Afraid to open your monthly IRA statements? Has stock market volatility of the last six months altered your retirement plans? We are all familiar with the typical IRA investing in stocks, bonds, and mutual funds, but with recent stock market lows, some investors may be thinking about putting their IRA funds in less conventional investments. Potential alternative investments may include commercial or residential real estate, interests in closely held businesses, hedge funds or personal property. While it may be tempting to escape the market and try your luck elsewhere, IRA investing is wrought with rules and regulations, and missteps can be fatal to the account. Here are a few of the issues to watch for should you decide to take advantage of the tax-deferred nature of IRA investing in planning for your future.
Investments and Transactions That are Off-Limits
The Internal Revenue Code specifically disallows certain assets as IRA investments. These include life insurance contracts and most collectibles. Excepted from this rule are certain gold, silver, and platinum coins, and bullion physically held by IRA trustees. Also disallowed is pledging IRA assets as security for a loan. Pledging IRA assets causes the portion of the account pledged to be treated as a distribution from the account, subject to income taxes and possibly withdrawal penalties if the IRA owner is under age 59 1/2.
Prohibited Transactions
IRA owners must also watch out for so-called self-dealing rules, or prohibited transactions. In general, these rules prohibit using IRA assets for the benefit of ‘disqualified persons’, and prohibit loans between the IRA and disqualified persons. Disqualified persons is defined as IRA owners and beneficiaries, and includes certain family members and controlled entities. Should a prohibited transaction occur, excise taxes, income taxes and loss of the account’s status as an IRA might result, with accompanying income tax liabilities and potential withdrawal penalties. Careful consideration must be given to whether or not the IRA owner or other disqualified person will benefit from a potential investment in any way other than by the investment return to the IRA account.
Unrelated Business Taxable Income
Unrelated business taxable income (UBTI) arises in IRAs in one of two ways:
- An IRA may invest in an unincorporated active business as a sole owner or as a partner; or
- The IRA may hold investments that are debt-financed (for example, real estate with acquisition financing).
If the alternative investment were to produce income, the income may be subject to income taxes on UBTI in excess of a $1,000 exemption. Trust tax rates would apply, which tend to be higher than individual tax rates. Also, the account would need to have enough cash available to pay the taxes. However, rental income is specifically excluded from the UBTI provisions, as are gains from the sale or other disposition of the property as long as it is not inventory or other business property. However, the debt-financed rules above still apply to rental property.
Valuations, Distributions
There are many situations in which IRAs are required to report the value of their assets and/or use those values for important tax calculations. Annually, IRA asset values are reported on Form 5498. When account owners attain age 59 ½, and/or after their deaths, required minimum distributions (RMDs) must be calculated. Also, when IRA assets are distributed, their fair market values are used to determine the taxable amount of the distributions. Performing these valuations may require additional expense and involve hiring valuation experts. This is much different than simply selling marketable securities or checking public price quotes when values are needed.
Similarly, making distributions of partial interests in alternative investments may be cumbersome and expensive. RMDs to the account owner and distributions to multiple beneficiaries after the account owner’s death will require valuations and careful planning, or potentially the sale of the asset, in order to facilitate the required distributions.
Administrative Difficulties
Certain proposed unconventional IRA investments may pose administrative hurdles or risks within the IRAs. One concern would be investments that might require expenditures that could exceed cash that can be readily raised within the IRAs. In that category falls real estate requiring expenditures for real estate taxes, insurance and maintenance, and partnerships that could make capital calls on partners. Keep in mind that any payments of such expenses by IRA owners would be treated as contributions to the IRA subject to the limits on annual IRA contributions. Also, borrowing within the IRA to make the expenditures would likely be a hassle and cause debt-financed UBTI.
Planning is Key
Although administering unconventional investments within an IRA can be tricky, with dire consequences for slip-ups, some investors may be ready to explore their IRA options. With investment values at historic lows, this may be the perfect time to do so. Please contact us if you would like to start this discussion. We can help you navigate the waters if you are considering bailing out your IRA.