Most people own a retirement plan of some type. It could be a traditional IRA, Roth IRA, Simple IRA, Traditional 401(k), Roth 401(k), SEP IRA, or 403(b). Very few people know that they can convert any of these retirement plans to a self-directed retirement plan and take total control over their investments. If you're like many people, you're unfamiliar with self-directed retirement plans. What are they, and should you consider incorporating one into your retirement planning?
In 1974, when the federal Employee Retirement Income Security Act (ERISA) took effect, IRAs came into being. The federal government created this vehicle in order to maximize the tax-free or tax-deferred growth of employees' investments for their retirement. Though much less well-known, self-directed IRAs have been around just as long.
Essentially the same as a typical IRA, self-directed IRAs have one significant difference: they place total control over investment decisions in the hands of the IRA owner instead of the IRA custodian. This is accomplished by the IRA owner becoming the manager of the self-directed IRA, LLC.
While IRAs ordinarily contain only certain stocks, bonds, certificates of deposit (CDs) and mutual funds approved by the IRA custodian, self-directed IRA, LLCs expand permissible investments to include real estate, foreign currency, precious metals, private placements, tax lien certificates, and other forms of investments not traditionally used with IRAs. The only prohibited investments are S corporation stock, life insurance, or personal collectibles such as wine, cars, paintings, etc.
Owners of self-directed IRAs often have specialized knowledge of a certain industry or type of asset, and self-directed IRA, LLCs allow them to use their knowledge to identify solid investments that they could not otherwise make while still reaping the tax benefits of an IRA.
Another advantage of having a self-directed IRA, LLC is that you have greater opportunity to diversify your investments, which may reduce the risk of loss. In other words, you're not putting all your eggs in one basket. Also, some types of self-directed IRAs allow you to pass assets in the account to your beneficiaries upon your death with few or no tax implications, which means wealth continues to grow tax-free for many more years, even generations.
For instance, let's say you want to invest in rental real estate because of its high rate of return. With a self-directed IRA, LLC, this becomes possible.
Self-directed IRAs must comply with certain IRS regulations. Failure to comply with regulations and engaging in prohibited transactions can result in loss of your account's tax-deferred status, leading to significant tax consequences.
Per IRS Publication 590, prohibited transactions are defined as "any improper use of your IRA account or annuity by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant." The publication also prohibits self-dealing and receiving indirect benefits from the IRA, such as using real property held in the IRA for an office or vacation home.
The same flexibility that offers you the chance to take advantage of non-traditional investment opportunities for exceptional growth also means that you have the freedom to make very poor investment choices with a self-directed IRA. In short, you have the potential for greater reward with a self-directed IRA, but also the potential for greater loss.
If the prospect of incorporating a self-directed IRA into your retirement planning intrigues you, work with an experienced estate planning attorney with the necessary background to help you understand the financial, tax, legal, and estate planning implications of your choices.
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