What is ERISA?
The Employee Retirement Income Security Act (ERISA) passed the responsibility of retirement savings from the employer to the employee. IRAs were created in 1975 to provide individuals a chance to direct where their retirement funds were invested. Rather than distinguishing which investments are allowed, the IRS code instead identifies which investments are not permitted under these laws.
Only two types of investments are excluded under ERISA and IRS Codes:
- Life Insurance Contracts
- Collectibles such as works of art, rugs, jewelry, etc.
IRS Code Sec. 401 IRC 408(a) (3)
What types of retirement accounts am I able to use?
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Profit Sharing Plans
- Qualified Annuities
- Coverdale Education Savings
- Money Purchase Plans
- and many more.
It must be noted that most employer sponsored plans such as a 401(k) will not allow you to roll your account into a new Self Directed IRA plan while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.
How many people have self directed IRA accounts?
The self directed industry is growing at a rapid pace and is expected to see upwards of $2 trillion enter the market over the next two years. Some of the latest numbers show over 45 million IRA holders in the U.S. and less than 4% of those funds are held in non-traditional assets. This number is expected to increase significantly over the next 5 years as more and more individuals and their financial advisors attain a greater awareness of self-directed IRAs.
Are there limits to the investments I can make?
Yes. As discussed previously, you cannot invest in Collectibles or Life Insurance Contracts. In addition, there are certain transactions in which you cannot participate when using IRA funds. These are referred to as “prohibited transactions”.
Prohibited Transactions are defined in IRC 4975(c)(1) and IRS Publication 590. They were established to maintain that everything the IRA engages in is for the exclusive benefit of the retirement plan. Professionals often refer to these as “self-dealing” transactions.
Self-dealing occurs when an IRA owner uses their individual retirement funds for their personal benefit rather than to benefit the IRA. As an IRA owner, if you violate these rules, your entire IRA could loose its tax-deferred or tax-free status. It is very important that you work with competent professionals to help avoid violating these rules.
Specifically, what are prohibited transactions?
IRC 4975(c) (1), identifies prohibited transactions to include any direct or indirect:
- Selling, exchanging, or leasing, any property between a plan and a disqualified person. For example, your IRA cannot buy property you currently own from you.
- Lending money or other extension of credit between a plan and a disqualified person. For example, you cannot personally guarantee a loan for a real estate purchase by your IRA.
- Furnishing goods, services, or facilities between a plan and a disqualified person. For example, you cannot use personal furniture to furnish your IRAs rental property.
- Transferring or using by or for the benefit of, a disqualified person the income or assets of a plan. For example, your IRA cannot buy a vacation property you or your family intends to use.
- Dealing with income or assets of a plan by a disqualified person who is a fiduciary acting in his own interest or for his own account. For example, you should not loan money to your CPA.
- Receiving any consideration for his or her personal account by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. For example, you cannot pay yourself income from profits generated from your IRAs rental property.
If you participate in a transaction which does not fit SPECIFICALLY within these guidelines, the Department of Labor or the IRS will analyze the specific facts and circumstances in order to decide whether you have engaged in a prohibited transaction.
Who are disqualified parties?
Many of the prohibited transactions are the result of a very simple equation:
Plan (or plan asset) + Disqualified person = Prohibited Transaction
A plan is defined to include tax-qualified plans, IRAs and other tax favored arrangements. For the complete definition you can reference IRC 4975(e) (1). A disqualified person (IRC 4975(e) (2)) is defined as:
- The IRA owner
- The IRA owner’s spouse
- Ancestors (Mom, Dad, Grandparents)
- Lineal Descendents (daughters, sons, grandchildren)
- Spouses of Lineal Descendents (son or daughter-in-law)
- Investment advisors
- Fiduciaries – those providing services to the plan
- Any business entity i.e., LLC, Corp, Trust or Partnership in which any of the disqualified persons
mentioned above has a 50% or greater interest.
Why are these rules considered to be complex?
These rules exist to ensure that your IRA does not engage in any investment activity other than for the exclusive benefit of the IRA. There are many types of investments which violate this law.
For example, buying a house and then letting your mother rent it would potentially create a conflict of interests. If your mother, who was making rent payments, all of a sudden could not – you would be conflicted from evicting her and finding a more reliable tenant.
You would then have a conflict of interest between your relationship with your mother and what is in the best interest of your IRA. These rules were put in place to help avoid these sort scenarios. See IRC 408
If my brother is not a disqualified party, can I buy a house and rent it to him??
Theoretically yes. Your brother is not a disqualified person. However just like the scenario mentioned above, if he occupied a rental property owned by your IRA and could not make the payments, you could run afoul of the exclusive benefit rule. This could cause your IRA to have participated in a prohibited transaction. It is important that you treat every investment the same – to benefit your IRA and only the IRA.
What are the consequence of a prohibited transaction?
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.
How do I make sure I am following the rules?
As mentioned previously, the IRS does not identify what investments or transactions you can make in your IRA. They instead state which investments are prohibited and what makes certain transactions prohibited. Identifying, interpreting and following these rules can be complicated, but not impossible. Utilizing specially trained professionals can help you follow Internal Revenue guidelines and steer clear of prohibited transactions.
My CPA or Financial Advisors says this is illegal. Why?
It may be they are influenced by self interest or they are simply uninformed. Attorneys stick to their core competencies and rarely deviate from them. Tax preparers are taught to do just that – prepare taxes. Your financial advisor’s company or agency may either be disinterested in this type of business or have not been educated regarding this type of investing format. A stock broker makes money when they sell stocks, bonds and mutual funds – not real estate or other types of investments..
What is a self directed IRA custodian?
The Custodian is a bank or savings and loan association, as defined in IRC 408(n), or any other entity that has the approval of the IRS to act as Custodian. In order to have a self-directed IRA, it needs to be held with a Custodian who will allow investments into non-traditional investments. There are very few of these types of custodians.
A Retirement Account Facilitator or Administrator can set up the legal structure such as an LLC or C Corporation that allows for checkbook control of the funds. The Facilitator or Administrator, unlike the Custodian, does not hold the funds, but usually contracts with a Custodian to hold the funds as part of the services provided.
Why are there not more of these custodians across the country?
There are very few non-traditional IRA custodians simply because the business is not as profitable as it is for the brokerage houses. It requires many more hours to complete a real estate transaction than to purchase stocks over an electronic system. Traditional banks do not compete because it does not fit within their business objectives. They make money by leveraging the dollars you have sitting in their accounts.
Are my funds safe with one of these custodians?
A custodian must be a registered Trust Company. For one to register as a Trust Company the institution must meet stringent state requirements and have adequate reserves. Your money is kept in a separate account for your benefit and not subject to creditors of the custodian. Further, if your funds have been placed into an LLC or C Corporation, the custodian never has control of your money – YOU DO! You are ALWAYS in control.Are my funds safe with one of these custodians?