Self-Directed Beneficiary IRAs: RMD and Investing Tips

Photo of a man hugging his mother in the kitchen.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. These distribution options dictate how you can invest the account. Please note that if you inherit an account from a spouse that you can just do a spousal rollover and consider the account as yours. This article is for those inheriting an IRA from a non-spouse.

Distribution Options

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 – Stretch IRA

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 and the rest can stay invested. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty when you pull money out of the account regardless of your age. Traditional beneficiary IRA distributions are taxable to the beneficiary while 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.

There is pending legislation which the House has passed but the Senate has sat on which would limit the ability to stretch the IRA out to a maximum of 10 years. Even if that legislation passes, the Stretch IRA will be a good option to at least continue the tax benefits of the inherited IRA for 10 years.

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 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 you will 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.

Buying a Retirement Home With Your Self-Directed IRA

One hand holding a pair of keys to the right of another hand with its palm opened upwards.A common self-directed IRA question 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 to your self personally then begin to personally use.

 

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 when you take a distribution of the property (which is done at fair market value). 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-B.

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, before purchasing a future retirement home with your IRA, self-directed investors should make sure they understand that they cannot have personal use while the property is owned by the IRA and that there are taxes due from traditional accounts when you later take the property as a distribution.

2018 Tax Reporting for Your Self-Directed IRA

Image of a red thumbtack on the December 31 date of a calendar.Self-Directed IRA investors should be aware of their self-directed IRA tax reporting responsibilities.  Some of these items are completed by your custodian and others are the IRA owner’s sole responsibility. Here’s a quick summary of what should be reported to the IRS each year for your self-directed IRA. Make sure you know how these items are coordinated on your account as the ultimate authority and responsible tax person on the account is, you, the account owner.

IRA Custodian Files

Your IRA Custodian will file the following forms to the IRS annually:

IRS FORM PURPOSE WHAT DOES IT REPORT
Form 5498 Filed to the IRS by your custodian. No taxes are due or paid as a result of Form 5498.  

IRA contributions, Roth conversions, the account’s fair market value as of 12/31/18, and required minimum distributions taken.

 

Form 1099-R Filed to the IRS by your custodian to report any distributions or Roth conversions. The amounts distributed or converted are generally subject to tax and are claimed on your personal tax return. IRA distributions for the year, Roth IRA conversions, and also rollovers that are not direct IRA trustee-to-IRA trustee.

IRA Owner’s Responsibility

Depending on your self-directed IRA investments, you may be required to file the following tax return(s) with the IRS for your IRA’s investments/income:

IRS FORM DOES MY IRA NEED TO FILE THIS? DUE DATE
1065 Partnership Tax Return If your IRA is an owner in an LLC, LP, or other partnership, then the partnership should file a 1065 tax return for the company to the IRS, and should issue a K-1 to your IRA for its share of income or loss. Make sure the accountant preparing the company return knows to use your custodian’s tax ID for your IRA’s K-1s, and not your personal SSN (or your IRA’s tax ID if it has one for UBIT 990-T tax return purposes). If your IRA owns an LLC 100%, then it is disregarded for tax purposes (a single-member LLC), and the LLC does not need to file a tax return to the IRS. March 15th, 6-month extension available
990-T IRA Tax Return (UBIT) If your IRA incurs Unrelated Business Income Tax (UBIT), then it is required to file a tax return. The IRA files a tax return and any taxes due are paid from the IRA. Most self-directed IRAs don’t need to file a 990-T for their IRA, but you may be required to file for your IRA if your IRA obtained a non-recourse loan to buy a property (UDFI tax), or if your IRA participates in non-passive real estate investments such as: Construction, development, or on-going short-term flips. You may also have UBIT if your IRA has received income from an active trade or business, such as a being a partner in an LLC that sells goods and services (C-Corp dividends exempt). Rental real estate income (no debt leverage), interest income, capital gain income, and dividend income are exempt from UBIT tax. April 15th, 6 -month extension available

Most Frequently Asked Questions

Below are my most frequently asked questions related to your IRA’s tax reporting responsibilities:

Q: My IRA is a member in an LLC with other investors. What should I tell the accountant preparing the tax return about reporting profit/loss for my IRA?

A: Let your accountant know that the IRA should receive the K-1 (e.g. ABC Trust Company FBO John Doe IRA) and that they should use the tax ID/EIN of your custodian and not your personal SSN. Contact your custodian to obtain their tax ID/EIN. Most custodians are familiar with this process, so it should be readily available. If your IRA has a tax ID/EIN because you file a 990-T for Unrelated Business Income Tax then you can provide that tax ID/EIN.

Q: Why do I need to provide an annual valuation to my custodian for the LLC (or other company) my IRA owns?

A: Your IRA custodian must report your IRA’s fair market value as of the end of the year (as of 12/31/18) to the IRS on Form 5498, and in order to do this they must have an accurate record of the value of your IRA’s investments. If your IRA owns an LLC, they need to know the value of that LLC. For example, let’s say you have an IRA that owns an LLC 100% and that this LLC owns a rental property, and that it also has a bank account with some cash. If the value of the rental property at the end of the year was $150,000, and if the cash in the LLC bank account is $15,000, then the value of the LLC at the end of the year is $165,000.

Q: I have a property owned by my IRA and I obtained a non-recourse loan to purchase the property. Does my IRA need to file a 990-T tax return?

A: Probably. A 990-T tax return is required if your IRA has income subject to UBIT tax. There is a tax called UDFI tax (Unrelated Debt Financed Income) that is triggered when your IRA uses debt to acquire an asset. Essentially, what the IRS does in this situation is they make you apportion the percent of your investment that is the IRA’s cash (tax favorable treatment) and the portion that is debt (subject to UDFI/UBIT tax) and your IRA ends up paying taxes on the profits that are generated from the debt as this is non-retirement plan money. If you have rental income for the year, then you can use expenses to offset this income. However, if you have $1,000 or more of gross income subject to UBIT, then you should file a 990-T tax return. In addition, if you have losses for the year, you may want to file 990-T to claim those losses as they can carry-forward to be used to offset future gains (e.g. sale of the property).

Q: How do I file a 990-T tax return for my IRA?

A: This is filed by your IRA and is not part of your personal tax return. If tax is due, you will need to send the completed tax form to your IRA Custodian along with an instruction to pay the tax due and your custodian will pay the taxes owed from the IRA to the IRS. Your IRA must obtain its own Tax ID to file Form 990-T. Your IRA custodian does not file this form or report UBIT tax to the IRS for your IRA. This is the IRA owner’s responsibility. Our law firm prepares and files 990-T tax returns for our self-directed IRA and 401(k) clients. Contact us at the law firm if you need assistance.

Sadly, not many professionals are familiar with the rules and tax procedures for self-directed IRAs, so it is important to seek out those attorneys, accountants, and CPAs who can help you understand your self-directed IRA tax reporting obligations. Our law firm routinely advises clients and their accountants on the rules and procedures that I have summarized in this article and we can also prepare and file your 990-T tax return.