by Mat Sorensen | Jan 20, 2015 | Investing
IRAs are the most commonly held retirement account and annuities are one of the most popular investments for retirees. Despite the popularity of each, the two concepts shouldn’t ordinarily be combined together. On the topic of IRAs and annuities, I am routinely asked the following questions.
- Can I buy an annuity with my IRA?
- Should I buy an annuity with my IRA?
- How do I get out of an annuity I bought with my IRA?
- Can I roll-over my annuity IRA to a self-directed IRA?
In this article I’ll answer each question, but before I do, let me first explain how an annuity works as it is essential to understanding the questions and your options. IRS Publication 939 is helpful in explaining the annuity tax rules and can be found here.
Annuity Basics
An annuity is an insurance product you can purchase whereby you invest funds with the annuity insurance company and they agree to make payments to you for the rest of your life or for a set period of years. The typical candidates of annuities are retirees seeking a guaranteed steady stream of income. The retiree gives up their cash now in exchange for payments back from the insurance company over time. There are many different types of annuities but the two most common are fixed annuities and variable annuities. In a fixed annuity, the insurance company agrees to pay you back based on a fixed payment schedule. Under a variable annuity, the insurance company agrees to pay you back based on the performance of the annuity investment (you have some limited choices in how those funds are invested in a variable annuity).
An annuity can begin paying you back immediately or it can be invested over a period of time and grow tax deferred and then later pay you out at retirement age. The income from an annuity is taxed as it is received by the annuity owner. Typically, when you receive payments from an annuity you personally own (outside a retirement account), a portion of the payment is taxable (the income/growth part) and the portion that is a return of your investment or premium is not taxable. The portion of the annuity payment that is taxable is subject to ordinary income tax rates.
Tax Deferral
One of the benefits of an annuity is that the funds grow in the annuity tax deferred with the funds compounding and without having to pay tax on any income the IRS. When you start receiving payments from the annuity, the funds you invested into the annuity are not taxed but the earnings are taxed.
No Contribution Limits
When you purchase an annuity outside of a retirement account such as an IRA, you can invest as much money as you want and you are not limited to annual contribution limits like you are with IRAs or 401(k)s. So, for example, if you want to buy a $250,000 annuity with $250,000 of cash, then you can make that investment all in one-year. You are not subject to $5,500 annual contribution limits.
Early Penalty
If you take funds from an annuity before you’re 59 ½, you’re subject to a 10% early withdrawal penalty on any taxable earnings. Any investment gains (above your initial investment) are also subject to tax and must be included as regular income on your personal tax return.
Surrender Charge
When you own an annuity you will typically have an account value for that annuity and if you decide to “cash-out” the annuity, instead of receiving the scheduled payments, you will likely be subject to a surrender charge. The surrender charge differs amongst annuity products and companies but the most common penalty is a 7% surrender charge during your first couple of years and then it goes down 1% each year until it is removed. So, if you have only had an annuity for a few years it is likely that you will have to pay the insurance company a surrender charge in order to “cash-out” the annuity. If you have had an annuity for ten years or longer, you are likely able to “cash-out” the annuity without penalty.
IRAs and Annuities
Now that we have the basics of annuities out of the way, let’s get to the questions about annuities and IRAs.
1. Can I buy an annuity with my IRA?
Yes, you can purchase an annuity with your IRA. However, just because you can doesn’t mean that you should. In my opinion, annuities can be part of a well structured financial plan but should be purchased with non- retirement plan (e.g. IRA) funds.
2. Should I buy an annuity with my IRA?
Probably not. One of the benefits of an annuity is that it gives you tax-deferral on the income that is being generated and as a result, using an IRA where you already obtain tax-deferral just doesn’t seem to make sense. If you like the annuity concept of fixed and guaranteed payments, albeit with modest gains from your principal, then you should consider an annuity with your non-retirement plan funds as those dollars aren;t getting any special treatment under the tax code when they are invested. If you already have a large nest-egg of retirement plan funds, why use that set of tax favorable funds to buy an investment product that you could buy with non-retirement plan funds and receive the same tax-treatment. Some say that buying an annuity with an IRA is like wearing a belt and suspenders since your money is already tax-deferred in a traditional IRA. Secondly, annuities are subject to surrender charges and as a result you are locked into that investment and face surrender penalties at the investment level (let alone the account level) if you want to get money out of the annuity to invest in something else or for personal use.
