The Basics of Self-Directed Retirement Accounts…

A self-directed retirement account could be an IRA, Roth IRA, 401(k), Roth 401(k), Pension Plan, SEP or even an HSA or Coverdell or College IRA. Any of these accounts could be moved from a traditional brokerage to a custodian or structure that allows you to invest in what Wall Street calls “alternative investments.” These other investments could include real estate, promissory notes, precious metals and private company stock.

The usual reaction I hear from investors is, “Why haven’t I ever heard of these self-directed IRAs or self-directed 401(k)s before? Furthermore, why have I always been told that my retirement portfolio has to be in a bunch of mutual funds or stocks?” The answer is quite simple: The large financial institutions that control most of the U.S. retirement accounts don’t make enough money off the self-directed industry or strategy. They just point you in the direction of products that generate sales commissions and excessive fees.

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What your stockbroker or captive financial advisor won’t tell you is that under current law, a retirement account is only restricted from investing in the following:

• Collectibles: such as art, stamps, coins, alcoholic beverages or antiques
• Life insurance
• S corporation stock
• Any investment that constitutes a prohibited transaction (dis­cussed below)
• Any investment not allowed under federal law (e.g., a marijuana dispensary)

What this means is that you have far more control than you ever imagined over your retirement accounts. You have the potential to get a tax deduction in your business to fund your retirement accounts and then invest those retirement accounts in a more creative fashion to build your financial freedom. This is one of the key buckets you should try to build with the profits from your business, so that you are more diversified in your wealth-building process.

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Avoiding prohibited transactions

When self-directing your retirement account, you must be aware of the prohibited transaction rules. This is typically the topic your standard financial advisor will jump on and warn you about in order to scare you off from self-directing. Your advisor may also tell you to avoid self-directing because you could get audited, have penalties or lose your retirement account altogether. Don’t listen to them! Yes, there are rules to follow, but investors have been using the self-directing strategy for over 30 years and have made billions of dollars doing it.

The general rules regarding prohibited transactions are found in Internal Revenue Code 4975 and the Employee Retirement Income Security Act (ERISA). These rules don’t restrict what your account can invest in but rather whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with a disqualified person.

The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax-advantaged accounts conducting transactions with parties who are close enough to the account owner that they could be designed to avoid or unfairly minimize tax by altering the true fair market value or price of the investment.

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Disqualified persons include the account owner, his or her spouse, children, parents and certain business partners. For example, your retirement account could not buy a rental property that is owned by your father. The IRA must hold the property strictly for investment. The property may be leased to your cousin, friend, sister or a random unrelated third party, but it cannot be leased or used by the IRA owner or the aforementioned prohibited family members or business partners. Only after the property has been distributed from the retirement account to the IRA owner may the owner or family members reside at or benefit from the property.

Of course, this short article can’t do the topic justice, and anyone self-directing an account is advised to speak with a tax advisor or lawyer who thoroughly understands the topic. This does not mean getting advice from your IRA custodian or 401(k) administrator. If you get audited or make a mistake, you pay the penalties and taxes, and no custodian or administrator will stand behind you. Their fine print always instructs the investor to get their own personal advisor — someone who is licensed and carries malpractice insurance to ensure the advice they give you is correct.