As of early 2016, the average retirement savings of all American families was $95,776 —not enough to go very far during those retirement years. Of course, self-directed account holders understand that they have the potential to grow that figure more aggressively through investments in alternative assets, such as real estate. However, given this U.S. figure, it’s tempting for account holders to consider using personal funds along with the funds in a self-directed retirement plan to make those nontraditional investments.
It sounds tempting, yes … but it could be a prohibited transaction that benefits the IRA owner rather than benefiting the retirement account. According to Internal Revenue Code Sections 408 & 4975, a disqualified person is generally defined as the IRA holder, any of his or her ascendants or descendants, and any entity controlled by such persons. Disqualified persons are prohibited from engaging in certain types of transactions.
In 2015, an Arkansas court decided on a bankruptcy case, which concerned the legality of partnering with one’s retirement funds to make alternative asset investments. The court held that forming a partnership between a self-directed IRA and an entity owned by the IRA holder (and spouse) was a prohibited transaction. The case involved the Kellermans, spouses who each owned a 50 percent share in Panther Mountain Land Development, LLC. In order to acquire and develop a four-acre property, the company partnered with Mr. Kellerman’s self-directed IRA: the IRA contributed property and Panther Mountain contributed property and cash. Since the couple owned Panther Mountain personally, it became a case of self-dealing … and triggered a prohibited transaction under IRC 4975(c)(1)(D).
By entering into a transaction with IRA funds that in some way directly or indirectly involves a disqualified person, the IRA owner must prove the transaction does not violate any prohibited transaction rules under IRC Section 4975, which can be difficult to satisfy, as the Kellermans found out. As the court stated, using assets of a self-directed IRA for the benefit of disqualified persons (in this case, their personally owned land development company) was a direct conflict of interest.
Of course, this was a very complicated case and every detail has not been hashed out within this article. It is also important to note that there are instances where an IRA account owner may partner with their own IRA or other disqualified parties IRAs and personal funds; however; there are many tests in order to determine if it is allowable and these partnerings must be structured and maintained in very specific ways.
At Next Generation Trust Services, our rigorous transaction review process is in place to help our clients become aware of when a transaction may be considered prohibited. Although combining self-directed retirement funds and personal funds on a transaction is not necessarily prohibited, it can be very risky and trigger the IRC Section 4975 prohibited transaction rules. If you are considering such a transaction, we advise that you consult an attorney that specializes in ERISA issues; and, as always, our helpful professionals are available to answer your questions about self-directed investments at Info@NextGenerationTrust.com or 1-888-857-8058.
Is Your Self-Directed IRA Looking For a Partner?
Keep Track of Income and Expenses
First of all, all income and expenses related to the purchased assets flow through the IRA, since the account is a separate entity from you (you are not personally the investor, the account is).
Then there are the prohibited transactions and disqualified people who may not engage, directly or indirectly with the self-directed retirement plan (those include the account holder and the account holder’s spouse, antecedents or descendants and their spouses, and the account holder’s entities).
The Exception to the Rule
There is an exception to this: a self-directed IRA may partner with a disqualified person or entity according to percentage of ownership AND simultaneous funding of the asset. These are important distinctions.
If a partnership were to form, it would have to be a new transaction and all income and expenses must go in and out of the IRAs at the same time. For example, let’s say an account holder partnered 50/50 with her self-directed IRA to purchase real estate and a $100 water bill for that investment property was due monthly. In this case, both the account holder and the retirement account would pay the water company $50. It would be considered prohibited if the account holder and IRA alternated paying the bill in full every other month.
The percentages of ownership cannot be transferred or changed when partnered with a disqualified person, so care must be taken to fully research this option and make sure that it is property set up.
The professionals at Next Generation Trust Services can explain this strategy to you and help you set up your self-directed retirement plan. Contact us to discuss this further at Info@NextGenerationTrust.com or (888) 857-8058. You can also read up on the basics of self-direction as a retirement wealth-building strategy in our helpful white paper.
How to Rectify a Prohibited Transaction
As discussed in a previous post, there are several ways investors can find themselves on the wrong side of a transaction in their self-directed IRAs. Whether the retirement account has invested in commercial paper, a private placement, real estate, a commodity or natural resource, or any of the many other allowable alternative assets, it is important to remember that:
- You personally are not the investor, the self-directed IRA is, and
- The account administrator must execute all transactions on your behalf, for the benefit of the self-directed retirement account.
