The traditional IRA permits up to $6,000 in annual contributions ($7,000 if you are 50 or older) in 2019. That amount will rise slightly for 2020 to $6,500 in annual contributions ($7,500 if you are 50 or older). This type of account allows workers to deduct the full amount of their contributions on their tax returns. The Roth IRA has similar contribution limits to the traditional account, but individuals make contributions after paying taxes on the capital. This might sound like a negative aspect at first, but paying taxes prior to contributing means that you do not pay them on withdrawals.
If you expect to generate high volumes of returns within the account, as is often the case for investors holding real estate assets in these accounts, then you may opt for the Roth account instead of a traditional IRA. On the other hand, if you need the tax deduction on your present-day returns and expect your annual income in retirement to place you in a lower tax bracket than the one you currently occupy, you might opt for the traditional account. Many self-directed investors work with their financial advisors to predict how much income take they might pay on their required minimum distributions during retirement in order to decide between Roth and traditional accounts. Required minimum distributions are the minimum amount you must withdraw each year once you reach a certain milestone age, usually 70½. Roth IRAs do not require required minimum distributions until after the death of the owner.
SEP IRAs operate in a similar fashion to traditional IRAs but permit much higher annual contributions. SEP stands for simplified employee pension. These accounts are available to small business owners, freelance workers, and self-employed individuals. If a business owner wants to make large contributions to their own account or wishes to contribute to employees’ accounts, then SEP IRAs can be a good vehicle for these actions. Annual contributions for SEP IRAs may be as high as $56,000 (as of 2019).
SIMPLE IRAs are savings incentive match plans for employees, which creates the acronym SIMPLE. Businesses with 100 employees or fewer may leverage these accounts to offer tax-deferred retirement plans, and the SIMPLE IRA requires the employer make contributions to accounts either on their own or in a matching process.
The latter five categories mentioned above simply deal with the identity of the beneficiary of the account, the source of the account, or the intent of the account. A rollover IRA has been rolled over from a past employer. A spousal IRA is an IRA associated with a non-working spouse and has identical contribution regulations to your IRA (this enables you to potentially double annual contributions, by the way). An inherited IRA has been inherited and may have different rules governing when you can withdraw money and how that money will be taxed (hint: In some cases, it is not taxed at all).
Finally, the term education IRA is an outdated term for a tax-advantaged account specifically designated for use in paying for higher education. Today, these accounts are formally known as Coverdell Education Savings Accounts (ESAs), and the funds and assets they hold may be used only for education, not for retirement.
Three vitally important rules for self-directed IRAs
Now that you have a full understanding of the different types of IRAs out there, you likely already recognize your type of account among the herd. If you do not yet have a self-directed IRA set up or if your individual retirement account is presently captive, don’t worry. We will deal with how to set up a new account or convert your account a little farther into the topic.
For now, however, the important thing you must realize is that the self-directed IRA rules apply across the board, no matter what type of customized name your account may hold. Put simply: An IRA is an IRA is an IRA. The differentiating factor lies in what the administrator or custodian will permit when it comes to your investment options.
And, speaking of your investment options, there are three vitally important rules for self-directed IRAs to which you must adhere. They are not open for discussion or debate. If you violate these three rules, your IRA will face fines, fees, and penalties that could wipe out the entirety of the capital in that retirement account. Fortunately, these three rules are not particularly complicated even though the results of breaking them are dire. Furthermore, a responsible self-directed investor will always consult an experienced attorney with an extensive background in self-directed investments and self-directed accounts before making any investment or leveraging any new strategy.
Let’s take a look at these important rules:
Rule #1: Do not use capital from your self-directed IRA to purchase prohibited assets
When IRAs were created by Congress in 1974, there were just two types of investments specifically prohibited by that legislation:
- Life insurance
If you can look at an asset and be definitively certain that you are not investing in life insurance or collectibles, then you are essentially in the clear. However, the definition of collectibles has expanded and evolved over the years. Fortunately, the IRS provides examples of collectibles in IRC Section 408(m)(2). That list currently includes (as of December 2019):
- Any work of art
- Any rug or antique
- Any metal or gem (with limited exceptions)
- Any stamp or coin (with limited exceptions)
- Any alcoholic beverage
- Any other tangible personal property that the IRS determines is a collectible under IRC Section 408(m)
You’re probably thinking, But what about gold and other precious metals? Well, the IRS permits certain types of exceptions to enable you to hold gold, silver, platinum, palladium, and certain types of coins in your self-directed account. However, there are rules that govern how you hold those assets and who has possession of them.
What happens if you break this rule? Well, you will owe some or possibly all of the following:
- Regular income taxes on the money you spent to acquire the prohibited asset
- A 10 percent early withdrawal penalty
- Interest on the taxes you owe
- An underpayment penalty (usually about 20 percent)
You will owe money on the purchase of the prohibited asset whether or not you ended up generating returns with that investment or not, and, furthermore, those fines, fees, and penalties will have to come out of your own pocket. After all, you spent the money the IRS is now considering distributed to acquire that asset!
Rule #2: Do not use your self-directed IRA to benefit a "disqualified person"
The IRS defines a disqualified person at length in the tax code, and those definitions are periodically updated and refined. It is important that you work with a qualified professional who can help you identify whether a party might be a disqualified person before you work with them.
Put simply, a disqualified person is any individual whose benefit might represent some sort of personal benefit to you. Why doesn’t the IRS want these individuals to benefit? Because the tax advantages that come with using an individual retirement account are intended to incentivize you to save for the future, not to generate income in the present. You cannot have your cake and eat it too!
The category of "disqualified person" includes people who are:
- You: the owner of the IRA
- Most of your family, including ancestors, your children, and your children’s children and their spouses.
- Businesses and organizations wherein you or a family member have ownership and/or influence
- IRA account professionals who offer services connected to the IRA.
If you use your self-directed IRA to benefit a disqualified person, the IRS will consider that to be a prohibited transaction and, as a result, your account to be fully distributed. This means that your account retroactively loses all tax advantages back to the first day of the year in which the prohibited transaction was committed. That is a big deal, and this type of distribution can easily cost you two-thirds or all of the funds in your self-directed account.
Rule # 3: Avoid doing deals or permitting your self-directed account to benefit any fiduciary or third party
This essentially tells self-directed account holders that just avoiding the letter of the law in terms of committing prohibited transactions with disqualified parties is not enough. It tells you that doing deals with anyone who might have substantial influence over you or your business or over whom you might have substantial influence can put your self-directed IRA at risk. If the IRS were to determine that you had done so, then you would be dealing with a prohibited transaction.
Unfortunately, there is not a lot of clarity on this last type of disqualified person. Of course, you should avoid working with your IRA custodian on a deal. You should not do deals in your self-directed account with your tax professional or real estate attorney. That seems relatively straightforward. However, you should also avoid your companies like the ones you use to appraise potential real estate purchases, etc.
The safest option is to consult with your expert SDIRA attorney before doing the deal. They can advise you not only on whether the rules about what you want to do are clear-cut or not, but also on previous IRS rulings and case law that might affect how the IRS would view your proposed actions.
Moving forward as a self-directed investor
At this point, you should have a reasonably sound grasp of what a self-directed IRA is and the vast potential it represents. Now you are ready to move forward! If you already have a self-directed IRA but have not yet begun investing, you should begin evaluating your opportunities and considering your options. If you hold a captive IRA, then you will need to convert that individual retirement account to a self-directed account by working with a self-directed IRA custodian. Finally, if you need to set up a new self-directed IRA, then start out with a custodian or administrator who permits this type of flexibility.