What is a Self-Directed IRA? What are Alternative Assets?

The term Alternative IRA, which has been in the news so much recently, is frequently misunderstood. It is often thought to be an IRS designation that signifies an account type that is different from a traditional IRA or a Roth IRA, which are designated IRS account types. It is also not unusual for people to be under the impression that self directed means that the IRA owns an LLC which holds the IRA assets. Neither of these is the case.

“Alternative” as well as “Self Directed” are descriptive terms, not legal distinctions, and are used largely as marketing tools. ( In fact, terms such as “Rollover IRA”, “Real Estate IRA”, and “Gold IRA” are also descriptive and used primarily for marketing.) The only consistent meaning that alternative IRA might have is that the assets held by the account include something other than stocks, bonds, mutual funds, etc. And the
meaning of self directed IRA is basically that the IRA holder will have some choice in terms of what assets the account will hold. That may be a choice between two or three publicly traded stocks or bonds or funds, or it may be the ability to choose real estate, gold, private lending, investment in private companies, and more. IRA providers are not bound by the IRS to offer any particular suite of assets. It is incumbent upon the IRA holder to choose a provider that services the desired asset types.

The IRS, which governs IRAs, allows two basic tax arrangements for retirement accounts:

1) With a Traditional IRA, the IRA holder contributes money to the account “pre-tax”. While that money is in the account, it performs tax-deferred, meaning that the increase or decrease in its value does not have an effect on the IRA holder’s personal annual taxes. The only time that the IRA holder’s personal taxes are affected are when they make a contribution or take a distribution. A contribution will decrease the amount of earned income that the account holder declares for a tax year. And when a distribution is taken, the amount of the distribution is then added to the person’s annual income for that tax year and taxed accordingly.

2) In a Roth IRA, contributions by the IRA holder are “post-tax”; the investments in the account perform without tax consequence; and then can be distributed tax free to the IRA holder after the age of 59.5. These two basic arrangements, along with the associated rules for contributions and distributions, are the same for all IRAs, alternative or not, self-directed or not. For example, if a person opens a traditional IRA that is self-directed with a provider like New Direction IRA, which handles a wide array of alternative asset types, that account holder could have that IRA invested in a couple of rental houses and some gold bars. The rental income and appreciation of the real estate and the appreciation of the gold would constitute the performance of the assets. Regardless of what the assets were, the IRA holder could continue to make contributions per IRS regulations.

With any IRA, there are two dynamics occurring that affect the account’s balance. The first is the pattern of contributions and distributions. These are governed by IRS rules and the IRA holder’s strategy. The second is the performance of the money/assets that are in the IRA. This is governed by the economic factors associated with each particular asset. In other words, was it a profitable investment or not. The two dynamics are only related in that they are functions of the same account and are guided by the IRA holder. These dynamics are not affected by whether an IRA is self directed or not and whether the assets are publicly traded securities or alternative.

In the case of IRA terminology, it may be that marketing attempts to make the consumers’ options more understandable have back-fired and actually created less understanding. It can be helpful to remember 3 categories of terms:

1) IRS designations are account types (Traditional, Roth, or an employer plan). These account types have rules associated with them about taxation and contributions/distributions.

2) Asset terms are simply that, the type of asset in which the IRA is invested: real estate, gold, loans, stock (public or private), etc.

3) Descriptive terms are used to help lead the consumer to the service that they desire (i.e. an IRA that has gold or real estate or an IRA that results from a 401(k) rollover) and do not affect tax status.

All of the current conversation regarding “Alternative” and “Self Directed” IRAs, may seem confusing unless one is familiar with the terminology. Whether it is the success of Mitt Romney’s IRA or the Jean Chatzky report on the Today Show that is fueling interest in retirement investing, what is certain is that IRA account holders are becoming more and more aware of the choices that they have when it comes to their retirement funds.

The 5-year rule for Roth IRA withdrawals

If you’re one of many investors contributing to a Roth IRA or considering a Roth Conversion for an existing pre-tax retirement account, it’s important to understand exactly how the “Five Year Rule” works. Below is a short explanation of how the rule affects your IRA distributions.

What is the Five Year Roth Rule?

