3-Steps to Evaluate Investments for IRS Compliance
The beauty of a self-directed IRA or Solo 401(k) is that you can invest in a wide array of opportunities. By being able to invest in what you know and understand, you can have greater control over the outcomes.
The trade-off for this flexibility and control is that you are tasked with navigating IRS rules as you choose and execute plan investments. When you are in the walled garden of an IRA with a brokerage firm, there is not as much concern about rules because you really can’t break them. Once you open up the possibilities and take more control, it is a different story.
While the IRS rules can be complex, and it is always important to have an experienced guide you can rely on, it is fairly simple to make a quick determination about the suitability of any particular strategy. We have a three-step method we recommend.
1 – Are Disqualified Parties Involved?
The main compliance concern with a self-directed retirement plan is operating in a way that is exclusively for the benefit of the IRA or 401(k). This means avoiding any self-dealing or interactions with disqualified persons to the IRA.
Disqualified persons include:
- The IRA account holder
- Their spouse if married
- Lineal antecedents such as parents, grandparents, etc.
- Lineal descendants such as children, grandchildren, etc.
- The spouse of a descendant
- A fiduciary or other person providing services to the plan
- Certain key employees, partners, or joint venturers of an entity sponsoring a plan or controlled by a disqualified person.
Any action that creates a direct or indirect transaction or benefit between a plan and a disqualified person will result in a prohibited transaction and severe tax consequences.
Things to avoid include:
- A sale, exchange, or transfer of value
- Lending of money, extension of credit, or any co-mingling of funds
- Furnishing of goods, services, or facilities
- Transfer or use of plan assets or income produced by plan assets
- Otherwise dealing in one’s own interest via the plan
With the above in mind, it is easy to determine if a planned investment will be within the rules. If the transaction involves a disqualified person, simply don’t go there.
Of course, as the first person on the list of disqualified persons, you are not restricted from administering your IRA. You can make decisions, execute contracts, fund transactions, and receive the income produced by investments. You just need to do all these things on behalf of the IRA and in the IRA’s interest, not in ways that provide a current benefit to you.
2 – Active vs Passive Income
A common misconception held by those new to the self-directed IRA space is that all investments made with a retirement plan are fully tax-sheltered. That is the way it works in the stock market, right?
In reality, there are certain types of activities that while allowable for an IRA will create a tax liability due to the nature of the income being produced.
An IRA or 401(k) is intended for passive investments. Income from passive activities like interest, dividends, royalties, rent from real property, the sale of an asset held over time, and the like will be fully sheltered into the plan.
When a tax-exempt entity like a retirement plan acts like a business and is deemed to be substantively competing with tax-paying enterprises, that is a different matter.
If a self-directed IRA is used in a way that is viewed as a trade or business, and does so on a regular or repeated basis, the gains from those activities are classified as Unrelated Business Taxable Income (UBTI). The IRA will then need to pay tax on the gains. This tax is designed to level the playing field and protect businesses from unfair competition.
Common examples of activities that generate UBTI include:
- Ownership in an operating business such as a restaurant, retail, or services company, if the entity is a pass-through for taxation. A business operating as a subchapter C corporation pays taxes on income and issues passive dividends to investors and will therefore not generate UBTI.
- Any kind of flipping or dealer transaction such as buying and reselling real property, vehicles, or other personal property.
- New home construction for immediate sale.
- Services oriented real estate such as hotels, short term rentals, adult care, and self-storage.
- High volume day-trading of securities.
Because an IRA is taxed at trust rates that can scale up to 37% quickly, caution should be exercised with opportunities that produce UBTI.
The mere presence of UBTI, however, is not always a deal-killer. It just depends on what income will be impacted and how that affects the overall risk/return of the investment. If the prize of an investment is operating income subject to UBIT, that may not produce a positive result unless the income is in excess of 25% returns. If operating capital is ancillary to the real goal, such as a gain in equity when a company is sold or goes public, then the impact of UBTI may not be a concern.
3 – Use of Debt-Financing
When an IRA or 401(k) borrows money to make an investment, another form of taxable income known as Unrelated Debt-Financed Income (UDFI) is generated.
The most common examples are using non-recourse mortgage financing to purchase an income property, or participating in a larger real estate partnership or syndication that uses bank financing for property acquisition.
Other types of activities that can incorporate debt include leveraged private investment funds and margin trading in the stock market.
The concept around UDFI is that the portion of income a plan receives that is derived from the non-plan (borrowed) capital is taxable.
As an example, if your IRA were to purchase a rental property with a 40% down payment, the project is 60% debt financed. That means that 60% of the income is deemed UDFI and subject to taxation.
