Self-Directed IRAs

Did you know it is possible to hold real estate and business entities through an IRA?  You can if your IRA's custodian is open to having "nontraditional" investments.

What is a Self-Directed IRA?

A self-directed IRA is simply an IRA whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against "prohibited transactions".

What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA's investments is a fiduciary);
2. A person providing services to the plan;
3. An employer whose employees are covered by the plan;
4. An employee organization whose members are covered by the plan;
5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
6. A family member of any of the above;
7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer's yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

• Selling property to or from the IRA;
• Lending money to or borrowing money from the IRA;
• Receiving unreasonable compensation for managing the IRA;
• Using the IRA as security for a loan; or
• Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let's look at an example.

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his "management fee" as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA's hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA's assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

• Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
• 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
• 20% accuracy related penalty in 2011;
• Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
• Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
• Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
• 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using a self-directed IRA as an investment vehicle.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

If you have any questions about self-directed IRAs, please do not hesitate to contact me.

As always, I appreciate you leaving your feedback in the comments section below.

Why Have a 401(k)?

What financial advice have you been given?

Throughout my life I received 2 main pieces of financial advice.  1) Save for my own retirement.  2) Contribute enough to a 401(k) plan to maximize the employer match.

Every 401(k) plan is different as businesses set them up in order to best meet their needs and the needs of their employees.  However, a typical arrangement is for employers to match their employees contributions to their 401(k) plans $0.50 on the dollar, up to 3% of the employees gross salary.

If that is how your 401(k) plan works, you should contribute at least 6% of your gross salary to your 401(k) plan.  That effectively increases your salary by 3%! Why would you want to leave money on the table?

I would encourage you to actually contribute more than that to your 401(k) plan, as long as you can afford to do so.  In a previous blog post, Plan For Your Retirement: No One Else Will, I discussed why you should contribute to your own retirement and the significant advantages to doing so.  Please read that post and see why you should contribute what you can afford to your qualified retirement plan.

But what is in it for employers?  As an employer, why should you set up a 401(k) plan and put your money into your employee's retirement fund?

• $1,500 Tax Credit. Employers are entitled to claim a tax credit equal to 50% of the cost to set up and administer the plan, and to educate employees about the plan.  The credit is worth a maximum of $500 per year for each of the first 3 years of the plan.  If you are unable to use this credit in any given year, the unused portion can be carried back or forward to other tax years.  There are a few basic requirements that you should discuss with a CPA.
• Tax Deduction.  Every penny that an employer contributes to a 401(k) plan, including to his or her own, is a tax deduction.  As an employer, you are also able to deduct the cost of administering the plan and educating your employees about the plan.  This is because the IRS considers the operation of a 401(k) plan to be an ordinary and necessary business expense.
• Better Employee Recruitment and Retention.  For any business, having great employees is essential.  They represent you, so it is important that you are able to recruit the best possible employees and retain them once you have them.  All else being equal, I would choose to work for a company that has a 401(k) plan over one that doesn't.  It shows employees that you care about them and their retirement.  It helps to build loyalty to your company.

If you would like to discuss the tax benefits of establishing and operating a 401(k) plan, or you have any questions, please send me an e-mail.

I would also be happy to refer you to a great financial advisor who can discuss all the non-tax aspects of your existing 401(k) plan or help you to establish a new 401(k) plan.

I appreciate your feedback.  Please feel free to leave a comment below.

Plan for Your Retirement: No One Else Will

The Social Security trust fund will be exhausted by 2037.  This is according to one estimate provided by the Social Security Administration.

This means that it is up to you to provide for your retirement. But don't worry, you can make sure that you have a comfortable retirement if you follow two pieces of advice:

1) Start saving for your retirement early.  Start now.  I know, you have a lot of bills to pay and it will be decades until you retire.  You feel like you can start saving when you are more financially secure, and will just make up for starting later by saving more in the future.  This could work, but it comes at a cost.

For example, take Bill and his friend Bob.  Both are young men with a lot of bills, but Bill's family taught him to start saving for his retirement as soon as he could.  Both got hired to full-time jobs when they were 24 years old.  Bill looked at his expenses, and realized he could contribute $2,000 a year to his retirement at the end of every year.  He invested conservatively, and earned a steady 5% return without taxes every year.  At the age of 65, he had just under $270,000 saved.

Bob, on the other hand, did not set aside any money in his 20s or 30s.  It took Bob 20 years to feel financially secure enough to start contributing to his retirement account.  Bob, now 44 years old, wanted to catch up with Bill and decided to put  $7,000 a year into his retirement account at the end of every year.  Bob invested the same as Bill, and earned the same steady 5% return without taxes every year.  At the age of 65, he had just over $260,000 saved.

As you can see, in order to have between $260,000 and $270,000 in their retirement accounts, Bill only had to contribute $82,000 while Bob had to contribute $147,000 ($65,000 more).  This is all because Bill started saving at an early age.

That is the power of compounding investment returns.

2) Invest through a qualified retirement plan.  The IRS gives special tax treatment to certain types of retirement accounts including, but not limited to:

• 401(k)
• 403(b)
• Traditional IRA
• Roth IRA

There are different features and tax incentives attached to each of these types of retirement accounts, but they share one very important feature.  All the earnings grow tax-free.  Bob and Bill both had their money invested in a qualified retirement account, so all of the earnings grew tax-free.  If they decided to put their retirement savings in a normal investment account, they each would have had far less in their retirement accounts because they would have a significant amount taken out each year in taxes.

It is very rare for the government to allow you to invest your money without taxing it for decades, if ever.

These types of retirement accounts have another significant tax incentive.

Contributions to 401(k)s and 403(b)s reduce the amount of taxable wages you report on your tax return.  For example, if you earned $100,000 in a year, and you contributed $5,000 to your 401(k), your W-2 would only show $95,000 of gross wages.

Contributions to a Traditional IRA are deductible for the year of the contribution.  Thus, if you earned $100,000 during the year and contributed $5,000 to your Traditional IRA, you would take a deduction on your tax return for $5,000, leaving you with gross income of $95,000.

Assuming you are in a 25% federal tax bracket, you would save $1,250 in federal taxes for making a $5,000 contribution to your own retirement.

Distributions from a Roth IRA are tax-free.  This is delayed gratification, but if you expect to be in a higher income tax bracket when you retire or you think that tax rates will go up, you can choose to put your money into a Roth IRA and let it grow tax-free and then eventually take it out of your retirement account tax-free.

Please note that this is only a very brief overview of retirement plans.  I plan to discuss different aspects of retirement plans and the benefits to employers to sponsoring a 401(k) or 403(b) plan in future blog posts.

I strongly encourage you to talk to your financial advisor about setting up a retirement plan if you do not have one already.  If you need a referral to a financial advisor, I know a great financial advisor who would be happy to answer any of your questions.

I would love to get your feedback through comments below.  If you have a question that you would like to discuss with me privately, please do not hesitate to send me an e-mail.