There has been a significant increase in the amount of marketing directed towards IRA owners for non-publicly traded investments. Many of these investment sponsors and promoters are using marketing slogans like “IRS Approved” or “IRA Approved”. Don’t be fooled though, as the IRS does not review or approve investments, nor do they comment or issue statements on investments in an IRA. In fact, the IRS recently revised and updated IRS Publication 3125 titled, “The IRS Does Not Approve IRA Investments,” in an effort to inform IRA investors.
IRAs Can Invest into Non-Publicly Traded Investments (Real Estate, LLCs and Precious Metals)
Yes, it’s true that a self-directed IRA can invest into real estate, LLCs, LPs, private stock, venture or hedge funds, start-ups and qualifying precious metals, among other things. However, just because you can invest in all of these assets doesn’t mean that you should. Make sure you’re investing your IRA into assets you are familiar with, and with persons and companies with whom you have thoroughly vetted. Non-publicly traded investments can be easier to understand and vet than a mutual fund prospectus, but you need to be careful when investing your funds with another person or when buying investments from third-parties who regularly sell to IRA owners using comforting, yet totally false, representations like “IRA Approved” or “IRS Approved.”
“IRA Approved” or “IRS Approved” Representations are False
Avoid any investment touted as “IRA Approved” or otherwise endorsed by the IRS.
Don’t buy an investment on the basis of a television “infomercial” or radio advertisement.
Beware of promises or no-risk, sky-high returns on exotic investments from your retirement account.
Never transfer or rollover your IRA or other retirement funds directly to an investment promoter.
Proceed with caution when you are encouraged to invest in a “general partnership” or “limited liability company”.
Don’t be swayed by the fact that a bank or trust department is serving as an IRA custodian.
Always check out an investment and promoter before you turn over your money.
Educate yourself about IRAs and retirement planning.
Exercise extra caution during tax season when it comes to making IRA investments.
As a self-directed IRA investor, you are solely responsible for investment decisions, and as a result you must make certain that you understand the investments you are selecting and the associated risks. Beware of slogans and terms like “IRA Approved” or “IRS Approved,” as such slogans are just false. In addition to the consideration from the IRS above, I’ve previously written my own “Self Directed IRA Investment Due Diligence Top Ten List” which includes additional tips and questions to ask when investing your hard-earned retirement plan dollars with others.
Take the IRS guidelines and my Top Ten List into consideration when investing your IRA, but in the end, don’t be scared about investing into non-publicly traded investments. Rather, keep the risk and opportunities in perspective, and realize that you may need to get out of your comfort zone by asking pointed questions, demanding additional documentation, or simply saying “no.” Remember: You are the best person to protect your retirement.
If you’ve inherited an IRA from a parent or other loved one, it is likely that you have a beneficiary IRA. These can be powerful accounts, but you need to understand the required minimum distribution (“RMD”) rules for your beneficiary IRA to properly utilize it. The inherited IRA may be a traditional or Roth IRA and there are three different distribution options you may elect when you inherit the IRA.
You will have three distribution options upon the death of your loved one to receive the funds from their IRA. In general, the best option is the “Life Expectancy Method” as it allows you to delay the withdrawal of funds from the IRA, and allows the money invested to grow tax-deferred (traditional) or tax-free (Roth). The three options are outlined fully below:
1. Lump Sum
The first option is to simply take a lump-sum and be taxed on the full distribution. There is no 10% early withdrawal penalty (regardless of your age or their deceased owner), but you are taxed on the amount distributed if it is a traditional IRA. You’re also giving up the tax-deferred (traditional) or tax-free (Roth) benefits of the account. Don’t take this option. It’s the worst tax and financial option you have.
2. Life Expectancy Method
The Life Expectancy Method is the best option. Under this option, you take distributions from the inherited IRA over your life-time based on the value of the account. These distributions are required for traditional IRAs and even for inherited Roth IRAs. For example, if you inherited a $100,000 IRA at age 50, you would have to take about $3,000 a year as a required minimum distribution each year. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty. Traditional beneficiary IRA distributions are taxable to the beneficiary, and Roth IRA distributions are tax-free. And yes, beneficiary Roth IRAs are subject to RMD even though there is no RMD for regular Roth IRAs.