3. How do I get out of an annuity bought with my IRA?
You can usually “cash-out” your annuity owned by your IRA, however, cashing out the annuity to the account value will typically cause a surrender charge. Most annuities have a surrender charge during the first 7 years or so, whereby the penalty is 7% for the first year or two and then decreases 1 percent each year until it is removed. Check with you annuity company or financial advisor in your specific situation though as the products and surrender charges do vary. If you “cash-out” an annuity owned with IRA funds and if those funds are returned to an IRA, then there is no taxable distribution or tax penalty. The only “penalty” would be the surrender penalty by the annuity insurance company. If you take the cash personally though, instead of sending it to your IRA, then those funds are subject to the regular IRA distribution rules and as a result you could be subject to taxes and early withdrawal penalties on the amounts received.
4. Can I roll-over my annuity IRA to a self-directed IRA?
Yes. You can roll-over your annuity IRA to a self-directed IRA. You’ll need to “cash-out” the IRA, pay any applicable surrender charges, and then instruct the annuity company to process a direct roll-over of the funds to your self-directed IRA custodian as a direct rollover. This rollover will NOT be subject to taxes or penalties. Keep in mind though, there may be a surrender penalty though with the annuity company. If there is a surrender penalty, you’ll want to determine whether the benefit and payments owed under the annuity are worth hanging on to the annuity investment or if you are better off simply paying the penalty and moving on to other investment options.
Unfortunately, the annuity and IRA rules can be a little tricky, but once understood you can make informed decisions about how to best use and invest your retirement dollars.
by Mat Sorensen | Dec 16, 2014 | Investing
In 1986, Congress allowed individual retirement accounts (IRA) to invest in precious metals bullion. Since then, many IRA owners have purchased and held precious metals bullion coins and bars in IRAs as a hedge against inflation and to diversify their retirement assets.
This white paper summarizes the legal requirements for purchasing and holding precious metals bullion in an IRA. The focus of this white paper is on the legal requirement that a bank remain in physical possession of precious metals bullion that is held in an IRA.
As a background, collectibles are prohibited from being held in an IRA.[1] A collectible is tangible personal property such as a stamp or coin, metal or gem, wine or a work of art.[2] In form and substance, collectibles are much different than traditional IRA investments like stocks, bonds, and certificates of deposit that offer no benefit of aesthetic value, personal use or consumption. The general theory behind the prohibition on investing in collectibles is that tax-deductible IRA assets should not be used, displayed, or enjoyed by an IRA owner before retirement or early distribution. If an IRA purchases or holds a collectible, then that asset is distributed from the IRA and the assets are deemed to be a collectible. A distribution typically results in taxes and penalties assessed to the IRA owner.
Congress created a very limited exception to the prohibition on holding collectibles in an IRA when it exempted certain precious metals bullion coins and bars from the definition of a collectible.[3] Section 408(m) of the Internal Revenue Code states:
(3) Exception for certain coins and bullion.–For purposes of this subsection, the term “collectible” shall not include –
(A) any coin which is –
(i) a gold coin described in paragraph (7), (8), (9), or (10) of section 5112(a) of Title 31, United States Code[4],
(ii) a silver coin described in section 5112(e) of Title 31, United States Code[5],
(iii) a platinum coin described in section 5112(k) of Title 31, United States Code[6], or
(iv) a coin issued under the laws of any State, or
(B) any gold, silver, platinum, or palladium bullion of a fineness equal to or exceeding the minimum fineness that a contract market (as described in section 7 of the Commodity Exchange Act, 7 U.S.C. 7) requires for metals which may be delivered in satisfaction of a regulated futures contract[7],
if such bullion is in the physical possession of a trustee described under subsection (a) of this section.
This white paper seeks to clarify the final paragraph of the subsection that requires a “trustee” to be in “physical possession” of precious metals bullion held in an IRA.
A “trustee” is a “bank…or such other person who demonstrates to the satisfaction of the Secretary [of the U.S. Treasury] that the manner in which such other person will administer the [IRA] will be consistent with the requirements of this section.”[8] A “bank” is defined as: (1) any bank; (2) an insured credit union; and (3) a corporation which, under the laws of the State of its incorporation, is subject to supervision and examination by the Commissioner of Banking, or other officer of such State in charge of the administration of the banking laws of such State.[9]
To be considered “a trustee,” an entity must be a bank, a credit union, a trust company or any other regulated entity supervised and examined by the banking commission of the state in which it is established. If an entity does not fit within a category above, it cannot be a “trustee” of IRA assets.[10]
Notably, the IRS has issued guidance on the issue of whether two non-bank entities could store precious metals bullion that is held in IRAs.[11] In deciding this issue, the IRS noted that the “limited exception” that allows IRAs to invest in bullion coins and bars “applies only if a certain type of bullion is in the physical possession of the IRA trustee.” The IRS then concluded that bullion stored by a non-bank, and not by a trustee, would be considered collectibles and treated as a distribution from the IRA and subject the IRA owner to taxes and penalties.
As a corollary to the “trustee” requirement, a “trustee” must be in “physical possession” of acceptable precious metals bullion. Unlike the term “trustee,” the Internal Revenue Code does not define what “physical possession” means.
