How is a Self-Directed IRA Taxed

Many retirement savers may chafe at the restrictions that come with regular IRAs. With those accounts, an investor is limited to traditional assets (think stocks, bonds, and mutual funds). Freedom-minded individuals may seek greater choice when it comes to investing for retirement. That’s where a self-directed IRA (SDIRA) comes in.

SDIRAs put investors in the driver’s seat, giving them the ability to chart their own course. In addition to traditional assets, SDIRAs can hold alternative assets, such as real estate, private equity, and private company shares, to name a few. These investments have the potential to diversify a portfolio and may provide higher returns in certain situations than publicly traded stocks and bonds. They do, it should be noted, often come with higher levels of risk. 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.

As with any kind of retirement account, it’s important to be aware of the key tax rules that are associated with a SDIRA. In the following article, we’ll give an overview of how a SDIRA is taxed, the tax reporting required of account holders, and other important issues surrounding taxation to consider.

Tax Rules for Traditional vs. Roth IRAs

IRAs generally come in two varieties: Traditional and Roth. What largely distinguishes these accounts from each other is how they are taxed.

With a Traditional IRA, 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 withdraw money from a Traditional IRA, you pay tax at your marginal income tax rate, assuming it was funded with pre-tax funds. If you withdraw money before the age of 59 ½ you may also be subject to an additional 10% tax

Roth IRAs essentially work in the opposite fashion. Contributions to a Roth account are made with after-tax dollars (so you don’t get a tax deduction), but qualified withdrawals are typically tax-free. For guidance on whether a withdrawal is tax-free, see the IRS guide here.

Traditional and Roth IRAs do share an important quality, however. Income and capital gains from investments generally accumulate on a tax-deferred basis while they’re in the account, which could help retirement savers maximize the growth of their assets.

Unrelated Business Taxable Income (UBTI)

In certain situations, a self-directed IRA will earn money that the IRS considers to be unrelated to the purpose of the account. For example, let’s say you purchase shares of a private company that operates a movie theatre. If the movie theatre’s business is profitable, your share of the net income may be subject to Unrelated Business Income Tax (UBIT).

Some SDIRA income, however, is excluded from this tax. According to accounting firm RSM, excluded income comprises the following:

1. Interest
2. Dividends
3. Royalties
4. Rents from real property
5. Capital gains

To add another wrinkle to the equation, if you use debt to purchase an investment in a SDIRA, the income attributable to the debt may also be considered Unrelated Business Income, and thus subject to tax. For example, if you borrow 60% of the funds to buy investment real estate, 60% of the rent you earn (as well as any capital gains) may be taxable. It’s important to speak to a financial professional or tax advisor to determine if UBIT may apply to your situation.

Tax Reporting Requirements, Forms and Filings, and Required Minimum Distributions

If you have a SDIRA, you will receive an IRS Form 5498 tax form from your account custodian (such as Forge Trust) each year. If you did not have any reportable transactions, your year-end statement may also serve as your substitute Form 5498. As H&R Block explains, this form reports the type of account you hold to the IRS as well as financial information about your IRA, such as

• Fair Market Value
• Contributions
• Conversions
• Rollovers
• Required Minimum Distributions

This form must be filed with the IRS by the custodian by May 31, which is also when it must be mailed to you, if applicable. You should cross-check it with any contributions made on your tax return (for the previous year) to ensure there are no errors.

Another form to be aware of is what’s known as a 1099-R. You will receive this form from your account’s custodian if you take a distribution (i.e. make a withdrawal) from your self-directed IRA. When you file your taxes, this information needs to be included.

If your SDIRA has Unrelated Business Income greater than $1,000 for any year, you must file what is known as a 990-T return (“Exempt Organization Business Income Tax Return”). You will file the return, but your custodian will help you make the payment necessary out of your SDIRA account.

Required Minimum Distributions (RMDs)

IRS rules stipulate that in the year an individual turns 73, owners of a traditional IRA must start taking Required Minimum Distributions (RMDs) from their SDIRA (age 73 as of 2024). You have until April 1st of the following year to take your first RMD. The minimum amount you are required to withdraw each year is based on dividing the prior December 31 account balance by your life expectancy as determined by tables published annually by the IRS.

Tax Considerations for Early Withdrawals

If you choose to withdraw money from an IRA before the age of 59 and a half, you typically are subject to a 10% penalty – but there are exceptions. For instance, if you lose your job and must withdraw money to pay for health care, you may be able to avoid paying this penalty. In addition, with a Roth IRA, you are only subject to the 10% penalty on any investment income. In other words, you can withdraw contributions without incurring any penalty.

Bottom Line

In this article, we’ve covered some of the main tax considerations if you’re thinking of opening a self-directed IRA. The tax considered addressed here are not all-encompassing. Please consult your tax advisor to discuss other potential taxes that may apply based on your investment(s) and your unique situation.

Self-directed IRAs may offer retirement savers flexibility. It’s crucial, before starting your SDIRA journey, however, to understand the tax rules and considerations associated with these innovative accounts. Knowing the ins and outs can save you significant headaches in the future.

Learn more about Forge Trust’s self-directed IRA offerings.