There are three very different types of accounts offered as self-directed IRAs. One is typically offered by a major bank or brokerage company. These accounts provide a buffet of traditional investments (stocks, bonds, mutual funds, REITs) the company offers which you to select from. For everything they offer they receive compensation. A problem arises when you want to invest in something they don't offer such as real estate. These accounts don't allow it.
A second type of SDI comes from a bank or trust company that offers no investments. Their business model involves charging fees for opening the account, maintenance fees and investment activity fees. You have the responsibility to research and choose the investments for your IRA. Upon your written direction the custodian will then purchase those investments on behalf of your IRA account. The same process occurs when you decide to liquidate an investment. For each action the custodian charges a fee.
Opting For Total Control
The third strategy offers the most flexibility but require the most work and expertise.
First open an IRA account that facilitates non-standard investments such as private LLCs. I recommend PENSCO, Equity Trust and Trust Company of America. I prefer that the IRA account qualify for its own tax ID number rather than using your SSN.
You then direct that the IRA invest in a manager-directed LLC for which you are the uncompensated manager and member representative (as the IRA beneficial account holder). The IRA as managed by the custodian is then invested passively in a static investment and the LLC can be as robust, daring or conservative as you want to make it. The LLC can own real estate, brokerage accounts, bank accounts, mutual funds.
Stay Away From Prohibited Transactions
A few investments or transactions are prohibited:
- Life Insurance Contracts - IRC ?408(a)(3).
- Collectibles - IRC ?408(m)(2).
- S Corporations. An IRA's holding of shares in a corporation will not adversely affect the IRA or IRA holder, but may cause the corporation to lose its S corporation status.
- Prohibited Transactions. "Prohibited transactions" may result in significant adverse income tax consequences to the IRA holder or other "disqualified persons" (you, parents, kids, spouses of any of the above) who participate in the transaction. IRC ? 4975(c)(1) details types of prohibited transactions.
Filing Tax Returns
As a single member LLC the LLC does not need to file a federal tax return. The IRA custodian will file an informational return on behalf of the IRA which may require a valuation of the LLC shares on an annual basis. This filing does not reconcile 1099 statements generated by LLC investments. When we used client SSN for the IRA account the IRS looked to the client tax return for the taxpayer portion of the 1099. Requiring the IRA to have its own tax ID number and registering the LLC as owned by that tax ID alleviated this problem.
Certain IRA investments makes may generate unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI). The presence of UBTI or UDFI neither is prohibited nor will cause an IRA as a whole to lose its tax-exempt status but will require the IRA to pay taxes on the UDFI or UBTI. If the LLC generates these taxes the best way to account for them is to file a tax return for the IRA, declare this income and pay the tax from the LLC.
Stay Within Fiduciary Boundaries
The Department of Labor believes that the use of the participant contributions to repay loans to the participants raises concerns under sections 403 and 404 of ERISA. It is the view of the Department that when the primary benefit requirement is not met, then there would also be a violation of the "exclusive purpose" and "solely in the interest" requirements of sections 403 and 404 of ERISA.
An individual setting up a self-directed IRA that owns an LLC participates as the beneficiary of their individual 401(k) and as the manager of the LLC. Given that the LLC is a plan asset, the manager has fiduciary duties to the IRA owner. Thus if the manager makes decisions about the assets based on any loyalties other than for the exclusive benefit of the beneficiary the Dept. of Labor might find a violation even if all of the players are the same person!
Additional resources provided by the author
Some custodians will work directly with investors. Others prefer to deal only with institutional accounts. A variety of companies such as Guidant Financial, IRA Roll-Over Solutions, and Self-Directed IRA will set you up with a turn-key product for a fee. Some attorneys will help you set up a third option type of self-directed IRA. Understand the differences, go with the option that makes the most sense for you and don't let anyone sell you a product you don't want or need.
Given the potential complications of the third type of SDI some people understandably opt to give up a measure of control and create one of the other two types of accounts. However, if you understand investments and the IRA rules the only type of IRA that is truly self-directed is the best way to keep full control of your retirement dollars.