The upside is that once an IRA or 401(k) has a tax liability, it can use allowable deductions to offset that income and reduce the tax burden. As such, the net tax impact of mortgaged real estate investments is not typically significant once deductions for depreciation, interest on the note, and other allowable expenses are factored in. Leverage creates a boost in return. The tax on UDFI will put a small dent in that boost but will not negate the overall benefit of leverage.
The great news for real estate investors who qualify for a Solo 401(k) is that such plans have a specific exemption from tax on UDFI when the debt is used for the acquisition of real property. Other non-real estate debt is still taxable, however.
The Other Important Consideration
Of course, just because an opportunity fits within the IRS rules, that does not automatically make it a good investment. You want to be sure to evaluate the merits of the deal, the risks involved, potential liquidity, and other factors to make sure it is a good investment for your retirement plan.
Making a Final Determination
If a potential investment strategy is suitably at arm’s length, is unlevered, and produces passive earnings, that is three green lights and you can proceed with confidence.
Any direct or indirect intersection with disqualified persons is a significant concern. You should exercise caution and consult with licensed professionals before proceeding.
When an investment has the potential to generate taxable UBTI or UFDI, additional research is required. If the net after-tax returns of an opportunity are good, it can still be a suitable investment for your plan.
As always, make a plan, take your time, consult with professionals, and get it right.
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Quick answers to common questions
We’ll take you through a simple, step by step process designed to put your investment future into your own hands…immediately. Everything is handled on a turn-key basis. You take 100% control of your Retirement funds legally and without a taxable distribution.
YES! In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) making IRA, 401(k) and other retirement plans possible. Only two types of investments are excluded under ERISA and IRS Codes: Life Insurance Contracts and Collectibles (art, jewelry, etc.). Everything else is fair game. IRS CodeSec. 401 IRC 408(a) (3)
It’s actually pretty simple. Early on, regulators let the securities industry take the lead in educating the public about retirement accounts. Naturally, brokers and banks promoted stocks, bonds, and mutual funds—giving the impression that those were the only allowed investments. That was never true... and still isn’t. You can probably guess why they kept the rest under wraps.
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Keogh
- 401(k)
- 403(b)
- Profit Sharing Plans
- Qualified Annuities
- 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 youraccount 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.
A Solo 401(k) requires a sponsoring employer in the format of an owner-only business. If you have a for-profit business activity – whether as your main income or as a side venture – and have no full-time employees other than potentially your spouse, your business may qualify. The business may be a sole-proprietorship, LLC, corporation or other entity type.
A self-directed retirement plan is a type of IRA or 401(k) that gives you greater control over how your retirement funds are invested. Unlike traditional accounts held at banks or brokerage firms that limit you to stocks, bonds, and mutual funds, self-directed plans allow you to invest in a wide range of alternative assets including real estate, private businesses, precious metals, cryptocurrency, and more.
These plans still follow the same IRS rules and maintain the same tax-deferred or tax-free benefits as conventional retirement accounts. The difference is simply in how and where you choose to invest.
No. Moving to a self-directed IRA or Solo 401(k) does not trigger any taxes, as long as your funds are eligible for rollover.
Self-directed retirement plans maintain the same tax-advantaged status as traditional plans offered by banks or brokerage firms. The key difference is flexibility—our plans are designed to give you greater control and allow for a wider range of alternative investments beyond stocks, bonds, and mutual funds.
A prohibited transaction is any action between your retirement plan and a disqualified person that violates IRS rules and can lead to serious tax consequences. Under IRS Code 4975(c)(1), prohibited transactions include:
- Selling or leasing property between your plan and a disqualified person Example: Your IRA cannot purchase a property you already own.
- Lending money or extending credit between the plan and a disqualified person Example: You cannot personally guarantee a loan your IRA uses to buy real estate.
- Providing goods or services between your plan and a disqualified person Example: You can’t use your personal furniture to furnish a rental property owned by your IRA.
- Using plan income or assets for the benefit of a disqualified person Example: Your IRA cannot buy a vacation home that you or your family use.
- Self-dealing by a fiduciary (using plan assets for their own benefit) Example: Your CPA shouldn't loan your IRA money if they’re advising the plan.
- Receiving personal benefit from a deal involving your IRA's assets Example: You can’t pay yourself from profits your IRA earns on a rental.
If a transaction doesn’t clearly fall within the allowed guidelines, the IRS or Department of Labor may review the situation to determine if it qualifies as a prohibited transaction.
Disqualified persons are individuals or entities that are prohibited from engaging in certain transactions with your IRA or 401(k). Doing so could trigger a prohibited transaction, which may result in taxes and penalties.
