Overview of Self-Directed IRA Rules and Regulations
According to U.S. tax codes, an IRA must be a trust or a custodial account formed in the United States for the exclusive benefit of an individual or his beneficiaries. The account needs to be governed by written instructions and meet particular requirements in relation to holdings, distributions, contributions, and the trustee or custodian’s identity. These give rise to a special type of IRA known as a self-directed IRA (SDIRA).
The Differences between Self-Managed and Self-Directed IRA
All IRAs permit account owners to select from investment opportunities acceptable under the IRA trust agreement, and to buy and sell those investments upon the account owner’s good judgment, on the condition that the sale proceeds will remain in the account. The limitation on investor choice comes from IRA custodians being allowed to choose the types of assets they will handle within the limitations imposed by tax regulations. Majority of IRA custodians only accept investments in very liquid, easily valued products – for example, approved stocks, mutual funds, etc.
However, a number of custodians are willing to manage accounts with alternate investments and to provide the account owner considerable control to “self-direct” such investments within the confines of tax regulations. The list of alternative investments is extensive, limited only by certain prohibitions against illegal or illiquid activities as per self-directed IRA rules, and the keenness of a custodian to manage the holding.
The most frequently provided example of an SDIRA alternative investment is direct ownership of real estate, which may involve property redevelopment or a rental situation. Direct real-estate ownership is very different from publicly traded REIT investments, since the latter is typically available through more conventional IRA accounts.
Advantages of a Self-Directed IRA
The advantages offered by an SDIRA have something to do with an account owner’s ability to use alternative investments in order to reach alpha in a tax-favored manner. At the end of the day, success in an SDIRA depends on the account owner’s unique knowledge or expertise meant to capture returns which, after bending for risk, exceed market returns.
An overarching premise in self-directed IRA rules is that self-dealing, where the owner or manager of an IRA uses the account for personal satisfaction or in a way that disrespects the tax law, is not allowed. Crucial elements of self-directed IRA rules and regulations and compliance include the identification of disqualified personalities and the transactions types they are prohibited from initiating with the account. The effects of disobeying transaction rules can be severe, such as the whole IRA being declared by the IRS as taxable at its market at the start of the year in which the prohibited transaction took place, which means the taxpayer may need to pay settle deferred taxes, besides a 10% early withdrawal penalty.
Aside from to the IRA owner, self-directed IRA rules classify a “disqualified person” as any individual controlling the assets, receipts, disbursements and investments, or those who have significant influence on investment decisions.