- You cannot take funds out of any investment the IRA has made directly. All income and expenses related to the investments must go through the account that made the investment before being transferred or distributed elsewhere.
A common error investors make is to sell the investment that the IRA made and have the proceeds forwarded directly to them or to another IRA account; they then deposit that amount received personally into another IRA with another IRA custodian. Because the proceeds from the sale were not sent back directly to the self-directed IRA custodian first, this is a prohibited transaction.
In the case of a prohibited transaction you erroneously conducted, there are a few steps you can take to correct the transaction, and avoid undue tax penalties and protect the tax-advantaged status of your self-directed IRA.
Steps to take to rectify a prohibited transaction pertaining to an improper recipient of funds
- Send the funds back to the investment directly. You will need to contact the incorrect IRA custodian to have the funds returned to you before sending the funds back to the investment. Or, if the funds from the investment went directly to another custodian, that custodian should send them back to the investment.
- Once the funds are received by the investment, the investment would then further direct the funds back to the proper IRA at the original custodian (in our case, back to Next Generation TS). Using our office as an example, the investment can make a check payable to your appropriate account (Next Generation TS FBO Client Name IRA ####) or send the funds via wire transfer.
- Once received by the NGTS IRA, the funds can then be further transferred or distributed at your discretion. Should you choose to direct NGTS to issue the funds out of the IRA, the account can then be closed if you no longer wish to take advantage of self direction.
At Next Generation Trust Services, our goal is to help our clients protect the tax-advantaged status of their self-directed IRAs. We provide clients with a 14-day window, as the IRS instructs, to correct the transaction so that the funds are not distributed as a prohibited transaction; this would be a taxable event and may be subject to IRS penalties. The Next Generation staff can explain and assist you with expediting these steps, and provides guidance and information throughout the process as part of our customer service commitment.
Because of potential tax ramifications, we recommend you consult with an attorney or CPA that specializes in ERISA* law and IRA Rules set forth in the Internal Revenue Code’s Title 26 USC § 4975 or other applicable retirement plan specialists. We can provide contact information for known ERISA attorneys; however, we cannot endorse or guarantee their services.
As always, if you have a question about your self-directed retirement plan, the types of investments you can make, or if you need information about liquidating an asset, contact our self-direction experts at Info@NextGenerationTrust.com or (888) 857-8058.
*Employee Retirement Income Security Act
Self-Directed IRA Investors: Make Sure You Don’t Conduct Prohibited Transactions
Although self-directed retirement plans allow for many diverse types of investments, there are several prohibited transactions as proscribed by the IRS that investors must adhere to . . . or risk paying penalties or having their accounts lose their tax-advantaged status.
A common error account holders make is to liquidate an investment that is in their self-directed IRA directly to them or to another IRA. This is not allowed because all income and expenses related to the investment must flow through the self-directed retirement account that made the initial investment. Therefore, any returns from the investment must go back to the IRA that invested in them.
Three common types of prohibited transactions are when:
- The account holder liquidates the IRA investment directly into another IRA – The proceeds must go back into the self-directed IRA first, and then can be rolled over or transferred into another IRA. Bottom line—the money has to go back into original account that made the investment. For example, say you had invested in a rental property through your self-directed IRA. If you sell that real estate, you are prohibited from directly taking the proceeds of the sale or liquidating them into another retirement account. The real estate IRA must receive the funds, which may then be distributed by the account custodian to the individual or transferred into another IRA, upon written instruction by the account holder.
- The investor takes the funds out from the investment directly and moves them to another account – Account holders are prohibited from doing this because the individual is not the investor, the self-directed IRA is. This causes the receiving custodian to treat and code the funds incorrectly. The other custodian will operate under the belief the money is income, a rollover or a contribution; however, this is not income from an asset it holds. Any transactions must be executed by the account custodian (upon instruction of the account owner), who will confirm that the transaction is allowed. There must be a trail that can be followed by the IRS in order to ensure the transaction and assets are treated properly.
It’s important to note here as well that any rollover from the liquidated assets into another IRA can be a taxable event, so investors are strongly advised to discuss their plans with their financial advisors or tax planners. The IRS will want to know where those funds came from. A distribution becomes a taxable event when the funds or asset is not rolled over to another tax-advantaged account within 60 days.