3. 5-Year Method
This option is available to all inherited Roth accounts, but is only available to inherited traditional IRAs where the deceased account owner was under age 70 1/2 at the date of their death. Under this option, the beneficiary IRA is not subject to RMD. However, it must be fully distributed by December 31st of the fifth year following the year of the account owner’s death. There is no 10% early withdrawal penalty, and distributions are subject to tax. Again, this option is only available to traditional accounts.
Investing with a Self-Directed Beneficiary IRA
Yes, you can self-direct your beneficiary IRA. Before you do, make sure you understand the amount of funds you’ll need to take as an RMD, and that you will have available cash in the account to cover the those RMDs. As I described above, assume you are 50 and inherited a beneficiary IRA for $100,000. You will need to take annual distributions of around $3,000. So, if you invest all of the $100,000 into an illiquid asset, then you will be unable to take RMDs and force the IRA account to pay stiff penalties. Consequently, when making a self-directed investment from a beneficiary IRA, you must take into account the amount of the investment, the total value of the account, and the time-line of the investment (when will it generate cash back to the IRA). If you inherited the $100,000 account above, you may decide to only invest $70,000 of the beneficiary IRA into an illiquid investment (e.g. real estate or private company), while leaving the other $30,000 to be invested into liquid investments like publicly-traded stocks, CDs, cash or mutual funds. This will leave funds available for RMD until such time as the illiquid investment generates income or is sold for profit.
Stretching out the benefits of an inherited IRA can be powerful, but make sure you plan for RMDs before you make any self-directed investment from your beneficiary IRA.
A common question among self-directed IRA investors is, “Can I buy a future retirement home with my IRA?” Yes, you can buy a future retirement home with your IRA, but you need to understand the rules and drawbacks before doing so. First, keep in mind that IRAs can only hold investments and you cannot go buy a residence or second home with your IRA for personal use. However, you can buy an investment property with a self-directed IRA (aka “SDIRA”) that you later distribute from your IRA and use personally.
The strategy essentially works in two phases. First, the IRA purchases the property and owns it as an investment until the IRA owner decides to retire. You’ll need to use a SDIRA for this type of investment. Second, upon retirement of the IRA owner (after age 59 ½), the IRA owner distributes the property via a title transfer from the SDIRA to the IRA owner personally and now the IRA owner may use it and benefit from it personally as the asset is outside the IRA. Before proceeding down this path, an SDIRA owner should consider a couple of key issues.
Avoid Prohibited Transactions
The prohibited transaction rules found in IRC Section 4975, which apply to all IRA investments, do not allow the IRA owner or certain family members to have any use or benefit from the property while it is owned by the IRA. The IRA must hold the property strictly for investment. The property may be leased to unrelated third parties, but it cannot be leased or used by the IRA owner or prohibited family members (e.g., spouse, kids, parents, etc.). Only after the property has been distributed from the self-directed IRA to the IRA owner may the IRA owner or family members reside at or benefit from the property.
Distribute the Property Fully Before Personal Use
The property must be distributed from the IRA to the IRA owner before the IRA owner or his/her family may use the property. Distribution of the property from the IRA to the IRA owner is called an “in-kind” distribution, and results in taxes due for traditional IRAs. For traditional IRAs, the custodian of the IRA will require a professional appraisal of the property before allowing the property to be distributed to the IRA owner. The fair market value of the property is then used to set the value of the distribution. For example, if my IRA owned a future retirement home that was appraised at $250,000, upon distribution of this property from my IRA (after age 59 ½) I would receive a 1099-R for $250,000 issued from my IRA custodian to me personally.
