With the rise in popularity of alternative asset investments for U.S. investors, traditional financial institutions have become more concerned and protective on their stranglehold of the $13 trillion IRA investment market. With an estimated 95% of IRA assets invested in publicly traded securities, such as stocks or ETFs, traditional financial institutions have a lot to lose.This article will explore some of the most common Self-Directed IRA myths that our clients have heard over the years from representatives of major financial institutions, banks, and brokerage firms on the option of using a Self-Directed IRA to make non-publicly traded investments with an IRA.
The Self-Directed IRA is a New Phenomenon
Since the creation of IRAs in 1974 by ERISA, alternative investments have always been permitted to be invested by IRAs. A Self-Directed IRA is not a legal term that you will find in the tax code.It’s essentially a standard IRA that allows for alternative asset investments (like real estate) in addition to traditional assets (such as stocks and mutual bonds).Conventional financial institutions generally do not allow IRAs to invest in alternative assets because they cannot earn fees or generate revenues from non-publicly traded investments. So, why can’t you invest your IRA in alternative assets at a bank or traditional brokerage firm?
Not surprisingly, the answer comes down to money. Brokerage firms make money and fees on your cash and from selling traditional investments, like stocks, mutual funds, and ETFs.They do not generate any revenues or profits when your IRA invests in alternative investments.Hence, it is not in their financial interest to publicize the fact that the IRS allows all IRAs to invest in alternative assets, such as real estate, precious metals, cryptocurrencies, private placements and much more.Thus, the Self-Directed IRA is not a new phenomenon; it was actually created in 1974 – the same exact time IRAs and 401(k) plans were created.
It’s Too Risky to Use a Self-Directed IRA
The quote from a financial advisor about a Self-Directed IRA being risky or unsafe is another myth that seems to be targeted as the Self-Directed IRA industry unfairly. As the term insinuates, the individual IRA owner is directly responsible for directing the IRA investment. Like any investment, whether stocks or real estate, there is no guaranteed rate of return – investing is risky by nature.That being said, the SEC has released investor fraud alerts over the years for Self-Directed IRA inventors to be cautious of investor scams. However, many of the investments offered require one to be an accredited investor, which is an SEC requirement and defined term.
An accredited investor is an individual with at least $1million of net worth, excluding a primary residence, or one that earns at least $300,000 of income, if married and filing jointly ($200,000 if single), for two consecutive years prior to the investment. Therefore, the SEC already has built in rules in place to protect many investors from fraud involving non-publicly traded securities.
Nevertheless, whether one is investing in publicly traded securities or private investments, every IRA investor should perform adequate diligence, understand the economics of the investment, as well as research the managers or promoters of the investment opportunity.Whether one invested in Silicon Valley Bank stock or a private real estate deal involving a local real estate promoter, investments have risks. It’s worth it to seek help with certified professionals before undertaking a new investment.
Using a Checkbook Control IRA LLC is Illegal
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments that require a high frequency of transactions (such as rental real estate) with limited liability protection.However, even after almost 30 years in use, it is still quite common for many IRA custodians to make the false claim that using a special purpose LLC owned by an IRA to make an investment is illegal.
Under the “Checkbook IRA” format, a limited liability company (LLC) is created, funded, and owned by the IRA, and managed by the IRA owner. This allows one to eliminate certain costs and delays often associated with using a full-service IRA custodian. Limited liability protection and a greater level of privacy are two additional benefits of the structure.The Checkbook IRA LLC allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
The use of the IRA LLC was deemed legal by the Tax Court and IRS for over 18 years before a 2013 Tax Court case, TC Memo 2013-245, directly confirmed that the use of a newly established LLC wholly owned by an IRA and managed by the IRA holder would not trigger a prohibited transaction. On October 2013, the Tax Court held that establishing a special purpose LLC to make an investment did not trigger a prohibited transaction, as a newly established LLC cannot be deemed a disqualified person pursuant to Internal Revenue Code Section 4975.
The notion of using an entity owned by an IRA to make an investment was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996). In Swanson, the Tax Court, in holding against the IRS, ruled that the capitalization of a new entity by an IRA for making IRA related investments was a permitted transaction and not prohibited pursuant to 4975. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011.
The impact of TC Memo 2013-245 is enormous because it directly supports the position that a retirement account can fund a newly established LLC without triggering a prohibited transaction. TC Memo 2013-245 is decisive because it will silence anyone who claims that using a special purpose LLC to make IRA investments would trigger a prohibited transaction and is not permitted by the IRS.
So why do some IRA custodians still make the false claim that using an LLC owned by an IRA to make an investment is not permitted? In general, the answer comes down to money.Many IRA custodians have built a fee model that is based on transaction fees.Using a Checkbook IRA takes the day-to-day operations of the IRA investment out of the hands of the IRA custodian and allows the LLC manager to transact on behalf of the LLC.What’s even more out of touch with reality is that in order to get a government loan for a real estate deal with Fannie or Freddie Mae, one has to use an LLC. Plus, the IRS partnership form K-1 even has a question that requests as to whether the entity is owned by an IRA or not.
In sum, for over 30 years, the Self-Directed IRA LLC has been used by millions of IRA investors to make IRA investments and gain added protection for their investment through the power of limited liability protection.
The Self-Directed IRA cannot be Used by a Roth IRA
The Roth IRA is one of the most powerful tax shelters that can be used by almost all Americans.The ability to make alternative asset investments with an IRA, also apply to the Roth IRA. The same IRS prohibited transaction rules under IRC Section 4975 that apply to IRAs also apply to Roths.
The Taxpayer Relief Act of 1997 created the Roth IRA. The main distinction between a traditional IRA and a Roth IRA is when taxes are taken. Traditional IRAs are tax-deductible, meaning taxes aren’t due until you make a withdrawal. However, there are no deductions with a Roth. They are funded with after-tax money. However, all qualified distributions are tax free! So long as the IRA holder is over the age of 59 and a half and any Roth IRA account has been established for at least five years, all withdrawals, including earnings, are not subject to tax.
Therefore, any type of IRA can be established as a Self-Directed IRA whether it’s a traditional or Roth IRA, or even a SEP or SIMPLE IRA. They can all be self-directed assuming your custodian allows for it. IRA Financial can set up any IRA as self-directed!
I cannot Invest in a Business I am involved in with a Self-Directed IRA
The Internal Revenue Code (IRC) does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits disqualified persons from engaging in certain type of transactions. The definition of a “disqualified person” extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity (50%) or management interest. In general, when using an IRA to make an investment, the IRS requires that the investment be made to exclusively benefit the IRA. Hence, the IRA investor cannot personally benefit directly or indirectly from any IRA investment.
There are some financial advisors that make the false claim that one cannot use an IRA to invest in a private business where the IRA owner (or any disqualified person) owned an interest in.This claim is false based on the language of IRC 4975 – an individual that will own less than 50% of an entity can use a Self-Directed IRA to make the investment.If one wants to invest in a business in which his/her total ownership, including personal and IRA funds, will be less than 50%, and the IRA owner can show that the investment was made exclusively to benefit the IRA and that there is no self-dealing or conflict of interest, then the investment should not violate the prohibited transaction rules.
Self-Directed IRA Myths Conclusion
Over the last 30 years, the Self-Directed IRA and Checkbook IRA LLC have helped millions of Americans gain investment freedom and independence. However, some traditional IRA custodians and even some Self-Directed IRA custodians continue to make certain false claims involving the use of an IRA to make alternative asset investments.The purpose of this article was to present some of the most popular myths and false claims and address them with facts and legal substance!