- The individual takes funds directly as a “distribution” – The account administrator cannot record this withdrawal as a distribution if the administrator did not first accept the funds. This is against the law and can have a negative cascading effect for the account holder.
If you ever have any doubt about a transaction, or you and your financial planner need clarification about how to handle liquidated assets, contact Next Generation Trust Services at Info@NextGenerationTrust.com or (888) 857-8058. Our experienced professionals can answer your questions about any aspect of self-directed retirement plans and the alternative assets allowed in them.
6 Mistakes That Can Ruin Your Retirement Savings
Finally opened that self-directed IRA? It’s easy to get swept up in the sea of options when it comes to choosing your own investments, but if you’re not careful, you can find yourself overwhelmed with taxes and penalties for simple mistakes you may not realize you’re making. When it comes to investing in a self-directed IRA, having your ducks in a row is most important to keep the heavy hand of the IRS at bay.
Here are 6 surefire ways to ruin your chance at a wonderful, self-directed retirement.
1. Using your IRA’s Property for Personal Use: A lot of prospects we speak to are often under the unfortunate impression that they can use their retirement funds to purchase a second home. Real estate within an IRA is for passive income only, which is to say it should only be to generate income for your IRA from arm’s length. In order to avoid penalty, excess tax and the distribution of your entire IRA and more, you or any other disqualified person may not live in the property, work or rehab the property directly.
2. Paying your IRA’s Expenses Out of Pocket: If your IRA has purchased an investment that incurs expenses, you want to make sure you leave enough cash within your account to cover this. In the case of real estate, this may include tax bills, rehabilitation costs and other everyday costs. You, personally, may never pay these expenses out of pockets—if you do, this may be considered an excess contribution and penalties may apply until these funds are removed from the IRA.
3. Using an Entity to “Hide” a Disqualified Person: Whereas loans and commercial paper can be very equitable for the savvy investor, the only hard rule standing on this topic is one that many try to get around. The IRS indicates that you cannot lend or transact with a disqualified person (yourself, your spouse, any ascendants, descendants or their spouses). This also goes for any entity owned fully or mostly by such a person. The IRS sees through all filters, and even if your self-directed custodian doesn’t catch that Awesome Business, LLC is owned by your son, the IRS will.
4. Taking Possession of Funds Directly from Your IRA’s Investment: The money’s yours right? So, it should be alright if your investment sends a check for the proceeds to you directly instead of to your self-directed custodian? This presumption can cost you dearly as doing this would be considered a distribution; your custodian will be required to release the entire investment at whatever value they have on file to you. This means 1099s, this means income tax and possible early withdrawal penalties if not corrected quickly. This will apply even if you send it over to another custodian. Income or principal must always return to the custodian that made the investment initially, from there, it can go wherever you’d like.
5. Funding an Investment Through a Custodian that Typically Does Not Self-Direct: It’s easy to get excited about a nontraditional investment, especially since you’ve found out that your investment options are not limited to stocks, bonds and mutual funds. A mistake many clients make is using their traditional custodian to make an investment without verifying that this is something they’re allowed to do within the company. Occasionally, these traditional custodians have a special department dedicated to these “unusual” assets, but most times, they’re actually making a taxable distribution of your funds to this investment and issuing a 1099 at year end. Make sure your custodian understands your intent when you provide these instructions, and if they cannot make this investment, transfer to a self-directed custodian.
6. Rolling Over Funds from a Non-Spouse Beneficiary IRA: Say you’ve inherited your old Aunt Sally’s IRA upon her passing. Though your investment options stay the same, there are other special tax rules for beneficiary accounts. One special rule that applies only to these accounts is that the only way to move funds from IRA to IRA is through a direct custodial transfer. If you take a distribution, it cannot be contributed into another beneficiary IRA as a rollover. All distributions are final, in your pocket and potentially taxable.
Many of the mistakes listed here can be avoided by keeping in contact with your self-directed custodian. It is the responsibility of the client to provide as much information as possible to ensure that they stay within IRS regulations. At Next Generation Trust Services, our focus is on education first, so we encourage you to give a call to go over the specifics of your investment scenario before making your investment.