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.