The five year Roth rule refers to a five year period that restricts tax-free distributions on the earnings/gains in a Roth IRA and distributions of converted funds in a Roth IRA. If a Roth IRA achieves gains in addition the contribution amount(s), distributions of those gains before the five year waiting period will be taxable. Similarly, funds that are converted from a “pre-tax” retirement plan to a Roth IRA must wait five years in order to be distributed tax-free. The five year period begins when an IRA holder opens a Roth IRA and begins making contributions OR when a new Roth Conversion is performed. In either event, the actual effective date of the five year Roth rule is always backdated to January 1 of the tax year the event takes place. This can be important because if you time things right, your wait time can actually be reduced by more than 20%. Let’s take a look at some math below to get a clearer understanding.

How is the Five Year Roth Rule Calculated?

New Roth IRA Example: If I start a Roth IRA in April, 2012 (remember to backdate) and begin making annual contributions beginning in the tax year of 2011, my five year time clock will have ended on January 1, 2016. Notice that my effective wait time was less than four years, not five. My wait period begins January 1, 2011, not April, 2012.

Traditional to Roth Conversion Example: If I have an existing Traditional IRA , it’s possible for me to perform a Roth conversion. To perform this process, I pay tax on the amount being converted in order to change my retirement funds from “pre-tax” to “post-tax”. I claim the converted amount on my tax return for the tax year in which I perform the conversion. Once I start this process, the five year rule begins. Just like before, the later in the year I perform my conversion, the more my five year rule becomes a four year wait.
It’s important to note that I must perform my conversion before December 31st or the tax year will effective change. For example, if I’d like my conversion to represent the tax year of 2012, I must complete my 2012 conversion before December 31st, 2012. Conversions made between January 1 – April 15th cannot be backdated to represent conversions in the prior year even though filing deadlines take place in April.

How does the Five Year Roth Rule affect my distributions?

As I mentioned above, the five year rule dictates that distributions, over and above the amount contributed and/or the amount converted, that are taken prior to the five year wait period after the establishment/conversion of the account are not tax-free. See the examples below for a comparison of scenarios.

John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007 for the tax year of 2006. On January 1st, 2011, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principle contribution and $2,000 is profitable earnings. 
Results: Since John is now over the age of 59.5 and his five year rule has expired (Jan 1, 2006 – Jan 1, 2011), the entire distribution is qualified for a tax-free distribution and isn’t included as taxable-income. In the example above, John made a profit of $2,000 over a period of almost four years but because his first contribution in the Roth IRA was dated back to January 1, 2006, his wait for tax-free distributions was considerably shorter than 5 years.

**Note that he was over the required age of 59.5 for tax-free distributions as well.

Now let’s look at the same example if John takes his distribution after only 3 years of participating in a Roth IRA:

John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007 for the tax year of 2006. On January 1st, 2009, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principle contribution and $2,000 is earnings. Even though John is now over the age of 59.5, his distribution on the earnings is being taken out of the account before the five year rule expires. $2,000 of his distribution must be claimed as taxable income on his tax return.
Results: After age 59 1/2 and once the five-tax-year holding period is met, any distribution from the Roth IRA will be considered a qualified distribution and be tax-free. Remember that each conversion from a pre-tax IRA will start its own individual five year waiting period. You may consider keeping any conversions and/or contribution accounts separated in different Roth IRAs for organization purposes.

Partnering with disqualified persons to your IRA

There is a lot of discussion about “Disqualified Persons” when one is creating a strategy for acquiring IRA assets. The IRS’s disallowance of self-dealing with regard to retirement accounts means that if an investor is considering transactions such as purchasing real estate, investing in a company, making a loan, or even buying hard assets like precious metals, they need to identify persons who are disqualified to their IRA in order to avoid a prohibited transaction and its concomitant penalties.

It may sound like a simple matter to list those people and entities that are disqualified, but the fact that there are several pages of the Internal Revenue Code (section 4975) dedicated to this issue indicates just how gray this area can get. To make this matter even a little more difficult to keep straight, partnering with these “disqualified” persons is allowed. While an exhaustive examination of this issue may not be desirable (or even possible), it is helpful to review a few of the basics.

Disqualified persons include one’s self, one’s spouse, lineal ascendants and descendants and those descendants’ spouses. The designation also extends to business entities owned and/or controlled by these people as well as some fiduciaries associated with these business entities.

Transactions in which an IRA is not allowed to participate with a disqualified person/entity include buying from, selling to, paying compensation to, extending credit to, receiving a loan from, and allowing use of assets.

Partnering with disqualified persons/entities is allowed. The way that works is that an IRA acquires a specified percentage of the asset as does each of the other partners. All income and payments related to that asset must be divided along the percentage lines established at the purchase of the asset. This can be somewhat cumbersome, depending on how much activity is associated with the investment, but it is imperative to keep up with this arrangement.

