Self-directed individual retirement accounts come with tax advantages and access to alternative investments — along with major technical caveats and the risk of costly mistakes.
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That’s why it’s important for investors tapping into alternative vehicles not allowed in traditional IRAs to not only pick the right service providers but also understand the complex rules for prohibited securities transactions, according to Todd Kesterson, a certified public accountant and principal of family office services with accounting and advisory firm Kaufman Rossin. Investors who turn to financial advisors to build their wealth via the strategy, which reportedly helped make Peter Thiel a billionaire, could wind up liable for taxes and excise penalties if they run afoul of the guidelines for self-directed IRAs.
“Then they liquidate the IRA. It’s done, and they dissolve it, and everything is distributed out and it’s a taxable transaction as well as an excise tax,” Kesterson said. “It hurts everyone.”
Self-directed IRAs cannot hold life insurance; collectibles; real estate properties used by the client households; investments into loans to the investor, family members or other related parties; or any asset acting as collateral, Kesterson wrote last month in Crain Currency, citing IRS Code Section 4975 and IRS Publication 590.
Regulators have frequently warned about the fraud risks involved with so-called self-directed IRA custodians — a third party between the investor and the fund or other product company that services the account.
“Self-directed IRA custodians: DO NOT sell investment products or provide investment advice; DO NOT evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters; and DO NOT verify the accuracy of any financial information that is provided for an investment in the account,” the North American Securities Administrators Association, a network of state regulators, said in a 2023 investor alert and bulletin. “Self-directed IRA custodians are only responsible for holding and administering the assets in the account. Furthermore, most custodial agreements between a self-directed IRA custodian and an investor explicitly state that the self-directed IRA custodian has no responsibility for investment performance.”
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Choose wisely and hire a professional
Wealthy investors may be somewhat less likely to fall victim to bad actors, but they can still benefit from the advice of advisors and tax pros as they think through their investments. Clients’ choices could be affected by legitimate custodians’ areas of expertise, varying fees and stances on whether an investor is a so-called disqualified person engaging in what the IRS deems to be “self-dealing.” In addition, the investors and their advisors must ensure that the custodians receive annual valuations of the assets from the fund company, Kesterson said.
“I wouldn’t say ‘shopping’ custodians, but there are going to be situations where one is more picky or detailed than others,” he said. “They all have different fee structures, depending on the type of investment.”
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Losses can’t be harvested, but unrelated business income can be taxed
Regardless of the type of vehicle, the investments in self-directed IRAs carry some tax requirements that could catch investors by surprise. For instance, loss-harvesting strategies do not apply to private equity funds or other assets in the accounts.
“You can’t deduct the loss like you could if you own it personally,” Kesterson said. “There’s no loss deduction; the investment is just gone, whereas if you own it personally you can write off the amount of investment that you had.”
Another tricky tax issue could come up if the self-directed IRA has invested in an operating company that is running another business or leveraged vehicles. Then the account could be earning so-called unrelated business taxable income (UBTI) that the client must report to the IRS on Form 990-T while paying the possible federal and state taxes.
“Even though it’s an IRA that’s not subject to tax, if an investment generates UBTI, then there’s actually a tax return that the IRA has to file,” Kesterson said. “A lot of people don’t know that.”
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Avoid self-directed self-dealing at all costs
Other tricky tax and rule pitfalls could emerge from shares in S corporations (which are not allowed in self-directed IRAs), required minimum distributions and inherited accounts.
But perhaps the biggest trap lies in regulations against self-dealing through the accounts, which cannot hold any personal assets. These rules for prohibited securities transactions often apply to real estate holdings or fund company owners’ desire to invest their companies’ product through a self-directed IRA, Kesterson noted.
Technically, the boundary is a 50% personal interest in the asset. But that gets murkier when incentive compensation at a startup or fund company pushes the equity control higher, so lawyers and tax pros must make a determination on behalf of the client. If the IRS decides later that the self-directed IRA engaged in a prohibited transaction, the client may need to liquidate the security entirely and pay accompanying taxes and penalties. So clients have a vested interest in figuring out early on whether they could face any problems down the line.
“It’s kind of facts and circumstances, but if they own 50%, the answer is no, you can’t do it,” Kesterson said. “Then you start having to peel back onions.”
