Yes, the Self-Directed IRA has all sorts of benefits. More freedom to choose investments you want in your portfolio. The potential for outstanding tax-free growth when using a Self-Directed Roth IRA with alternative assets.  But are there any obstacles that could stand in the way of your Self-Directed IRA and a well-protected retirement? There are a few, and you’ll need to know how to avoid them. Fortunately, these rules apply to any retirement account. With a Self-Directed IRA, however, investors simply need to be especially mindful about avoiding prohibited transactions.

What Is a Prohibited Transaction in a Self-Directed IRA?

A prohibited transaction (see the IRS definition here) is “certain transactions between a retirement plan and a disqualified person.” In other words, it’s all about who benefits from the retirement asset in question.

A tenant can rent property owned by your IRA, for example—but if that tenant is you or a disqualified person, that would disqualify the asset as a legitimate retirement investment. After all, you’re using the asset right now rather than in retirement, as intended.

To better understand what those transactions might be, let’s look at how the IRS defines a few:

• A disqualified person’s transfer of plan income or assets for immediate use or benefit
  • Any fiduciary act in which they deal with the income or assets of the plan for their own interest or benefit
  • Transactions such as selling, exchanging, or leasing property, or lending money or extending credit between the plan and a disqualified person

In other words, your IRA can’t interact with a disqualified person as if it were any other transaction. Your retirement account is for retirement purposes—and allowing your sister to benefit from a loan issued by your IRA would not be considered a valid retirement transaction.

Who Is a Disqualified Person in a Self-Directed IRA?

This is where investors really have to pay attention. You can rent out a property to someone you don’t know—after all, that’s what makes real estate within an IRA particularly appealing. But what about people you know? What constitutes a disqualified person?

A disqualified person includes you, your spouse, your parents and grandparents, your children and grandchildren, and their spouses. It also includes certain entities those individuals control, such as a company where you own a significant stake.

Notice who is not on that list. Siblings, aunts, uncles, and cousins typically are not considered disqualified persons under IRS rules. That surprises many people.

Let’s say your Self-Directed IRA owns a rental property. You can’t rent it to your son. You can’t buy a property you already personally own and transfer it into your IRA. You also can’t personally guarantee a loan for your IRA-owned property, because that’s considered extending credit between you and the plan.

These rules may sound restrictive at first. But they serve a clear purpose. Retirement accounts receive powerful tax advantages. In exchange, the IRS expects those accounts to be used strictly for retirement investing—not for personal convenience or short-term gain.

The Consequences of Getting It Wrong

Here’s where things become more than just technicalities. If you engage in a prohibited transaction, the IRS can treat your entire IRA as distributed as of the first day of that year. That means the full value of the account could become taxable. If you’re under age 59½, early withdrawal penalties may apply as well.

That’s not a small administrative headache. It can undo years of careful saving and tax planning in one stroke. In many cases, investors didn’t intend to break any rules—they simply didn’t understand how strict the boundaries really are.

This is why it’s so important to educate yourself as a Self-Directed IRA investor. The investments themselves can be powerful. But the way you manage those assets must stay in accordance with IRS retirement rules.

Interested in learning more about Self-Directed IRAs?  Contact American IRA, LLC at 866-7500-IRA (472) for a free consultation.  Download our free guides or visit us online at www.AmericanIRA.com.