Here’s who is considered a disqualified person:
- You (the account holder)
- Your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and their spouses
- Any advisor or fiduciary to the plan
- Any business or entity owned 50% or more by you or another disqualified person, or where you have decision-making authority
These rules exist to prevent self-dealing and ensure your retirement plan remains in compliance with IRS regulations.
(Reference: IRC 4975)
Understanding and following these rules can be tricky, but it’s very doable. The best way to stay compliant is to work with professionals who specialize in self-directed retirement plans. They can help you navigate IRS guidelines and avoid prohibited transactions.
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.
Yes. While self-directed retirement plans allow for a wide range of investments, there are a few important restrictions.
You cannot invest in collectibles or life insurance contracts, and you must avoid prohibited transactions—activities that benefit you personally rather than the retirement plan. These include things like buying or selling property to yourself or family members, using plan assets for personal gain, or self-dealing in any way.
Violating these rules could cause your entire IRA to lose its tax-advantaged status. To protect your account, it’s essential to work with professionals who understand IRS regulations and can help you stay compliant.
This is a common misconception. In many cases, professionals may simply be unfamiliar with self-directed retirement plans, as they fall outside their usual scope of work. CPAs and tax preparers are trained to file taxes, not necessarily to advise on alternative retirement strategies. Financial advisors and brokers often work for firms that focus on traditional investments like stocks and mutual funds—and may not benefit from or support alternative options like real estate or private lending.
Self-directed retirement investing is legal under IRS rules—but like any specialized area, it requires working with professionals who understand how it works.
The IRS has rules in place to make sure your IRA is used only for the exclusive benefit of the retirement account—not for personal gain or to help family members. These rules can get complicated because there are many ways a conflict of interest can occur, even unintentionally.
For example, if your IRA buys a house and rents it to your mother, you might be reluctant to evict her if she stops paying rent. That emotional connection creates a conflict between what’s best for your IRA and your personal relationships, something the IRS aims to prevent.
These rules help ensure your retirement account stays compliant and protected. (See IRC 408)
Yes. Most tax-deferred retirement accounts—such as Traditional IRAs, old 401(k)s, 403(b)s, and TSPs—can be rolled over into a self-directed IRA or Solo 401(k), depending on your eligibility. Roth IRAs cannot be rolled into these accounts.
You can contribute directly from earned income, subject to annual IRS contribution limits. The method and amount depend on the type of plan you have (e.g., Solo 401(k) vs. IRA).
To take a distribution, you'll request funds through your custodian or plan administrator. Distributions may be taxable depending on your account type and age. Early withdrawals may be subject to penalties.
For 2025, the Solo 401(k) max contribution limit is $81,250 if age 60-63, $77,500 if age 50-59 or 69+, and $70,000 if under 50. Traditional and Roth IRAs have a limit of $7,000 ($8,000 if age 50+). Limits are subject to IRS adjustments.
Yes. IRA contributions are typically due by your personal tax filing deadline (e.g., April 15). Solo 401(k) contributions follow your business tax filing deadline, including extensions.
IRS reporting requirements vary depending on the type of self-directed retirement plan you have. Here’s a quick breakdown of what you need to know
Please note: Our team can help you understand what’s required for your specific account, but we don’t provide tax or legal advice. We always recommend working with a qualified tax professional to ensure full IRS compliance.
Self-Directed IRA (Traditional or Roth)
- Form 5498 – Filed by your custodian each year to report contributions, rollovers, and the fair market value (FMV) of your account.
- Form 1099-R – Issued if you take a distribution or move funds out of your IRA.
- Annual Valuation – You'll need to provide updated FMV for any alternative assets held in the account, such as real estate or private placements.
Solo 401(k)
- Form 5500-EZ – Required if your plan assets exceed $250,000 as of year-end. Must be filed annually by the plan participant.
- Form 1099-R – Required if you take a distribution or roll funds out of the plan.
- Contribution Tracking – Keep records of employee and employer contributions. These are not filed with the IRS but may be needed for tax reporting or audits.
SEP IRA
- Form 5498 – Filed by your custodian to report contributions and FMV.
- Form 1099-R – Filed by your custodian. Issued for any distributions.
- Employer Contributions – Must be reported on your business tax return (and on employee W-2s, if applicable).
Health Savings Account (HSA)
- Form 5498-SA – Filed by your HSA custodian to report contributions.
- Form 1099-SA – Filed by your HAS custodian. Issued for any distributions.
- Form 8889 – Must be included with your personal tax return to report contributions, distributions, and how funds were used.
