Top Ten Frequently Asked Self-Directed IRA Questions (and Answers)

Attendees listening to attorney Mat Sorensen at the Self-Directed IRA Summit 2017 with the text "Top Ten Frequently Asked Self-Directed IRA Questions and Answers"It’s finally here: My top ten list of frequently asked self-directed IRA questions! Whether you’re just getting started or you’ve been investing with a self-directed account for decades, make sure you know the answers to these ten questions. In most instances, I’ve linked to more comprehensive articles and videos on the subject. And of course, you can always crack open the best-selling book on the subject for even more information and detail: The Self-Directed IRA Handbook.

 

1. What is a self-directed IRA?

A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include: Real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is, “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.

2. Can I rollover or transfer my existing retirement account to a self-directed IRA?

Well, it depends. Here’s my chart that breaks down every possible scenario:

SituationTransfer/Rollover 
I have a 401(k) account with a former employer.Yes, you can rollover to a self directed IRA. If it is a Traditional 401(k), it will be a self-directed IRA. If it is a Roth 401(k), it will be a self-directed Roth IRA.
I have a 403(b) account with a former employer.Yes, you can roll-over to a Traditional self-directed IRA.
I have a Traditional IRA with a bank or brokerage.Yes, you can transfer to a self-directed IRA.
I have a Roth IRA with a bank or brokerage.Yes, you can transfer to a self-directed Roth IRA.
I inherited an IRA and keep the account with a brokerage or bank as an inherited IRA.Yes, you can transfer to a self-directed inherited IRA.
I don’t have any retirement accounts but want to establish a new self-directed IRA.Yes, you can establish a new Traditional or Roth self-directed IRA, and can make new contributions according to the contribution limits and rules found in IRS Publication 590.
I have a 401(k) or other company plan with a current employer.No, in most instances your current employer’s plan will restrict you from rolling funds out of that plan. However, some plans do allow for an in-service withdrawal if you are at retirement age.

 

3. What can a self-directed IRA invest in?

Under current law, a retirement account is only restricted from investing in the following:

And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).

The most popular self-directed retirement account investments include:

  • Rental real estate;
  • Secured loans to others for real estate (trust deed lending);
  • Private small business stock or LLC interest; and
  • Precious metals, such as gold or silver.

These investments are all allowed by law and can be great assets for investors with experience in these areas.

 

4. What restrictions are there on using a self-directed IRA?

When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes: The account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.

Here’s a diagram outlining who is disqualified to your IRA:

Prohibited transactions should be avoided as the consequence is distribution of the entire account involved.

 

5. Can my self-directed IRA invest in my personal business, company, or deal?

No, it would violate the prohibited transaction rules if your IRA transacted with you personally (or with a company you own). In addition, your IRA cannot transact with or benefit anyone who is a disqualified person (e.g. IRA owner, spouse, children, parents, spouses of children, etc.)

 

6. What is a checkbook-control IRA or IRA/LLC?

Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC (aka “checkbook-control IRA”) as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner, and the IRA owner then directs the LLC investments and the LLC to take title to the assets, pay the expenses to the investment, and receive the income from the investment. There are many restrictions against the IRA owner being the manager (such as not receiving compensation or personal benefit) and many laws to consider, so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, including cases and structuring options, please refer to my blog post, “New Case Answers Important Questions about IRA/LLCs.”

Here’s a simple diagram that outlines how the IRA/LLC (checkbook-control IRA) operates:

7. Can my IRA invest cash and can I get a loan to buy real estate with my IRA?

Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).

 

 

 

8. Are there any tax traps? What about UBIT/UBTI?

The tax UBIT applies when your IRA receives “unrelated business income.” However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income exempt from UBIT includes the following.

  • Real Estate Rental Income (IRC 512(b)(3)– Rent from real estate is investment income, and is exempt from UBIT.
  • Interest Income (IRC 512(b)(1)) – Interest and points made from the money lending is investment income, and is exempt from UBIT.
  • Capital Gain Income (IRC 512(b)(5)) – The sale, exchange, or disposition of assets is investment income, and is exempt from UBIT.
  • Dividend Income (IRC 512(b)(1))  Dividend income from a C-Corp where the company paid corporate tax is investment income, and exempt from UBIT.
  • Royalty Income (IRC 512(b)(2))  Royalty income derived from intangible property rights, such as intellectual property, and from oil/gas and mineral leasing activities is investment income, and is exempt from UBIT.

So, make sure your IRA receives investment income as opposed to “business income”.

There are two common areas where self-directed IRA investors run into UBIT issues and are outside of the exemptions outlined above. The first occurs when an IRA invests and buys LLC ownership in an operating business (e.g. sells goods or services) that is structured as a pass-thru entity for taxes (e.g. partnership), and does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income, it will flow down to the IRA as ordinary income on the K-1, and this will cause tax to the IRA as this will be business income and it does not fit into one of the investment income exemptions. If your IRA has UBIT income, it must file it’s own tax return using IRS Form 990-T. The second instance occurs when the IRA invests into real estate activities whereby the IRA is deemed to be in the business of real estate as opposed to investing in real estate (e.g. real estate development, construction, significant short-term real estate flips).

 

9. What is unrelated debt financed income (UDFI)?

If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as “unrelated debt financed income” (UDFI), and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan. For example, let’s say an IRA buys a rental property for $100,000, and that $40,000 came from the IRA and $60,000 came from a non-recourse loan. The property is thus 60% leveraged, and as a result, 60% of the income is not a result of the IRAs investment, but the result of the debt invested. Because of this debt, which is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of net rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.

For a more detailed outline on UDFI, please refer to my free one-hour webinar.

