The Dangers of Self-directed IRAs
This week’s guest blogger is Stephen Paul, CPA, a staff accountant at WithumSmith+Brown.
A recent article in Wall Street Journal reminds me of the pitfalls that can sink self-directed IRAs. The article (click here for a free version posted on Yahoo! Finance) explains how investors who held units of a master limited partnership (MLP) in IRA accounts were hit with a painful Unrelated Business Income Tax (UBIT) due to a significant partnership transaction. The specifics of this case are best explained in the WSJ article, so let’s discuss in general what to be wary of with your IRA investments.
Self-directed IRAs allow you to hold a wider range of investments beyond the typical marketable securities offerings of most big banks and brokerages. You can open a self-directed IRA with a custodian (often a trust company or boutique brokerage) which agrees to hold nontraditional investments such as MLPs, publicly traded partnerships (PTPs), private equity funds, real estate, private loans, and closely held business entities. Essentially, a self-directed IRA can hold any asset except collectibles and life insurance. Self-directed IRAs are generally funded through a rollover from another IRA with the intention of earning tax-deferral on high income streams or outsized returns through alternative assets.
What’s to worry? Well, IRAs have very strict rules, and breaking them can trigger unintended taxes. A few red flags:
- Self-dealing is when an investment directly or indirectly provides a personal benefit to the IRA owner or a disqualified person. For example, your IRA can’t own the LLC that pays your salary. You also can’t own the LLC that pays your friends or family in your IRA. Definitely don’t put your vacation home in your IRA! Self-dealing is an IRA killer. Prohibited transactions disqualify the IRA and the entire account is deemed a taxable distribution.
- Unrelated Business Income Tax (UBIT) is an IRA risk when investing in pass-through entities such as MLPs, PTPs, and private equity funds. UBIT is imposed on tax-exempt entities, including retirement plans, which earn income unrelated to their exempt purpose. The purpose of your IRA is for passive investments to grow for future use, specifically retirement. If your IRA owns a partnership interest, the IRA is considered the partner with the partnership income flowing to the IRA for tax purposes. When there’s partnership income from an active trade or business (versus passive income such as dividends and interest) your IRA has earned unrelated business income which is subject to UBIT and taxed at corporate rates when incurred. This negates the tax-deferral you were taking advantage of in the first place.
- Liquidity and/or Capital Calls may or may not result in additional tax and penalties, but it’s something to watch. Many alternative assets have significantly reduced liquidity (i.e. it takes longer to convert to cash) or capital contribution commitments, which can cause problems with required minimum distributions (RMDs) or when passing the account to a beneficiary.
We’re just scratching the surface here. The key takeaways are:
- IRA rules are complex.
- Your investments can trigger unintended taxes or even disqualify your account.
- Plan carefully and do your due diligence.