To accurately interpret what “physical possession” means, a three-step approach is required. First, the term “physical possession” must be given its ordinary and common meaning. Second, since an investment in precious metals is a very limited exception to the general rule that collectibles are prohibited from being held in an IRA, the language in this exception must be narrowly construed so that the exception does not “swallow the rule.”[12] Third, interpretation of the term “physical possession” must take into account, and be in harmony with, the legislative intent of the exception that allows IRAs to invest in precious metals bullion coins and bars.
Black’s Law Dictionary is an authoritative source of legal definitions that is useful in obtaining the meaning of physical possession, and distinguishing it from “constructive possession” of tangible personal property. Physical possession describes the actions of “a person who knowingly has direct physical control over a thing.”[13] In contrast, constructive possession describes the actions of “[a] person who, although not in actual possession, knowingly has both the power and the intention at a given time to exercise dominion or control over a thing, either directly or through another person or persons.”[14] A trustee is in physical possession of precious metals bullion if it has actual, physical control over such bullion. Constructive possession does not amount to physical possession because a trustee is merely exercising custodial control over the bullion, as opposed to being in actual, physical possession of the bullion.
As an example, if an IRA custodian were to delegate to a non-bank the responsibility of storing precious metals bullion in its custody, the “physical possession” requirement would not be met because the non-bank, and not a trustee, is in actual, physical control of bullion held in an IRA. Therefore, an IRA custodian (or any other trustee) should not delegate storage of bullion in an IRA to any party who itself does not qualify as a “trustee.”
Courts that are called upon to interpret the meaning of “physical possession” in Section 408(m) would be required to narrowly interpret that term because that term is included within an exception to the general rule that collectibles should not be held in IRAs. A narrow interpretation of the modifier “physical,” next to and in connection with the term “possession,” naturally yields a finding that a trustee must have direct physical control over bullion.
For example, if an IRA custodian leases depository space from a non-bank, and precious metals bullion stored within the leased space is exclusively handled and stored by non-bank’s employees, the IRA custodian cannot be said to be in physical possession of the bullion. This is because the non-bank’s employees maintain physical control of the bullion. Put simply, a literal and narrow interpretation of physical possession would lead to the conclusion that the IRA custodian’s metaphysical control over its leased space is not tantamount to physical possession.
Lastly, the legislative intent in requiring “physical possession” of bullion by a trustee must be examined. Section 408(m) is a very limited exception to the general prohibition on holding collectibles in an IRA. It allows an IRA to invest in certain precious metals that are unlike traditional investments because they are tangible items that are portable, durable, and liquid. These unique characteristics of bullion coins and bars underscore the need to require a regulated or Treasury-approved entity store this type of IRA asset. Without such a requirement, bullion could come into the IRA owner’s possession or be stolen – without a trace of evidence – prior to retirement or early distribution.
In conclusion, to avoid the possibility of otherwise acceptable bullion being deemed a “collectible” by the IRS (and, by extension, treated as a distribution from the IRA), the prudent course for IRA custodians, third-party administrators, and IRA owners is to deposit bullion into the custody and safekeeping of a precious metals depository that meets the Internal Revenue Code’s definition of a “bank” (i.e., a bank, credit union, or trust company). Storing in any other manner invites uncertainty to retirement planning, and it raises the distinct possibility that the retirement assets will be forfeited based on the decision to store bullion outside the physical possession of a trustee.
[1] 26 U.S.C.A. § 408(m)(1)
[2] 26 U.S.C.A. § 408(m)(2)
[3] 26 U.S.C.A. § 408(m)(3)
[4] Respectively refers to the one ounce ($50 face value), one-half ounce ($25 face value), one-fourth ounce ($10 face value), and one-tenth ounce ($5 face value) Gold American Eagle coins distributed by the United States Mint.
[5] Refers to one ounce Silver American Eagle coins distributed by the United States Mint.
[6] Refers to any platinum bullion and proof platinum coin distributed by the United States Mint.
[7] The minimum fineness requirement of each metal is as follows: Gold = 995 parts per 1,000 (99.5%); Silver = 999 parts per 1,000 (99.9%); Platinum = 999.5 parts per 1,000 (99.95%); Palladium = 999 parts per 1,000 (99.95%)
[8] 26 U.S.C.A. § 408(a)(2)
[9] 26 U.S.C.A. § 408(n)
[10] A nonbank may approved as a “nonbank trustee” if it is approved by the US Treasury upon demonstrating, among other things, that it is experienced in discharging fiduciary duties. See, 26 C.F.R. § 1.408-2(e)
[11] I.R.S. P.L.R. 200217059 (Apr. 26, 2002)
[12] See, e.g., In re Woods, 743 F.3d 689, 699 (10th Cir. 2014) (“we are guided by the interpretive principle that exceptions to a general proposition should be construed narrowly.”)
