A self-directed IRA can provide investors a lot of opportunities. However, there are limits imposed by the law that every investor should know.
In this article:
- Life Insurance Policies: Great Assets but Not Alternative Investments
- Collectibles That Are Not Approved as IRA Investments
- Personal Loans: Your IRA Is a Retirement Vehicle, Not a Lender
- Complex Derivative Positions: Not Suitable for Retirement
- Precious Metals That Do Not Reach Required Purity Levels
- S Corporation Shares: A Relatively Unknown Prohibited Investment
- Your Businesses: Self-Serving Loopholes Are Frowned Upon
- Your Domicile or Residence: Retirement Investment, Not Retirement Use
- Self-Dealing and Disqualified Transactions
Prohibited Investments for Self-Directed IRA
1. Life Insurance Policies: Great Assets but Not Investments for an IRA
Everyone should have a life insurance policy for protection — not for themselves, but for their loved ones. However, the law does not allow life insurance inside your self-directed IRA. For one, life insurance is not an investment. By itself, an insurance policy is for the beneficiaries, not the plan holder.
IRAs accept investment vehicles that give income upon retirement. Life insurance does not give returns or a guaranteed income but instead gives a lump sum. Some insurance policies may also have an annuities rider that gives a return, but life insurance by itself does not qualify as an investment for an IRA.
Another reason you cannot purchase life insurance for an IRA is due to the nature of insurance. IRAs accept assets that grow in value. Life insurance policies do not grow on their own, but rather they provide a fixed amount guaranteed by the insurance company.
Lastly, life insurance policies already have tax benefits. If you add those tax benefits together with the advantages of being inside an IRA, then the government will lose more tax revenue.
2. Collectibles That Are Not Approved as IRA Investments
You cannot use your IRA as your collector’s pocket. Technically, you can add collectibles in your IRA, but the IRS considers the value of the collectibles as a distribution as soon as you place them inside the IRA. This means that you will be taxed for this amount, plus if you are under retirement age, there will be a 10% penalty.
Therefore, the antiques that you discover may be better off not inside an IRA. The IRS specifically states that works of art, rugs, gemstones, stamps, and alcoholic beverages are collectibles. If you want a more in-depth resource, the IRS FAQs for investments can point you in the right direction.
An important thing to note is the IRS prohibits any asset that is a collectible as an investment in your IRA. Most of the time, if the object is physical, purchased for the purpose of growth in speculative value, and has a sizeable demand of collectors, then that object is deemed a collectible, at least to the IRS.
3. Personal Loans: Your IRA Is a Retirement Vehicle, Not a Lender
Any IRAs, whether self-directed or of the conventional variety, can invest in debt assets. You can purchase treasury bills and corporate bonds. In fact, self-directed IRAs can accept personal loans as long as there is interest and it is used as an investment.
However, some investors may want to access the funds without the IRS considering the withdrawal as a distribution, which can affect their tax status and can levy penalties on the IRA. To counteract that, investors will borrow capital in the IRA, apply a small interest, and then use the withdrawal/loan as they see fit.
The IRS discourages such manipulation of the rules. The penalty is quite stiff; once the IRS discovers that an investor has used the IRA as their personal lender, they consider the whole IRA, not just the withdrawal, as nonexistent. This means that all the assets in the IRA are already distributed on the first day of the year, which may garnering hefty penalties as well as a substantial and artificial increase in net worth and income. The increase in income and net worth could mean a higher tax bracket. This situation can easily get worse, making retirement extremely difficult.
4. Complex Derivative Positions: Not Suitable for Retirement
Derivative contracts, like put and call options, allow investors to leverage relatively small amounts of capital to profit from market movements. These are future-dated contracts and have their own complex trading rules, compliance regulations, as well as documentation for assets and the date traded, among other important things like the strike price.
A self-directed IRA can accept derivatives. However, the more complex derivative options are prohibited. An example of this is buying a call option of a stock without owning the security. The IRS prohibits this strategy, called a naked call, as it is immensely risky.
A guiding principle to see if your derivative option is eligible to add to your portfolio is about retirement security. Does the derivative have a system that limits loss? Does the derivative provide both protection and diversification? If the answer is “yes” to both questions, that derivative has a good chance of being eligible.
Always do your research. It is better to err on the side of caution regarding derivatives. When in doubt, take it out.
5. Precious Metals That Do Not Meet Required Purity Levels
Gold is a great store of value. A self-directed IRA can benefit from having gold as an investment. However, the gold you purchased from a relative or acquaintance may not meet the eligibility standards as per the IRS guidelines. For gold, silver, and other precious metals, purity levels must reach at least 99%.
Some collectible gold and silver coins have actually been exempted from the no-collectibles rule according to 26 US Code Section 408.
Please be cautious though, as a lot of counterfeit coins have affected investors. It is best to talk to professionals with a sterling reputation and experience for the precious metals market. Investors should go to reputable gold specialists such as the Birch Gold Group to provide authentic precious metal investments.
6. S Corporation Shares: A Relatively Unknown Prohibited Investment
Your self-directed IRA cannot invest in S corporations, which have less than 100 shareholders. They function like an LLC, but can only utilize one class of stocks.
For example, any S corporation should only have either common stocks or preferred stocks. Also, S corporations theoretically exist in perpetuity, as there is no expiration date (unlike LLCs). S Corporations also pass income directly, meaning double taxation is almost impossible, giving S corporation investors a relatively stable and marginally taxed income.
Why are S corporations not allowed in an IRA? It is not the IRS that prohibits IRAs from investing, but the law around S Corporations. 26 US Code Section 1361 only allows individuals, estates, and specific trusts.
7. Your Businesses: Self-Serving Loopholes Are Frowned Upon
The IRS wants to ensure that IRAs are used for retirement purposes. Creative individuals can use the tax benefits of a self-directed IRA for their businesses. They create an LLC owned by them or lend to themselves or their company, benefiting themselves in the form of lower taxes and manipulation of income reports.
By framing your goals toward retirement and not tax avoidance through loopholes, you can at the very least reason out to the IRS that your investments are made in good faith.
8. Your Home or Residence: Retirement Investment, Not Retirement Use
Real estate is a good choice as an investment for your self-directed IRA. However, the house where you reside is not an eligible investment for it.
First off, your house does not provide you income. Investors can say that their residence lowers their expenses in the form of rent. However, the house by itself does not provide the retirement income the IRS is looking for.
9. Self-Dealing and Disqualified Transactions
Even if your investment is eligible, the IRS can retroactively cancel the IRA status of your portfolio.
The prohibited entities, as enumerated in the IRS Retirement FAQs, are the IRA owners, the spouse, the fiduciary, the employer, and any entity that the account-holder owns more than 50% of. Also, if the account holder is an officer, director, owns at least 10% of an entity like a company, then that entity is also prohibited.
With the list of prohibited entities, there is only much an account-holder can do. Examples of transactions that the IRS forbids include prohibited entities not permitted to borrow from the IRA, selling property that benefits a prohibited entity or using any asset in the IRA as a security or collateral for a loan to the benefit of a prohibited entity.
Ignorance of the law excuses no one. Arm yourself with knowledge and you can make your retirement journey easier. Do not make the mistake of working around and bending the rules to your advantage. This will make working towards your retirement difficult.
Have you reviewed your investments to see if they are eligible? Do you have any questions about the eligibility of your investments? Let us discuss in the comments section below.
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