Every Roth IRA account owner knows that the main benefit of the Roth IRA is that there are no taxes due on withdrawals taken after the account owner is 59 ½. However, what taxes or penalties apply to distributions taken before the Roth IRA owner reaches 59 ½?
Roth IRA distributions before age 59 ½ are broken into two categories, contributions and earnings.
Contributions Can Be Withdrawn Before 59 ½ Without Tax or Penalty
The first first category is Roth IRA contributions. This category is distinct because these amounts have been subject to tax before the funds were included in the Roth IRA. The amounts withdrawn from a Roth IRA that do not exceed the amounts of Roth IRA contributions are not subject to taxes or penalties upon early distribution from the Roth IRA. However, any amounts distributed in excess of the Roth IRA contributions, which would typically be the investment returns, are subject to taxes and the early withdrawal penalty of 10%.
This is an excellent perk as it allows Roth IRA owners to take money back that they contributed to the Roth IRA without worrying about penalties or taxes.
Earnings Are Subject to Tax the 10% Early Withdrawal Penalty
Amounts withdrawn before 59 ½ that comprise the Roth IRA’s earnings are subject to tax and a 10% early withdrawal penalty. IRC § 408A(d)(2)(A) & Treasury Reg. §1.408A-6, Q&A-1(b). “Earnings” is the amount over the sums you have contributed to the Roth IRA, and is essentially your investment returns and gains.
Since there are taxes AND penalties on the earnings, you should only take distributions when absolutely necessary.
Example of Roth IRA Distribution Before 59 ½
For example, let’s say a Roth IRA owner is 45 and has a Roth IRA with $65,000. This balance consists of $35,000 in Roth IRA contributions and $30,000 in earnings or investment returns. If the Roth IRA owner took a distribution of the entire account then $35,000 would NOT be subject to early withdrawal penalties as this amount comprised Roth IRA contributions where taxes have been paid already. However, the remaining $30,000 distributed represents investment returns/gains made in the Roth IRA and would be subject to early withdrawal penalties of 10% and must be also be included in the taxable income of the Roth IRA owner. As a result, Roth IRA owners under age 59 ½ should avoid distributions of their Roth IRA in excess of their contributions.
An IRA must report its fair market value to the IRS annually. Fair market value is reported to the IRS by your IRA custodian via IRS Form 5498. For standard IRAs holding stocks or mutual funds, those account values are automatically determined as they simply take the stock or fund price as of the close of the market on December 31st each year. They then use these amounts to set the year-end account fair market value. For self-directed accounts, such fair market values are not readily available, and it becomes the IRA account owner’s responsibility to obtain their self-directed investment values so that their custodian can properly report the account’s fair market value. The value of an account is important for a few reasons. First, the IRS requires it to be updated annually. Second, it is used to set required minimum distributions (RMDs) for those account holders over the age of 70 ½ with Traditional IRAs. Last, the account value is used when converting an entire account, or a particular investment or portion of the account, from a Traditional IRA to a Roth IRA.
What is “Fair Market Value?”
Fair market value of an investment has been broadly defined by the Court as:
“The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” U.S. v. Cartwright, 411 US 546 (1973).
Now here’s the hard part: Even though the IRS requires IRAs to update their fair market value on an annual basis, the Government Accountability Office noted in their recent report that:
“Current IRS guidance includes NO [emphasis added] guidance or advice to custodians or IRA owners regarding how to determine the FMV [fair market value]”. United States Government Accountability Office, GAO-17-02, Retirement Security Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets. (Dec. 2016).
The absence of guidance, however, has not relieved IRA owners or their custodians from obtaining and reporting this information. While there is no specific fair market valuation guidance for IRAs, there are commonly accepted methods of reporting value used by professionals and companies within the self-directed IRA industry. Most of these methods have been adopted from law and regulations governing employer retirement plans or estates.
Methods to be used by Asset Type
The table below outlines preferred valuation methods that are commonly used in the industry for the most common self-directed IRA assets. As you will note, when the valuation is needed for a taxable event, such as a distribution or Roth conversion, greater detail and supporting information will be required as the valuation will result in tax being due.*
Non-Taxable (Annual FMV)
Taxable (RMD, distribution or conversion)
Comparative Market Analysis (CMA) from a real estate professional is preferred. Some IRA custodians accept property tax assessor values or Zillow reports in non-taxable situations.
Real estate appraisal is preferred. Some IRA custodians accept a broker’s price opinion.
Value of a note can be reported by calculating the principal due plus any accrued and unpaid interest. This is the valuation method used for calculating the value of a note for estate tax purposes.
Same as non-taxable, principal amount due plus accrued and un-paid interest. For notes in default, a third-party opinion as to value is typically required in order for the note to be written-down below face value.
For bullion, use the spot value of the metal in question times the ounces owned. Spot value is widely reported on a daily basis on financial sites.
For acceptable coins, use market data for the coin in question via the Grey Sheets available at www.bullionvalues.com.
Same as non-taxable.
LLC, LP, or Private Company Interest
Obtain a third party-opinion of value of the LLC interest. The opinion should rely on IRS Revenue Ruling 59-60. For asset holding companies, the valuation should focus on the value of the assets. For operating companies, the valuation should focus on earnings.
Similar requirement, but the detail of the opinion should be more significant. For example, for an asset holding company where the IRA’s interest is determined by the assets of the LLC. A CMA would be acceptable for calculating that assets value in the company in an annual valuation. However, an appraisal of the real estate to calculate in that asset would be required in a taxable situation.
