You may not realize it, but when it comes to saving for retirement using an IRA, you don’t necessarily have to stick to just mutual funds and stocks. If you’re a little more aggressive and willing to take on some risk, then perhaps setting up a self directed IRA would be a better alternative.
A self directed IRA is a special type of individual retirement arrangement that allows an investor to choose from a wider range of investment options than are usually available with a typical IRA. By doing so the investor exposes themselves to the potential for much higher returns than they might receive from a stock market index fund based portfolio.
Unfortunately since these investments are more complex, you’ll have to make sure you really fully understand the self directed IRA rules before you invest in one. The following are some of the basics of these types of plans and some of the things you’ll have to be careful to avoid so that you don’t end up paying penalties.
How Does a Self Directed IRA Work?
The first thing you need to understand about a self directed IRA is that it is managed differently than a regular IRA. According to IRS regulations, the assets of the self directed IRA are held by a qualified trustee or custodian on behalf of the IRA owner. It is this trustee or custodian (not the owner) who handles all the transactions and reporting associated with the account.
The reason for having this third party intervention is to help keep the IRA investments unbiased. Many of the investments that are allowed by this type of IRA could easily be manipulated for personal gain if not kept in check.
Prohibited Transactions and Disqualified Persons:
While regular IRA’s allow you to invest in things like stocks and bonds, a self directed IRA allows you go one step further by investing in alternative selections such as real estate, mortgages, LLCs and LPs, notes, and precious metals.
However not everything is fair game. Recall that the purpose of an IRA is to provide income later on in life during retirement. Therefore, any sort of transaction where you could gain personally is not permitted by the IRS. Examples would include:
- Collectibles (coins, stamps, wine, etc)
- Life insurance policies
- A sale, leasing, or exchange of property
- Borrowing money
- Using it as a security for a loan
- Personal use of the asset (such as a primary residence or summer home)
- Income generated from the asset (such as business income)
- Furnishing services, goods or facilities to the asset
(You can find more examples of prohibited transactions at this article here).
In addition to certain transactions being prohibited there are also certain people called “disqualified persons” who are also not allowed to interact with the IRA (for reasons of conflict of interest). Examples of this would include yourself (the IRA owner), your spouse, children, grandchildren and parents. The IRS does not include siblings, uncles, aunts, cousins and step relations as related parties.
How to Qualify for a Self Directed IRA:
Similar to a regular IRA, you need to have earned income (either from your job or business) before you can open a self directed IRA.
The contribution limits for a self-directed IRA are the same as they are for a traditional IRA. In 2015, you can contribute as much as $5,500 for the year. If you are 50 years old or older, you have the option of adding a catch-up contribution and saving as much as $6,500.
If you have other retirement accounts that you would like to have more control over, you are allowed to transfer your balances to a self-directed IRA. You can transfer 401k accounts, Roth IRA accounts, SEP IRA accounts and SIMPLE IRA accounts to a self-directed IRA. Be aware that transferring your account could take up to four weeks, depending on the company who is currently managing your retirement funds and the IRA custodian you are choosing to handle your self-directed IRA.
When transferring the funds of another retirement account to your self-directed IRA, you will need to inform your custodian that you will be rolling your funds over to your self-directed IRA. You will receive the necessary forms to make that happen. Be sure to fill out the forms completely to avoid any delays. Your custodian may allow you to roll your funds over in their current investments, but if not, you will need to sell the investments you currently have and buy the investments you want once you have set up your self-directed IRA. As long as you make a direct transfer and do not withdraw any funds at any time, you will not have to pay taxes on the funds you roll over.
Get Professional Help to Follow the Self Directed IRA Rules Correctly:
Don’t be penny wise and pound foolish. If any of the above self directed IRA rules seem unclear or you would simply like some more guidance, seek the advice of a financial consultant that has some experience with this kind of savings tool. While it might cost you a few hundred dollars to schedule a consultation with a professional, the direction they give could end up helping you avoid paying thousands of dollars in taxes and fines later on. Let them help you find a trusted custodian and setup your self directed IRA the right way.
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