self-directed INVESTING, IRAS AND THE LAW
INTRODUCTION
When someone first hears about “self-directed investing” or "self-directed IRAs", their usual reaction is something like, “Is that legal?” Honestly, that was our response so being good attorneys, we did some research. This is what we found on self-directed investing IRA rules.
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TERMINOLOGY
To begin, let’s understand the terminology. First, “self-directed” is not a legal term. It is a term used by the industry to describe a type of retirement account that allows for unrestricted investing. Second, the term IRA stands for Individual Retirement Account. Also included are employer 401K accounts and other tax deferred accounts typically set up to fund one’s retirement. Third, the terms “traditional” investments and “non-traditional” investments are used to help understand the value in using a self-directed IRA. Traditional investments are defined as those made in the stock market. Non-traditional investments are investments that are not stocks, bonds, or mutual funds. One major advantage of using a self-directed IRA is to make non-traditional investments.
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HISTORY
When Congress passed the Employee Retirement Income Security Act (ERISA) in 1974, the IRA and 401(k) were born. ERISA and the Internal Revenue Code (IRC) established a framework for employees to establish and fund tax-deferred retirement accounts. This began the movement away from employer funded pensions to employee controlled IRAs.
Wall Street seized the opportunity to control the trillions (with a “T”) of dollars that would be used to fund IRAs. Financial institutions became custodians for IRA accounts and offered their own investments that were limited to stocks, bonds, and mutual funds. A typical 401k plan offered by an employer has only a few dozen investment choices.
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THE LAW
ERISA is the legislation but the law regulating IRAs is the Internal Revenue Code (IRC) and Department of Labor (DOL) regulations. This is exclusively federal law and is exclusive in nature meaning it provides only the types of investments that are prohibited. There have been recent court cases and administrative rulings that also apply to IRAs.
The IRC sets the rules (IRC Section 4975) for the types of IRA investments that are legal and which entities can legally be custodians for IRA accounts IRC Section 408 (n). Three types of investments are specifically prohibited: Life Insurance Contracts (IRC Section 408 (a)(3), Collectibles (IRC Section 408 (m), and Stock in S Corporations (IRC). Otherwise, IRA investments are legal if they are not deemed prohibited transactions under IRC Section 4975. Entities that serve as IRA custodians are defined by the Code as “Banks.” This includes a bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia) or of any State, an insured credit union, and state chartered banks.
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PROHIBITED TRANSACTIONS
The most important thing to know relating to self-directed investing in IRAs is what constitutes a prohibited transaction. The simplest definition of a prohibited transaction is one in which the IRA engages in a transaction for a non-investment purpose or with a disqualified person. The IRA owner cannot benefit directly or indirectly from any transaction made by the IRA. For example, the IRA cannot purchase a home that the IRA owner occupies. For more information about this, please consult your legal counsel.
The consequences to the IRA holder of engaging in a prohibited transaction are severe. The value of the transaction is deemed a distribution as of the first day of the year of the transaction subject to income tax. Consequences also apply to the disqualified person in a prohibited transaction, so it’s vital to be sure you're getting good legal advice.
The legal analysis of prohibited transactions needs to be carefully conducted for each investment. That said, the opportunities for legal investments by an IRA are many and go well beyond stocks and bonds.
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CONCLUSION
The law allows significant discretion for IRA holders in choosing investments. It critical to ensure the transaction and all persons involved won’t run afoul of the rules and cause problems so contact your attorney or accountant before you invest. You will find that most alternative investments, including the purchase of real estate, are perfectly legal and increasingly common in IRAs.
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Mike Ritter
Partner/Real Estate Attorney
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