Since the valuation reporting policies of custodians vary, IRA owners should make sure that they understand their IRA custodian’s policies for valuations of the assets in question.
Our firm routinely assists clients with obtaining third-party opinions of value, and can assist IRA owners who need to produce a report or third party opinion as to an LLC or other investment interest held by an IRA. Call us at (888) 801-0010.
*Please note that there are clearly differences of opinions on these matters, and since there is no specific legal guidance for IRA valuations, please keep in mind that the table above is based on my own industry experience and opinions. Seek a licensed professional in all instances for your specific situation.
Many self-directed IRA investors use an IRA/LLC to make and hold their self-directed IRA investments. In essence, an IRA/LLC (aka “checkbook-controlled IRA”) is an LLC owned 100% by an IRA. For a summary and description of an IRA/LLC, please refer to my video here. While most self-directed investors are using the IRA/LLC to invest in real estate or other non-publicly traded assets, there are many instances where an IRA/LLC owner would like to invest the cash from their IRA/LLC checking account into stocks or other publicly-traded investments. This may arise with portions of cash that are not yet large enough to make a desired self-directed investment, or when the IRA/LLC is between investments, such as after the sale of an asset or investment and before a new self-directed investment may be found. Or, it could simply arise because the account owner finds a publicly traded opportunity that they would like to pursue using the IRA/LLC account funds and structure.
I. Can My IRA/LLC Establish a Brokerage Account to Buy Stocks?
Yes, an IRA/LLC may have a brokerage account to buy stocks or other publicly traded assets. This account must be established in the name of the LLC. The brokerage account cannot have a margin account whereby account trades on credit. A margin account typically requires the personal guarantee of the underlying IRA/LLC owner, and this would amount to an extension of credit prohibited transaction. Additionally, any profits due from the trading on credit, even if you could get around a personal guarantee, would be subject to unrelated business income tax (UBIT).
II. What Are the Pros and Cons of Having a Brokerage Account with an IRA/LLC That I Should Know About?
Uninvested or accumulating cash from an income producing asset often times sit without earning any income in an IRA/LLC. By having a brokerage account with an IRA/LLC, the cash could be invested into stocks or other publicly traded investments, but could still be somewhat liquid in the event that funds are needed for a self-directed investment.
Most brokerage firms do not have a specific account option for IRA/LLCs. As a result, most brokerage firms will simply treat the brokerage account as an LLC brokerage account. The problem with this is that they will send the IRS and your LLC tax reporting via IRS From 1099-B for trading income. While I’ve had many clients receive and ignore this, because the LLC is owned by their IRA, it does raise concern of an IRS audit for failure to report the 1099-B.
3. Potential Solution
TD Ameritrade has a specialty account for LLCs where you can identify that the account is owned by an IRA. This is optimal as it’s the only LLC brokerage account I’ve come across where the IRA can be identified as the owner of the LLC. Refer to TD Ameritrade’s Specialty Account Page and their account form here.
III. What are the Options?
A second option to establishing a brokerage account with your IRA/LLC is to simply return funds from the LLC back to the self-directed IRA. This is not taxable. It is a return of investment funds or profits to the IRA. Then transfer funds from the self-directed IRA to a brokerage IRA as a trustee-to-trustee transfer. This is also not taxable. Now, you can buy stocks with the IRA funds in the brokerage account. When you would like the funds back in the IRA/LLC for a self-directed investment, you would send funds from the brokerage IRA back to the self-directed IRA as a trustee-to-trustee transfer, and would then invest the funds from the self-directed IRA to the IRA/LLC. While this involves more steps, its cleaner in the end as the brokerage IRA will be set-up with no tax reporting to the IRS on trading income. In the end, both options are viable, but self-directed investors should understand the differences and requirements for each option before proceeding with a brokerage account with their IRA/LLC funds.
Many self-directed investors have the option of choosing between a self-directed IRA or a self-directed solo 401k. Both accounts can be self-directed so that you can invest into any investment allowed by law such as real estate, LLCs, precious metals, or private company stock. However, depending on your situation, you may choose one account type over the other. What are the differences? When should you choose one over the other?
Must be an individual with earned income or funds in a retirement account to rollover.
Must be self-employed with no other employees besides the business owner and family/partners.
$5,500 max annual contribution. Additional $1,000 if over 50.
$53,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer.
Traditional & Roth
You can have a Roth IRA and/or a Traditional IRA. The amount you contribute to each is added together in determining total contributions.
A solo 401(k) can have a traditional account and a roth account within the same plan. You can convert traditional sums over to Roth as well.
Cost and Set-Up
You will work with a self-directed IRA custodian who will receive the IRA contributions in a SDIRA account. Most of the custodians we work with have an annual fee of $300-$350 a year for a self-directed IRA.
You must use an IRS preapproved document when establishing a solo 401k. This adds additional cost over an IRA. Our fee for a self-directed and self-trusteed solo 401(k) is $1,200.
An IRA must have a third party custodian involved on the account (e.g. bank. Credit union, trust company) who is the trustee of the IRA.
A 401(k) can be self trustee’d, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.
A self-directed IRA is invested through the self directed IRA custodian. A self-directed IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate.
A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.
Keep in mind that the solo 401(k) is only available to self-employed persons while the self-directed IRA is available to everyone who has earned income or who has funds in an existing retirement account that can be rolled over to an IRA.
Based on the differences outlined above, 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. 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 that can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier to and cheaper to establish.
Another major consideration in deciding between a solo 401(k) and self-directed IRA is whether there will be debt on real estate investments. If there is debt and if 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.
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.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.
2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.
3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
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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.