Investing via Self-Directed IRAs (SD-IRAs): Opportunities and Considerations

Investing via Self-Directed IRAs (SD-IRAs): Opportunities and Considerations

Self-Directed Individual Retirement Accounts (SD-IRAs) offer investors the ability to diversify their retirement portfolios beyond traditional assets like stocks and bonds. With custodians like Strata Trust Company and similar firms, you can invest in alternative assets such as real estate, private equity, venture capital, precious metals, and more. However, while SD-IRAs provide unique opportunities for growth, they also come with specific risks and compliance requirements. Key considerations include understanding IRS rules on prohibited transactions and potential tax implications like Unrelated Business Income Tax (UBIT).

This article provides an overview of investing via SD-IRAs, highlighting the benefits, risks, and essential compliance considerations.

What is an SD-IRA?

A Self-Directed IRA is a retirement account that allows you to invest in a broader range of assets than traditional IRAs. SD-IRAs are typically administered by specialized custodians like Strata Trust Company, Equity Trust, or Entrust Group, who facilitate transactions and ensure compliance with IRS regulations.

Types of Investments Allowed in SD-IRAs

  • Real Estate: Residential, commercial, land, and more.

  • Private Equity: Investments in startups or private companies.

  • Precious Metals: Gold, silver, and other IRS-approved metals.

  • Cryptocurrency: Bitcoin and other digital assets (depending on the custodian).

  • Promissory Notes: Lending arrangements backed by collateral.

Benefits of Investing via SD-IRAs

  1. Portfolio Diversification:

    • SD-IRAs enable you to include alternative investments, reducing dependency on traditional markets.

    • Examples: Investing in rental properties or private funds.

  2. Tax Advantages:

    • Like traditional IRAs, SD-IRAs offer tax-deferred growth, and Roth SD-IRAs provide tax-free growth if conditions are met.

  3. Control Over Investments:

    • Investors have full discretion to direct their funds into opportunities that align with their financial goals or expertise.

Key Compliance Rules

While SD-IRAs offer flexibility, they also come with strict IRS regulations. Non-compliance can lead to significant penalties or the disqualification of your IRA. Here are some critical rules to follow:

1. Prohibited Transactions

Certain transactions are strictly prohibited by the IRS to ensure that the account benefits your retirement exclusively and not you or related parties personally.

  • Prohibited Parties: Yourself, your spouse, descendants, ascendants (e.g., parents), and certain business entities connected to you.

  • Examples of Prohibited Transactions:

    • Using IRA funds to purchase property you or a family member personally use.

    • Lending money from your SD-IRA to a disqualified person.

    • Receiving personal benefits from an asset owned by the SD-IRA, such as rental income.

2. Custodian Requirements

  • SD-IRAs must be held by a qualified custodian. Companies like Strata Trust ensure that your investments comply with IRS regulations and handle the paperwork required for alternative assets.

3. Recordkeeping and Reporting

  • The custodian must file annual reports to the IRS, including the valuation of assets held in the account.

  • You are responsible for maintaining thorough documentation to prove compliance with IRS rules.

Tax Implications

While SD-IRAs offer tax advantages, certain investments can trigger tax liabilities. It’s crucial to understand these implications before proceeding.

1. Unrelated Business Income Tax (UBIT)

  • What is UBIT?: If your SD-IRA invests in a business that generates income not related to the IRA's tax-exempt purpose, the income may be subject to UBIT.

  • Common Triggers:

    • Investing in operating businesses through LLCs or partnerships.

    • Leveraged real estate investments (e.g., buying property using a mortgage within the SD-IRA).

2. Tax Reporting

  • Any UBIT liability must be reported on IRS Form 990-T, and taxes must be paid using IRA funds.

Risks and Considerations

  1. Due Diligence:

    • Custodians do not provide investment advice or vet opportunities, so it’s your responsibility to research investments thoroughly.

  2. Liquidity Concerns:

    • Many alternative investments are illiquid, which can pose challenges if you need to meet required minimum distributions (RMDs) in retirement.

  3. Valuation Challenges:

    • Non-traditional assets may be difficult to value accurately, complicating annual reporting and compliance.

  4. Penalties for Non-Compliance:

    • Engaging in prohibited transactions or failing to comply with IRS rules can result in the disqualification of the IRA, making the entire balance taxable and subject to penalties.

Best Practices for SD-IRA Investors

  1. Consult a Financial Advisor:

    • Work with a professional who understands SD-IRA rules and can guide you on compliance, investment strategy, and tax implications.

  2. Choose the Right Custodian:

    • Select a reputable custodian like Strata Trust or similar providers with experience in alternative investments.

  3. Stay Informed:

    • Regularly review IRS rules and updates regarding SD-IRA investments.

  4. Plan for Liquidity:

    • Ensure you have adequate funds to cover taxes, fees, or RMDs without forcing the sale of illiquid assets.

Conclusion

Investing via an SD-IRA offers unparalleled opportunities to diversify your portfolio and leverage alternative investments. However, the flexibility comes with significant compliance requirements and potential tax liabilities like UBIT. By partnering with a knowledgeable custodian, conducting thorough due diligence, and consulting with financial advisors, you can harness the full potential of SD-IRAs while avoiding costly mistakes. Always remember, the key to successful investing in SD-IRAs is balancing opportunity with compliance.

Venture CapitalFrancesca Tabor