The flexibility of a self-directed IRA can be a great thing. It gives you the opportunity to make investments that you might not be able to make through other retirement plans. But the ability to go after a broader set of investments could also land you in trouble with the IRS if you aren’t careful and stay up to date on the rules. And the ramifications could be serious – if the IRS voids your account because of non-compliance, you would be forced to withdraw all funds and pay income tax on the entire balance (plus a potential 10 percent penalty if you are younger than 59 ½).
Here are some common mistakes self-directed IRA investors make. Are you headed toward any of these pitfalls?
1. Personally guaranteeing debts in the IRA
This rule can be tricky and you might not even know you are breaking it. For example, if you buy investment real estate for your account and take out a mortgage on the property, you are not allowed to guarantee the mortgage with your personal assets.
Another rule-breaking scenario would be if you invest through your IRA with a broker that requires investors to make up shortfalls in their investment accounts with their personal assets. (Some brokers require this). Signing this type of agreement would be a violation under self-directed IRA rules and the IRS could void your account.
2. Making deals with “disqualified persons”
The IRS has strict rules around who you can and cannot make business dealings with under your IRA. “Disqualified persons” in this case includes family members, friends and other people with whom you have a prior personal relationship.
This rule is in place to stop people from making the kind of sweetheart deals that could abuse the tax advantages under your IRA. For example, someone could use an IRA to buy a piece of real estate at a steep discount from their parents and later sell it for a huge gain while avoiding taxes.
It’s best to avoid personal deals altogether – even if you make a deal with a friend or family member that is completely fair and true to market conditions, the IRS could still void your account.
3. Investing in non-approved assets
While the self-directed IRA allows a large list of alternative investments, there are still some investments that are excluded. This includes most collectibles like antiques, stamps, gems, artwork, and rugs.
Other categories carry specific exemptions. Only certain types of precious metals are allowed on the self-directed IRA investment list. Most, but not all gold coins are acceptable. For example, if you want to buy gold coins, you can buy American Eagle and Canadian Maple Leaf gold coins, but not the South African Krugerrand.
If the IRS catches you investing in a non-approved asset, you will be forced take out the asset as a distribution and you will owe taxes on the amount of the withdrawal.
4. Mishandling improvement and repairs to real estate
There are specific rules about how you pay for repairs or improvements to a piece of real estate in your self-directed IRA. Paying for these repairs out-of-pocket or out of your personal assets is not allowed, and the IRS could force you to withdraw the real estate from the IRA. Instead, you must hire someone else to handle this work for you using funds from your self-directed IRA.
Too many investors run into trouble simply because they don’t understand the rules for self-directed IRAs. Remember to do your research before making investments with your IRA.