 

10. Should I use a solo 401(k) instead of a self-directed IRA?

A solo 401(k) is a great self-directed account option, and can be used instead of an IRA for persons who are self-employed with no other employees (other than business owners and spouses). If you are not self-employed, then the solo K will not work in your situation.

A solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions, as the solo 401(k) has much higher contribution amounts ($54,000 annually versus $5,500 annually for an IRA). On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts which can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.

Another major consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.

Here’s what the solo 401(k) look like and how the money flows:

 

 

Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account. Check out my blog article and video outlining the differences between self-directed IRAs and solo 401(k)s.

Maximize Roth 401(k) Dollars: What Can You Roll-Over or Convert to Roth in Your Solo 401(k)?

Photo of an adult Shiba Inu dog rolling over with text reading "Maximize Roth 401(k) Dollars: What Can You Roll Over or Convert to Roth in Your Solo 401(k)?"Many savvy investors have come to find Roth retirement accounts as a great tool to building long-term tax-free wealth. Roth IRAs were first introduced in 1997. Roth 401(k)s came around in 2006 but had many restrictions and were not widely offered. Under current 401(k) rules, you can contribute $17,500 a year to your Roth 401(k) account as an employee contribution. You can contribute up to an additional $34,500 to your 401(k) for the year, depending on your income, up to a total amount of $52,000 but the $34,500 would be employer contributions and must be Traditional dollars. So, if you’re self-employed and have a solo 401(k) and want to max-out your 401(k) contributions you could contribute $17,500 as Roth 401(k) dollars and $34,500 of Traditional 401(k) dollars. But what if you want all of the funds to be Roth 401(k) dollars? Well, have no fear; all you have to do is convert the Traditional 401(k) dollars to Roth. Also, what if you want to roll-over existing retirement accounts to your Roth 401(k)? This is also possible, you just have to roll the funds over and convert. This article outlines the brief history and details on how you can maximize your Roth 401(k) account.

The American Tax Payer Relief Act of 2012 (“ATRA”) totally changed the game for Roth 401(k)s. Following ATRA, Roth 401(k)s became significantly more beneficial to investors for one simple reason: you could more easily put your existing retirement plan dollars into it. Since 2012, any 401(k) account owner, whose plan offers a Roth 401(k) account (and most now do), is eligible to convert any and all of their existing Traditional 401(k) dollars to Roth 401(k) dollars. This includes Traditional IRA rollovers to the 401(k), 401(k) employee contributions, and vested 401(k) employer contributions. Keep in mind that when you convert any Traditional retirement plan dollars to Roth 401(k) dollars that you will be taxed on the amount converted. That’s what Roth retirement account dollars are. They are post-tax retirement plan funds (you’ve paid taxes on them already) that grow tax-free and are withdrawn at retirement tax-free (age 59 ½).

Transfer and Rollover Rules

Additionally, funds in prior employer Roth 401(k)’s may be rolled into your existing Roth 401(k). Unfortunately, one source of funds that cannot be rolled, transferred, or converted into a Roth 401(k) are Roth IRAs. Here’s a quick chart breaking down the rules.

Existing Retirement Plan DollarsCan These Retirement Plan Dollars Go Into My Roth 401(k)?
Transfer/Rollover from a Traditional IRA or Prior Employer Traditional 401(k).Yes, but tax will be due at the time of conversion on the amount converted to Roth.
Traditional Employee Contribution Made to Your Traditional 401(k) Account.Yes, but tax will be due at the time of conversion on the amount converted to Roth.
Employer Contribution Made to Your 401(k). These Are Always Contributed as Traditional Dollars.Yes, but tax will be due at the time of conversion on the amount converted.
Prior Employer Roth 401(k).Yes, these are rolled from the old Roth 401(k) plan to the existing Roth 401(k).
Roth IRANo, right now you cannot roll Roth IRA dollars into a Roth 401(k). We expect this law to change over time but not anytime soon.

In addition to the chart above, here’s a link to IRS Notice 2013-74 which discusses Roth 401(k) conversions and rollovers.

Keep in mind that conversions to Roth dollars are only permitted if your 401(k) plan allows it.  Most Solo or Owner Only 401(k) plans allow for Roth contributions and conversions.  Also, only vested amounts are available for conversion, which in a Solo 401(k) plan, all amounts contributed are usually immediately vested.  Finally, keep in mind that any amounts converted are still subject to tax based on your personal tax rate liability.  However, once converted, all subsequent distributions will be tax-free, so long as any converted funds remain in the Roth account for five years prior to distribution.

In summary, Roth 401(k) sums can be accumulated from many different sources. They can be accumulated from conversions of traditional IRAs, old employer Traditional 401(k)s, and from existing Traditional 401(k) contributions (employee or employer). You aren’t just limited to putting in your annual $17,500 of Roth 401(k) dollars each year. So, if you want to maximize your Roth 401(k) account, all you need to do is rollover and/or convert your existing dollars to Roth.

Roth IRAs Are for High-Income Earners, Too

A pug puppy sadly starting at it's owner as the other puppies sit together with the text "Roth IRAs Are for High-Income Earners, Too"Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.

Examples

Here’s a few examples of earners who can establish and fund a Roth IRA.

  1. I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
  2. I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers.

The Process

The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction the amounts contributed but the funds are held in a Roth IRA and grow and come at tax-free upon retirement (just like a Roth IRA). Here’s how it works.

Step 1: Fund a new non-deductible traditional IRA

This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. Don’t worry about having non-deductible contributions though as you’re converting to a Roth IRA so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.

If you’re a high-income earner and you don’t have a company based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.

Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA

In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, since 2010 all taxpayers are able to covert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.

If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.

There are two work-arounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer based plan as employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allows for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner only 401(k) plan and you can roll over your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill now so careful planning must be taken.

The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.