Because the tax burden upon distribution can be significant, this strategy is not one without its drawbacks. Some owners will instead take partial distributions of the property over time, holding a portion of the property personally and a portion still in the IRA to spread out the tax consequences of distribution. This can be burdensome though, as it requires appraisals each year to set the fair market valuation. While this can lessen the tax burden by keeping the IRA owner in lower tax brackets, the IRA owner and his/her family still cannot personally use or benefit from the property until it is entirely distributed from the IRA. Many investors will use an IRA/LLC and will transfer the LLC ownership over time from the IRA to the IRA owner to accomplish distribution.
For Roth IRAs, the distribution of the property will not be taxable as qualified Roth IRA distributions are not subject to tax. For an extensive discussion of the tax consequences of distribution, please refer to IRS Publication 590.
Additionally, keep in mind that the IRA owners should wait until after he/she turns 59 ½ before taking the property as a distribution, as there is an early withdrawal penalty of 10% for distributions before age 59 ½.
As stated at the outset of this article, while the strategy is possible, it is not for everyone and certainly is not the easiest to accomplish. As a result, self-directed IRA investors should make sure they understand the rules – no personal use while owned by the IRA – and drawbacks – taxes upon distribution and before personal use – before purchasing a future retirement home with their IRA.
The so-called “DOL Fiduciary Rule” went into effect in June and has caused negative repercussions on self-directed retirement account investors who self-directed their IRA, 401(k), or pension into alternative investments. Many self-directed investors have been shut out from investing into private offerings – real estate funds, private placements, start-ups, private REITs, etc. – as investment sponsors or private companies raising funds fear that, by accepting the self-directed retirement account’s investment, they will be labeled a “fiduciary” and will need to adhere to fiduciary rules really meant for investment advisers.
What is a Fiduciary?
The Department of Labor (“DOL”) recently expanded the definition of who a “fiduciary” is to include any person or entity who renders “investment advice” for a fee or other compensation. The fee doesn’t need to be from the compensation itself, but just has to flow from the investment. Here’s the problem: If you run a private fund, start-up, or a real estate partnership, and you take investment dollars from a retirement account, then the DOL definition may include you as a fiduciary since your investment documents will likely contain information that would be considered “investment advice.” And, since you will indirectly receiving compensation as a part of management of the fund or start-up, then you are indirectly receiving a fee for providing investment advice and may consequently be deemed a fiduciary.
Fiduciary Rule Repercussions
Most investment sponsors dread being labelled a fiduciary as they are placed with very high legal standards including as the duty of prudence, the duty of loyalty, and they have to avoid self-dealing prohibited transactions that may arise if they are receiving any compensation that isn’t found to be “reasonable”. In short, application of the fiduciary rule makes them re-align the company’s or management’s interests to be in the best interest of the invested retirement account. While this sounds like a good deal for the retirement account investor – and it is – it puts the interests of management at odds with the retirement account, and creates significant liability to management if they accept retirement plan dollars when they are a fiduciary.
The fiduciary rule was primarily intended to apply to an adviser advising a client so that the investment adviser recommended investments in the best interest of the client, not just the highest paying commission for the adviser. Although that makes sense, the new definition is so broad that it also could apply to the company raising funds from a self-directed IRA or 401(k), and force those companies to reject investment dollars from self-directed IRAs and 401(k)s.
There are two exceptions to the Fiduciary Rule that will allow a self-directed retirement account to invest into a private investment offering: Independent Fiduciaries and Best Interest Contract Exemption.
If the self-directed retirement account investor has an independent fiduciary, then that fiduciary is responsible for their investment advice and the offering company won’t be deemed a fiduciary. An independent fiduciary would include a registered investment adviser or a broker-dealer. Consequently, if a self-directed IRA investor had an investment adviser who reviewed the investment, then the offering company would likely not be deemed a fiduciary for this investment. I’ve seen numerous companies starting to require this for all retirement account investments. For those clients who already use an investment adviser, this is easier to comply with. But, most self-directed investors do not use an adviser, and as a result would need to spend money to engage one for the purposes of reviewing the investment just so they could qualify to invest.
