What Are You Not Allowed to Put Into a Self-Directed IRA?
Self-directed IRAs allow investors to invest in a wider variety of assets than traditional IRAs do, but must be handled with extreme caution due to higher risks involved. Any violation of IRS rules such as prohibited transactions could cost you dearly.
As an example, you cannot reside in property owned by your SDIRA or allow disqualified individuals to benefit from it. Furthermore, any violations regarding prohibited transactions or self-dealing are forbidden.
Unrelated Business Income Tax (UBIT)
Though most nonprofits earn income that reflects their stated purposes, certain amounts may generate unrelated business taxable income (UBTI). Such taxes must be taxed at corporate rates and submitted via IRS Form 990-T filing.
To qualify as an activity conducted under UBTI, it must meet three criteria. These include (1) being classified as a trade or business. (2) Operating regularly. And (3) benefitting others directly. For instance, community performing arts organizations often charge admission to their quarterly productions, fulfilling all three of these requirements while at the same time serving to educate audiences about performance art.
If investments in this type of business generate positive UBTI of $1,000 or more, a special tax form must be filed and any associated taxes and penalties paid from your retirement account using available cash. Fidelity will file and pay this type of UBTI tax on your behalf in such instances.
Excess Contributions
When exceeding an IRA contribution limit, it’s imperative that any excess contributions be removed by tax filing deadline (plus extensions). Failure to do so results in an IRS excise penalty of 6% annually until all excess is removed from your account.
One strategy for correcting an excess is limiting annual contributions in the following year; this will prevent it from producing earnings in that year and may help avoid incurring penalties. Another option is moving excess into a traditional IRA (known as recharacterization); this must be completed prior to your tax filing deadline or extension deadline and also helps avoid earning income but could incur an excise penalty on how much money was moved there.
Avoiding excise penalties requires taking a dollar-limited distribution; however, this eliminates your ability to remove excess contributions in future years by absorption method and will require paying income tax on that portion removed (calculated using Net Income Attributable formula).
Self-Dealing
Self-directed IRAs (SDIRAs) allow account owners to invest in an expansive range of assets beyond what traditional IRAs allow, including precious metals and commodities, real estate, promissory notes, limited partnerships, tax lien certificates and many other alternative investments. But doing so requires greater initiative and care from account owners.
SDIRAs must abide by complex IRS regulations, or risk incurring extra taxes and financial penalties that could lead to the potential loss of their tax-deferred status. Before investing in these types of assets it’s wise to consult with an advisor first.
If you open a SDIRA, make sure to select a custodian approved by the IRS who specializes in helping IRA investors understand these prohibited transactions. The RITA Association maintains a list of accredited SDIRA custodians; you can also verify them through IRS verification services. Be wary of fake custodians as fraudsters may attempt to take your funds without authorization.
Disqualified Persons
Engaging in prohibited transactions could cost you in taxes or penalties, so to stay out of trouble with regulations it is a good idea to understand who are qualified persons when setting up or running a self-directed IRA.
Disqualified person refers to any entity you and/or your spouse (or lineal ascendant or descendant) own 50% or more of, certain companies related to you with their controlling individuals and fiduciaries such as custodians. This definition is quite expansive but should be taken seriously.
Simply stated, no asset you own in a self-directed IRA should be used for personal gain. For instance, you are not permitted to buy life insurance on yourself through it or even use property that belongs to it for vacations or hunting trips – the fair market value must also be submitted annually to the IRS.
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