[13] Black’s Law Dictionary, 606-607 (5th Ed. 1983).
[14] Black’s Law Dictionary, 1163 (6th Ed. 1990).
About the Author:
Mat Sorensen, Esq. is a partner at KKOS Lawyers in its Phoenix, AZ office. Mat is the author The Self Directed IRA Handbook
Scott B. Schwartz, Esq., contributed to the content of this paper.
by Mat Sorensen | Sep 9, 2014 | Investing
Every buyer of a small business should consider the following three key legal issues when acquiring a business.
1. Buy Assets and Not Liabilities. Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions. A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business. There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible. Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.
2. Negotiate For Some Seller Financed Terms. Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full. Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.
3. Conduct Adequate Due Diligence. While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.
Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign. Oh, and make sure you get a well drafted set of purchase documents to sign.
by Mat Sorensen | Aug 12, 2014 | Investing
We’ve all heard the buzz words of crowdfunding, PPMs, and IPOs, but there are less complicated ways to raise money and start a business and one of the most reliable and most used methods is that of partnerships or joint ventures.
If you ‘re raising money from others in an LLC, partnership, or joint venture, you must take specific precautions in structuring your documents so that the investment of money from any member, partner, or joint venturer does not constitute a violation of federal or state securities laws. Failure to comply with the securities laws can result in civil and criminal penalties. Many real estate investments, real estate developments, and emerging companies rely on numerous strategies to raising capital that are outside of publicly traded stock and that do not require registration with a state securities division or the federal Securities and Exchange Commission. This article addresses those strategies and outlines some of the key issues to consider when raising funds through an LLC, partnership, or joint venture arrangement. This article addresses the legal considerations that should be analyzed when bringing in “cash partners” or “investors” into your LLC, partnership, or joint venture.
Is the LLC Member, Partner or Joint Venturer Contributing More Than Just Money?
The courts have widely held that an investment in an LLC, joint venture, or partnership is a security when the investor is investing solely cash and has no involvement, vote, or say in the investment. In these instances where the investor just puts in cash (sometimes called “silent cash partner” arrangements), the investment will likely be deemed a security. In a famous securities law case called Williamson, the Fifth Circuit Court of Appeals held that a joint venture contract investment is a security if the investor has little say or voting power, no involvement in the business or investment, and no experience that would provide any benefit to the business or investment. Williamson, 645 F.2d 424. As a result, to avoid triggering these factors and having your investment or business deemed a security we strongly recommend that all investors in Joint Venture agreements, LLCs, or partnerships have voting rights and that they participate in the key decision-making functions of the investment or business. Investors do not have to be part of the management team but they do need to have voting rights and need to have real opportunities to use those voting rights. For example, they could have voting rights on incurring additional debt, on management compensation, and/or on buying or selling property.
Don’t Give Yourself Unlimited Control as Manager
In most LLCs with cash partners, the person organizing the investment and running the operations is often the manager of the LLC, partnership, or joint venture and has the ability to bind the company or partnership. When making this selection as the manager, it is key that you do not give yourself unlimited control and authority. If you do give yourself unlimited control as manager, your investors may be deemed to have purchased a security since their voting rights will have been extinguished by placing to much control and power in the manager/management. What is recommended is that the members have the ability to remove the manager by majority vote and that the manager may only make key decisions (e.g. incurring debt, selling an asset, setting management salaries, etc.) upon the agreement and majority vote of the investors. While key decisions and issues should be left to the members, day to day decisions can be handled by the manager without a vote of the members/investors.
Don’t Combine Too Many People Into One LLC, JV or Partnership
The Courts have consistently held that even if an investor is given voting rights and has an opportunity to vote on company matters that the investor’s interest can be deemed a security if there are too many other investors involved in the LLC, JV, or Partnership. Holden, 978 F.2d 1120. As a general rule of advice, you should only structure investments and partnerships that include 5 or less cash investors as the securities laws and the involvement of more individuals than this could potentially cause the investment to be deemed a security. When there are more than 10 investors it is critical for clients to consider structuring the investment as a Regulation D Offering and that they complete offering documents and memorandums and make a notice filings to the SEC. Many people refer to this type of investment structure as a PPM. When there are a lot of investors involved, a Regulation D Offering provides the person organizing the investment with exemptions from the securities laws and can allow someone to raise an unlimited amount of money from an un-limited amount of investors.
In sum, there are many factors and issues to consider when raising money from others in an LLC, JV, or partnership and it is crucial that you properly structure and document these investments so that they can withstand thes challenges of securities law violations. For help in structuring your investments please contact the law firm at 602-761-9798.
