What are the Top IRS Rules for Self-Directed IRAs?

What are the Top IRS Rules for Self-Directed IRAs?

What are the Top IRS Rules for Self-Directed IRAs?

A self-directed IRA (SDIRA) is in many ways similar to both a traditional IRA and Roth IRA. In fact, you can set up an SDIRA to function as either one.

These plans help save for retirement while providing tax benefits unseen in other investment products.

In exchange for these benefits, however, there are certain IRS rules for self-directed IRAs that an investor must consider before choosing an investment strategy.

How Does a Self-directed IRA Differ from Other IRAs?

The main difference between an SDIRA and a traditional or Roth IRA is the investment options.

SDIRAs allow you to invest in assets not necessarily traded openly in the secondary markets, such as partnerships, real estate properties, and even precious metals. If you can find a custodian willing to accept the plan’s terms, you can invest in almost anything (within reason, of course).

This wider range of permitted investments allows an investor to diversify an SDIRA portfolio beyond that provided by run-of-the-mill stocks and bonds. The increased high-risk/high-reward exposure is often attractive to investors who are still several years from retirement and have the time to recover from market dips.

What Are You Not Allowed to Put into a Self-Directed IRA?

While there are many asset types available to you, not everything is allowable in an SDIRA. IRS rules for Self-Directed IRAs do exclude certain investments. Three major exclusions are as follows:

Life Insurance

You are not allowed to buy whole, variable, or universal, life insurance products through an SDIRA (or any IRA, for that matter).

Your Home

While real estate properties, in general, are permitted, you are prohibited from investing SDIRA funds in any property that you either use personally or from which you benefit financially. This includes your permanent residence, vacation homes such as summer beach houses or cabins, and any rental properties registered under your name.

If you do manage a rental property, consider doing so via a separate business account to ensure that money remains legally separate from your personal SDIRA.

High-Risk Derivatives

SDIRA custodians will typically permit standard financial derivatives such as futures contracts on commodities or call options on equities. However, higher-risk derivatives that carry an unhedged risk component (meaning that exposure is unlimited) are not allowed by the IRS.

Who is Eligible for a Self-Directed IRA?

IRS rules for self-directed IRA eligibility are the same as those for either a traditional IRA or Roth IRA (again, depending on which type you choose).

There has never been an age limit for contributing to a Roth IRA. While contributions to a traditional IRA were in the past restricted to those investors under the age of 70 ½, that rule changed in 2019 with the passing of the SECURE Act. Now, you can make contributions at any age so long as you are employed.

There is also no age restriction for opening a new traditional IRA provided that the source of funds for the plan are assets being transferred from another IRA or other eligible retirement plan.

In the case of either IRA type, you must be earning taxable income to make contributions. The annual contributions limits for 2021 for both IRA types are $6,000 for investors under the age of 50 and $7,000 thereafter.

Who is Disqualified from a Self-Directed IRA?

The following would-be investment participants are defined as “Disqualified Persons” for purposes of your SDIRA:

  • You (you cannot do business with yourself).
  • Your spouse/partner.
  • Your children.
  • Your grandchildren.
  • Any advisors or fiduciaries involved with your SDIRA.
  • Any business entity in which you own 50% or more of the voting stock.

Top Five IRS Rules for Self-Directed IRAs

Like other IRAs, the IRS imposes certain rules on SDIRAs in return for their preferential tax treatment. In return, certain IRS rules for self-directed IRAs apply. Five of those rules are as follows:

1. The Prohibited Transaction Rule

Investors rarely find themselves involved in “prohibited transactions” because most IRAs are invested in traditional equity and bond portfolios. These investments are (typically by default) unallowed in transactions that would fall into this category.

However, when a prohibited transaction does occur, it is likely a result of dealings with a disqualified person — namely themselves.

This is commonly referred to as a “self-dealing” transaction and is often unintentional. While this blunder can happen in many ways, the most common (and as mentioned earlier) involve turning a profit on SDIRA-owned properties (such as a rental unit) or using funds to invest in a company that you at least partially own.

2. Contribution Restrictions

As discussed previously, an SDIRA follows the same rules as do traditional and Roth IRAs regarding contribution amounts and timing. Unlike a traditional or Roth IRA, however, all contributions and required minimum distributions must be made through the IRA directly — not into or from the IRA’s bank account.

3. Reporting Requirements

The IRS requires the owner of an SDIRA to complete and submit the following three forms:

  • Form 990-T. This is used for filing any potential Unrelated Business Income Tax (UBIT) or Unrelated Debt-Financed Income (UDFI).
  • Form 5948. This form is used to disclose the market value of the SDIRA as well as a record of the prior year’s contributions.
  • Form 1099R. This reports any distributions you receive from the SDIRA.

4. Using Your Self-Directed IRA as Credit

You cannot use an SDIRA to apply for a line of credit, including a basic credit card. Applying for credit involves making a legally binding promise that you will make good on repayment obligations. The IRS prohibits an SDIRA’s exposure to this practice.

5. Tax Considerations

While both a traditional IRA and Roth IRA provide a tax shelter while funds remain inside the account, this is not always the case with an SDIRA. More specifically, there are two possible (and uncommon) situations when taxes are owed before a withdrawal from the plan.

The first is the UBIT (as mentioned previously) which is a tax imposed on SDIRAs that are affiliated with an active business entity.

The second is the UDFI, which is a tax on any income earned from leveraged funds (i.e., borrowed money).

Self-directed IRAs can be a great way to diversify your retirement portfolio. They allow investment in products not available in more traditional investment plans while still preserving standard IRA tax benefits.

However, IRS rules for self-directed IRAs can be tricky, easy to miss, and — if not followed properly — may negatively impact the tax status of your investments.

Companies like Horizon Trust have a team of SDIRA experts dedicated to educating our clients on SDIRA rules and procedures, as well as providing seamless account set-ups and top-notch custodial services.