15 Sep #1 Self-Directed IRA Mistake to Avoid
As self-directed IRAs grow in popularity, it’s critical that owners understand the rules and adhere to them.
There is a BIG self-directed IRA mistake you need to be aware of. In fact, if you make this mistake, your entire IRA could become taxable.
We’re not talking about a portion of it – we’re talking about the entire thing!
If you have a self-directed IRA or you’re thinking of opening one soon, stop what you’re doing and read this entire article. Do what you can now to educate yourself so you don’t make this costly mistake.
Why Self-Directed IRAs?
As the name implies, a self-directed IRA is one you direct – not an advisor.
A self-directed IRA allows you to invest into assets not allowed in most traditional IRAs. Invest in real estate, cryptocurrency, gold, commodities, tax liens, limited partnerships, and many other alternative investments.
Self-directed IRAs do NOT allow you to invest in collectibles such as art, antiques, rugs, any alcoholic beverages, and anything else the IRS says is a collectible.
The beauty of a self-directed IRA is that you may make higher returns because the assets invested are not typically found in traditional or Roth IRAs.
And a big plus is that you have total control over your retirement savings.
But, because you have total control, you must do EVERYTHING yourself.
And that means knowing the rules, keeping up with IRS guidelines, keeping up with contribution limits, researching investments, making and monitoring trades, and making sure your account is compliant in the eyes of the IRS.
It can be a lot to keep up with if you aren’t detail-oriented and committed to staying on top of rules and regulations.
Make a prohibited transaction, and this mistake can cause your entire IRA to become taxable.
What Is a Prohibited Transaction?
As the name implies, these are main transactions that are NOT allowed in self-directed IRAs by the owner, his or her beneficiary, or any disqualified person.
According to the IRS, possible prohibited transactions with an IRA could include:
- Borrowing money from it.
- Selling property to it.
- Using it as security for a loan.
- Buying property for personal use (present or future) with IRA funds.
What Does the IRS Mean by a Disqualified Person?
The IRS says you cannot use a self-directed IRA to benefit you personally or your beneficiaries.
For example, you cannot take the income of one of your investments and place it into your personal bank account. It must go into the self-directed IRA.
Some other disqualified people, according to the IRS are relatives, businesses which you receive payments from, family members, and entities owned by any disqualified person.
What If I Make a Prohibited Transaction?
According to the IRS, if you or your beneficiaries make a prohibited transaction:
“The account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.”
In other words, your IRA will IMMEDIATELY be taxable. All of it.
And it will be taxed as ordinary income in the year it was closed.
Let’s say you make $75,000 per year. If you had $100,000 in your self-directed IRA and the IRS forces you to take a taxable distribution, your income on your tax return will show $175,000!
That’s going to be a nasty tax bill come the following April.
Is a Self-Directed IRA Right for Me?
As mentioned above, self-directed IRAs have numerous advantages. Because of the various non-traditional assets you can hold in them, they are great for someone looking to increase returns and hedge investments against volatility or economic conditions.
Self-directed IRAs also allow for more control over your investments.
They are also ideal for someone who loves investing and is willing to take the time to research investment options, as well as stay on top of regulations and IRS tax code.
On the flip side, they aren’t right for those with little or no investment experience.
And they definitely are not right for those who don’t pay attention to details and don’t have time to do the research on the rules and keep up on them.