitfall investors fall into is that self directed IRAs have a checking account feature, thereby tempting the account holder to use the IRA account indiscriminately to very severe penalties. Keep in mind that the self directed IRA is a legal entity separate from the account holder.
Common Self Directed IRA Mistakes
- Checking account: The checking account platform is to be used solely for business and investment purposes, not for personal use, and all transactions, including contributions and withdrawals, need to conducted through the custodian.
- Do not use the IRA account for collateral: An IRA account is strictly for retirement purposes, and needs to be kept at arm’s length of investors. The self directed IRA comes in the form of a LLC and needs to be kept completely separated from the individual. Applying for a credit card, overdraft protection or line of credit using the self directed IRA account is strictly prohibited.
- Active management: Assets in the self directed IRA do not grow in value by themselves. The account holder effectively becomes the money manager of the assets held in the IRA, thus proactive management is definitely called for.
- Unrelated Business Taxable Income (UBTI): Income generated by any active business activity is subject to this tax. A passive investment in a business that generates its income through active management will fall under these guidelines.
- Use of personal assets benefiting the IRA: The self directed IRA can purchase a property to be used as a rental, but if the account holder uses personally owned equipment to renovate said property, just the “sweat equity” part can bust contribution limits.
- Gold: Gold investment can only be in the form of bullion or coins and have to be surrendered to the custodian. Jewelry is not acceptable.
- Commissions: Personally receiving commissions from a transaction with the IRA is prohibited.
- Prohibited transactions: These includes transactions with related parties as defined under IRS rules. The rules governing prohibited transactions are actually so extensive as to almost require legal interpretation of IRS rules 408 and 4975. Legal assistance is therefore fully advised. However, hundreds of exemptions are granted annually by the Department of Labor, which has full authority to grant these exemptions. Class exemption 96-62 can be very helpful.
As the old adage says, with greater freedom comes greater responsibility, therefore steer from self directed IRA mistakes, and avoid yourself directed IRA from being declared fully distributed.