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Pacific Premier Trust Blog

Fresh alternative asset insights and the latest news on real estate and private equity investing.

Financial Literacy for Self-Directed IRA Investors

Piggybank with glasses on book

  |  By Christopher Orr, CISP®, SDIP

Many investors use self-directed IRAs so they can put themselves in control of their retirement savings. Self-directed investors want to invest in what they know and love, and they are driven to use their knowledge to grow their nest egg. If you’re one of these investors—or want to become one—it’s important to be as educated as possible when it comes to retirement planning, and the ins and outs of self-directed IRAs.

Given that April is Financial Literacy Month and it includes National Retirement Planning Week, we decided to wrap up the month with a review of five major concepts that self-directed IRA investors should understand. After all, brushing up on your financial literacy is helpful no matter how long or short you’ve been investing for retirement.

1. There really is no such thing as a “self-directed IRA”

The IRA was created more than 40 years ago, and since then, numerous types of IRAs have been introduced, including the Roth, SEP and SIMPLE IRA. Each type of IRA has specific rules that dictate who can open one, how much can be contributed and what the tax implications are for each account.

“Self-directed” IRAs aren’t listed above, and that’s because the term “self-directed” is only a descriptor. In the eyes of the IRS, there is no such thing as a self-directed IRA. Rather, the term has become industry shorthand to describe an IRA in which the custodian or administrator allows for an IRA account to go beyond the stock market and hold non-traded alternative assets.

While some alternative asset custodians call their IRAs “real estate IRAs” or “Bitcoin IRAs,” those are marketing tactics. If you want to invest in alternative assets like real estate, you simply need to work with a custodian, like PENSCO, to open a Traditional, Roth, SIMPLE, or SEP IRA that allows you to self direct your investments.

2. Know your alternative investment options

An alternative investment is an investment that is NOT made up of stocks, bonds or cash, and is not normally traded on an exchange. Self-directing your IRA enables you to own alternative assets in your retirement account. While the IRS is very specific about what you cannot invest in—life insurance and collectibles—beyond that, everything from raw land and private placements to real estate and promissory notes can be held in your self-directed IRA.

Before you make an investment, you need to ensure you’re comfortable with the asset. Just because you can invest in something doesn’t mean you should. Remember: When it comes to managing a self-directed IRA, you are in the driver’s seat. You control your investment choices, and you are responsible for evaluating the merits and suitability of every investment you pursue. We encourage all of our clients to conduct thorough due diligence when considering an investment.

3. Beware of taxable income in your IRA

One advantage of a self-directed IRA is that it allows you to grow your investments tax-deferred if you use a Traditional IRA or tax-free with a Roth IRA. The investment income generated by most passive investments held in your IRA—like dividends from equities or gains on the sale in real estate—are deferred until the IRA owner withdraws the funds from the IRA, or tax-exempt on the gains with a Roth IRA.[1]

But many IRA owners are unaware that certain IRA transactions can generate Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt-Financed Income (UDFI)—income that is subject to taxation. For instance, if an LLC is formed in an IRA to purchase a gas station, that business is unrelated to the primary purpose of the IRA (which is to save for retirement), and net income may be taxed as UBTI at the trust tax rate. Another example where you may be subject to UDFI is if you purchase Real Property with your IRA financed by a non-recourse loan, then sell the property for a profit.

Given the tax implications associated with the use of retirement funds, it’s important to consult with a professional who can help you determine the proper structure for the investment you’re considering. Custodians, like PENSCO, cannot advise on UBTI or UDFI.

4. Avoid prohibited transactions and disqualified persons

The IRS prohibits certain IRA investment types and transactions, and it restricts the ways you can use the investments in your self-directed IRA. Breaking these rules and conducting a prohibited transaction, even unintentionally, may result in your account losing its qualified tax-protected IRA status. You may face taxes plus additional penalties.

In general, the IRS does not allow IRAs to conduct transactions that benefit you, your beneficiaries, your business or other so-called disqualified person like your spouse or children. This is called "self-dealing," and it is prohibited.

For example, your IRA can't hold real estate that you or other disqualified persons live in, plan to live in or use in any way while that property is held in your retirement account. Your IRA also cannot purchase private equity shares of your own business (or that of any other disqualified person).

You should work with a tax specialist and review IRS guidance to avoid prohibited transactions and disqualified parties.

5. Self-directed investors still need to take RMDs

Remember, a self-directed is just a descriptor for how you manage your IRA. So if you’re self-directing a traditional, SIMPLE or SEP IRA you will need to start taking required minimum distributions (RMDs) after you turn 70½. Your first required minimum distribution must be taken by April 1 of the year following the year in which you turn 70½. For subsequent years, RMDs must be taken by Dec. 31.

There are significant penalties for not taking your RMD during the correct timeframe. If you fail to take a required minimum distribution or you withdraw the incorrect amount, the amount you should have withdrawn is subject to a 50% excess accumulation tax. That is in addition to the regular income tax you owe on the distribution.

PENSCO has numerous resources to help with RMDs, including these blog posts:

At PENSCO, we want our self-directed IRA clients to be confident in managing their retirement savings and well informed. If you have questions on any of these financial concepts or your self-directed IRA, please call us at 1-800-962-4238.

[1]Penalties are incurred for withdrawing from a Roth IRA before five tax years have passed. However, these penalties may be avoided for qualified withdrawals. You should consult with your tax professional to determine which investment options are best for you.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

Pacific Premier Trust (formerly PENSCO Trust Company) performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Pacific Premier Trust is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.