A helpful way to think about whether you are contemplating a transaction with a disqualified person/entity, which is prohibited, or a partnership, which is allowed, is to think of a negotiating table on which a transaction will be made. On this table, money will move from one side of the table to the other, and, in return, a benefit or asset will move in the opposite direction. If the disqualified person/entity is on the same side of the table as your IRA, you are likely okay. If the disqualified person is on the other side of the table, you might be looking at a prohibited transaction.

In some cases, IRS parameters for IRAs can be confusing. The information above that describes some basic principles that apply to disqualified persons and what an IRA can do in relation to them is only part of the whole picture. Despite the fact that it can daunting, it is much better to invest the time to learn about the rules now, before making a move with your IRA, than to pay for a mistake with your hard earned retirement funds later. The good news is that you have a place to start the process in Entrust New Direction IRA. Their knowledgeable staff, informative website, and frequent educational programs are excellent sources of information about all aspects of IRAs.

UBIT: What is UBIT and do I need to pay it?

As a self-directed IRA provider, we get dozens of questions about UBIT, taxes on IRAs and taxes on other retirement accounts every day. Most perplexing to clients, it seems, is Unrelated Business Income Tax, or UBIT. Here are two of our most commonly asked questions and our answers.

Question: My Roth IRA purchased a rental property, funding it with 10% from the IRA and 90% from a bank loan. The net income is $3,000 a year. Is all the net income from this property tax-free? Or is $2,700 taxable and only $300 is tax-free?

Answer: The bank loan part is subject to UBIT. If your calculated net income is $3,000, after all expenses (including depreciation), then roughly 90%, or $2,700 is taxable to the IRA. The IRA’s first $1,000 would be tax-free, thus, it would pay tax on $1,700 (around $255). If you didn’t calculate net income with all allowable expenses and depreciation, then go back and do so. We often find that IRAs, like other real estate investors, find that they have positive cash flow but a tax loss. It is important to file the 990-T to report the loss and thus carry it forward to future years. Also note the debt-financed percentage is recalculated each year.

Question: An article I read claimed that any leveraged property in an IRA can trigger the Unrelated Business Income Tax. When mortgaged investments post a profit of over $1,000 in any year, the gain beyond $1,000 is taxed at anywhere from 15% to 40%. IRA investors can get around the tax by applying excess profit to the loan principal. Once the loan is paid, the UBIT no longer applies to any profit, and if the property is held for an additional 12 months in the IRA, eventual sale profits won’t be subject to the tax either.

Is it true that applying the excess profit from rents to principal pay down will avoid UBIT? 

Answer: The article shouldn’t recommend “getting around that tax”, but instead that paying down the debt balance will reduce the taxable portion of the income. The intent of the article is to highlight that by paying off the loan as soon as possible (and then have a 0 loan balance for a 12 month period), the IRA can reduce to 0 the debt-financed percentage and thus have no UBIT. The profits from the investment, plus any other available cash can be used to pay down the loan. Note that this strategy limits your IRA’s other investment options since the money is going to the bank instead of buying new investments. Run the numbers to see what makes the most sense in your situation.

Question Let’s just say my self-directed IRA purchases a 5% interest in an LLC that buys a shopping center for cash. In the first year, the LLC has net income of $100,000 and distributes $5,000 to the IRA. The following year, the LLC obtains a non-recourse loan of $1,000,000. The LLC uses $100,000 of the loan proceeds to hire an unrelated contractor to make improvements to the property, and distributes $900,000 of the proceeds. $45,000 of this $900,000 is distributed to the LLC. After the debt is added, net income remains the same, and thus $5,000 of net income is distributed to the IRA in year two. Is there now unrelated business income, and if so, how much?

Answer The amount of UBIT is determined on the percentage of the amount of total indebtedness from the acquisition of the property. Depending on the business activity of the LLC, it may be that the LLC is operating a business, and thus all of its earnings may be subject to UBIT as a result.

Assuming in your example that the LLC is just a passive rental operation, then you need to calculate the debt financed portion of the property. Using the property for security for a loan does not make the property debt-financed unless the money is used on the property. In your case, $100,000 of the loan which was used to improve the property is debt-financed, and income generated by the overall debt-financed portion is subject to tax (avg debt/average depreciated basis of the property plus improvements). The other $900,000 was not used to acquire any asset, other