What are the Potential Benefits of a Self-Directed IRA for Tax Purposes?

Self-directed IRAs are popular retirement accounts for those who value choice when it comes to their investment options. In addition to traditional assets (think stocks, bonds, and mutual funds), SDIRAs allow savers to own alternative assets, such as private company shares, precious metals, and investment real estate. These assets, while sometimes higher risk, may outperform the stock market at times, and can help diversify an investment portfolio.

In addition, self-directed IRAs may offer tax benefits to Americans, which can help them save for their retirements in the most efficient way possible. In this article, we’ll look at some of the key tax advantages associated with SDIRAs—and outline key tax-related considerations so investors stay on the right side of the IRS.

Self-Directed IRA Tax Benefits

As we explained previously, there are two main kinds of SDIRAs: Traditional and Roth. With a traditional SDIRA, your contributions may be made with pre-tax dollars and thus, reduce your taxable income, subject to IRS limitations. (Contributions to traditional IRAs are not always tax-deductible: If you have an employer retirement plan, for example, there are limits to deductibility).

When you eventually withdraw funds from a Traditional SDIRA, you pay tax on the proceeds at your marginal tax rate. This can be especially beneficial if you believe your marginal tax rate in retirement will be lower than it is today.

Roth SDIRAs effectively work in reverse. Contributions are made with after-tax dollars, meaning you don’t get a deduction when the contributions are made. However, because you’ve already paid tax on the contributions, qualified withdrawals are generally tax-free. If you expect your marginal tax rate to be higher in retirement than it is today, this feature can be advantageous.

Traditional and Roth self-directed IRAs do share an important characteristic, however. In both types of accounts, income (both capital gains and interest) generally accumulate tax free. This helps investors maximize their retirement savings.

Investment Flexibility and Diversification

Compared to regular IRAs (offered by banks and brokerages), self-directed IRAs offer savers a wider range of investment options. They can still own traditional assets such as stocks, bonds, mutual funds, but they may also hold so-called alternative assets, which include:

• Real estate
• Private debt and private lending
• Private company shares
• Partnerships
• Tax liens
• Limited Liability Companies (LLCs)
• Certain precious metals, such as gold and silver

Retirement savers purchase alternative assets for the potential for better returns and/or increased diversification. Alternatives may outperform the stock market in some situations and my underperform in other situations. And they also may zig while the stock market zags—meaning alternative assets may not move in lockstep with the S&P 500, Nasdaq 100, or Dow Jones Industrial Average. Certain types of alternative assets may be ‘uncorrelated’ to stocks, which may dampen the overall volatility of a portfolio.

Alternative assets, it must be noted, often come with higher levels of risk and higher costs. Key risks associated with alternative assets include the potential for a significant decline in the value of an asset, higher volatility, and a lack of liquidity. Liquidity is the ability to buy and sell an investment at or near the current market price. Another risk, with private company shares and other alternative assets, is that they may not be uncorrelated to traditional assets, particularly in times of broader market stress.

Compliance and Reporting

If you’re thinking about opening a self-directed IRA, it’s important to be aware of key IRS rules and regulations regarding these accounts. For starters, you’ll need to steer clear of what are known as Prohibited Transactions. These include transactions where the SDIRA account holder personally benefits. For example, if you purchase an investment property, you cannot live in it, as this would constitute a prohibited transaction.

The IRS also deems SDIRA transactions with Disqualified Persons to be Prohibited Transactions. Disqualified Persons include your spouse, parents, your children, and their spouses. Long story short, you cannot lend money, buy or sell property, or allow a Disqualified Person to benefit in any way from a transaction in your self-directed IRA.

The potential consequences of engaging in Prohibited Transaction can be severe. As the IRS explains:

“…if an IRA owner or his or her beneficiaries engage in a prohibited transaction in connection with an IRA account at any time during the year, the account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.”

Unrelated Business Income Tax (UBIT)

Another potential self-directed IRA tax minefield that you may want to avoid is Unrelated Business Income Tax (UBIT). UBIT can be triggered in two ways:

• If you earn money in your self-directed IRA investment that is deemed unrelated to the purpose of the account. Typically, these are situations where there’s an ‘active’ component to an investment. For example, if you purchase shares in a movie theatre, you may be taxed on your share of the theatre’s profits.
• If you use debt to purchase an investment in an SDIRA. Let’s say you buy investment real estate and borrow 60% of the money required to complete the purchase. The IRS may tax you on your profits attributable to the debt used (i.e. 60%).

Reporting Obligations

As with traditional IRA accounts, self-directed IRAs may involve tax reporting obligations, both for the account holder and custodian.

• A Form 5498 is required to be filed to the IRS by the custodian if a contribution to an account has been made in a given tax year. The Form also lists any Conversions, Rollovers, or Required Minimum Distributions. The custodian (such as Forge Trust) sends you a copy of this document. You should cross-check this form with your own records to ensure the custodian’s reporting is accurate.
• If your self-directed IRA has Unrelated Business Income in excess of $1,000 for any year, you must file a 990-T return (“Exempt Organization Business Income Tax Return”).
• You will receive a 1099-R form from your account’s custodian if you take a distribution (i.e. make a withdrawal) or have another tax reporting event from your SDIRA. When you file your taxes, you need to include this form.

Conclusion

Self-directed IRAs allow retirement savers to hold a wider range of investments than regular IRAs. SDIRAs, like regular IRAs, also come with potential tax benefits, which may help you keep more of your money. Learn more about Forge Trust’s self-directed IRA offerings.