Best Interest Contract Exemption (BICE)
The second exemption is the best interest contract exemption, otherwise known as “BICE.” BICE provides that a person is exempt from the fiduciary rule, but has lengthy requirements that really won’t work for an investment sponsor or someone raising private capital from an IRA. Based on the requirements, it will really only work for advisers or insurance companies offering financial products.
What to Do Moving Forward?
Many private investment offerings are not restricting self-directed accounts yet. They are either agreeing that they are fiduciaries and are taking that into account their company’s operations or they are taking the legal position that the fiduciary rule doesn’t apply to them, which may be correct as the law is new and still unclear. However, if you end up being restricted from investing your self-directed IRA or 401(k) into a private investment because the offering company is worried about the fiduciary rule, you may choose to rely on the Independent Fiduciary exemption and could engage an investment adviser – if you don’t already have one – to review this investment and serve as the fiduciary for the investment.
Yes, your IRA can invest in and own bitcoin and other cryptocurrencies. Bitcoin is a form of virtual currency using blockchain technology, and can be exchanged between parties for goods and services, or for dollars. From 2011 to July 2017, the value of Bitcoin has risen from $0.30 per Bitcoin to $2,550 per Bitcoin. As a result, we’ve seen a significant increase in the number of questions from investors whether their retirement account can invest in and own actual Bitcoin or other forms of cryptocurrency.
Can Your IRA Own Bitcoin?
Well, the short answer is: “Yes, your IRA can own Bitcoin and other forms of cryptocurrencies, such as Ethereum and Litecoin.” The only items an IRA cannot invest in is life insurance, S-Corp stock, and collectibles as mentioned in IRC 408(m), which refers to tangible personal property such as “art, rugs, coins, etc.” and “any other tangible personal property the Secretary determines.” Bitcoin is certainly an intangible item by all accounts and would not be considered tangible. As a result, an IRA can own Bitcoin or other cryptocurrency since such investments are not restricted.
How Are Bitcoin Gains Taxed?
The IRS issued IRS Notice 2014-21 addressing the taxation of Bitcoin and cryptocurrency, and stated that Bitcoin and other forms of virtual currency are property. The sale of property by an IRA is generally treated as capital gain, so the buying and selling of cryptocurrency for investment purposes wouldn’t trigger unrelated business income tax (UBIT) or other adverse tax consequences that can occasionally arise in an IRA.
How Do I Own Bitcoin with My SDIRA?
There are three steps to own Bitcoin or other cryptocurrency with your IRA:
1. First, you will need a self-directed IRA with a custodian who allows for alternative assets, such as LLCs.
2. Second, you will invest funds from the IRA into the LLC. Your IRA will own an LLC 100%, and that LLC will have a business checking account. For more details on IRA/LLCs, please check out my prior video here.
3. And third, the IRA/LLC will use its LLC business checking account to establish a wallet to invest and own Bitcoin through the wallet. The most widely used Bitcoin wallet is through a company called Coinbase, and you can use your wallet on Coinbase to buy, sell and digitally store your cryptocurrency.
There are already certain publicly-traded funds and other avenues (e.g. Bitcoin Investments Trust) where you can own shares of a fund that in turn owns Bitcoin. But, if you want to own Bitcoin directly with your IRA, you’d need to follow the steps outlined above. Keep in mind, Bitcoin and other forms of cryptocurrency have significant potential in the digital age. However, as with any new market investment, make sure you proceed with caution, and don’t “bet the farm” or “go all in” on just one investment or deal.
There are 25 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments (e.g. Bitcoin and cryptocurrencies). It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. There are over 30 companies who provide self-directed IRAs. For a detailed list of the companies that provide these types of accounts, check out the Retirement Industry Trust Association’s website and membership list. RITA is the national association for the self-directed retirement plan industry, and most major companies who provide these accounts are members of RITA.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 39.6% at $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
So, here’s a brief summary of what we’ve learned. First, there’s $25 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.
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Tom W. Anderson
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CEO / Polycomp Trust Company
"The Self Directed IRA Handbook by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA."
Founder and Retired CEO, PENSCO Trust Company
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.