David Moore with IRA Advantage looks at self-directed IRAs: what they are, what you can do with them, and how to invest with them. Self-directed IRAs offer many opportunities for investors. Learn about this investment option and put your retirement accounts to work for you.
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What Is a Self-Directed IRA?
There is no legal definition of a self-directed IRA. It’s merely a term that describes an account that allows you to do what you want to do. If you want to buy real estate with a self-directed IRA, there is no need to pull money out of your account; you are just shifting the custodian.
Any limitation you might have with a self-directed IRA today is not by law—it’s by that custodian’s policies and what they’re going to allow you to do. If you’re looking at buying real estate, you’re going to have to have a custodian that’s going to allow you to do that. If we’re talking about a 401(k) plan, for example, we’re going to look at the plan. Does the plan allow you to do what you want? If it doesn’t, can we amend the plan to allow it to be done? If we can’t amend the plan, can we replace the plan? You’re always just looking at the situation where you are today, what you want to do, and does it allow you to make the investments you want to make? If it doesn’t, we’re going to change. For IRAs, we change the custodian. For 401(k) plans, we change the plan.
If you’re looking at a self-directed IRA in its most basic form, a self-directed IRA, you’re just moving money, and it’s not all or nothing. Keep the money you want to keep in Wall Street with your current advisor or the current custodian, and move what you want to use to the self-directed world. Just move that amount. If you have a Wall Street IRA, you can make a poor investment, but you really don’t have the ability to commit a prohibited transaction. If you’ve got a truly self-directed IRA, you do have that ability. And it’s important to understand that committing a prohibited transaction with an IRA constitutes full distribution of the account’s funds as of the first day in the year in which the indiscretion occurred. This makes it important to isolate things. If you have a Wall Street IRA, keep it where it is. If you want to take the self-directed IRA and go out and buy real estate, notes, loans, whatever you want to do there, we’ll move that money.
In that way you have isolation, diversification, and protection. Any advisor will tell you to diversify is a good thing. And since we’re talking about advisors, I just want to clarify that we don’t sell investments at IRA Advantage. We don’t give investment advice. We merely provide the investment vehicle to allow you to go by what you want to buy.
How Do I Invest with my Self-Directed IRA?
If you told me, “I just want to go out and buy a passive investment, not time sensitive,” we’re going to do a basic self-directed IRA for you. That entails moving what you want to use from custodian A that won’t allow you to do what you want to custodian B that does. And you need to understand there’s a variety of different self-directed custodians out there. Each of them have different requirements as well as different ways to charge you. It’s important to understand how those things work with what you want to do.
If you want to move funds from with a basic self-directed IRA from custodian A to custodian B, you submit the investment to the custodian. Upon their approval, they’re going to make the investment for you. And the owner of that investment is typically going to be the custodian. It’s going to read something like this: the custodian CFBO (Custodian for Benefit of) IRA number whatever it might be. And that’s going to be your IRA number. To make that investment, you’re typically going to submit an investment authorization form, probably some type of prohibited transaction form. And then there are going to be requirements for each specific type of investment they’re going to want to see.
If, on the other hand, you do a lot of investments or time-sensitive investments, we’re going to do a checkbook IRA for you. A checkbook IRA just means we’re putting an IRA-specific limited liability company between the custodian and the ultimate investment. That’s it.
Of course, don’t just go out and put an LLC together, because the custodian is not going to take it. And if you’re working with a lawyer that hasn’t done this sort of thing, then you’re going to be paying them to learn. Make sure whoever is putting that limited liability company together for you understands what it takes and what is involved. This doesn’t get done for some nominal fee. It typically costs a fair bit more than a normal limited liability company. But the people who do these things will provide you with a lot of information, and they’re going to help you create it and keep it going through time.
Custodians will not do this. They might have names to provide for you. Regardless, if you have a checkbook IRA, you have to have that basic custodial account. But instead of submitting every investment to the custodian, a checkbook IRA allows the custodian to make one investment. The investment they make is in the membership interest of this limited liability company. Such an account can have all different structures, all different members, including both disqualified parties and non-disqualified parties as common members. Keep in mind that when we look at what you can and can’t do with an IRA, there are two factors. The first is that you can buy anything unless it’s specifically prohibited. The second is who are you transacting between or for the benefit of? That’s where you can have problems. Transacting between or for the benefit of a disqualified party would constitute a prohibited transaction. Transacting along with a disqualified party does not.
The idea is to look at what’s happening—where you are today and where you want to be in two, five, or ten years—and then we’re going to help you get there. But when we create that limited liability company, depending on the membership, we’re going to look at this situation differently. If it’s one account alone, great. Let’s say you have traditional and Roth money. Now we’ve got a multimember limited liability company. Those two accounts can be combined as common members of a single LLC, but now you’ve got an LLC with two disqualified parties as members. Therefore, we can’t have additional investments in the limited liability company in the future.
So if you said, “I need $100,000 for this project,” and you run into something, you only that much in there, and now you’ve run into some problem, you don’t have the ability to get money from either one of those sources into that. This is why I’m going to tell you to overfund that limited liability company in that situation.
When that custodian makes the investment in the LLC, typically our client’s going to be the manager of the limited liability company. The limited liability company is going to have a bank account in the LLC’s name, and an EIN with the client as the manager. It’s a manager managed limited liability company. They’re going to open the bank account. The investment the custodian makes is in the membership interest in the LLC, which funds a bank account.
You then make an investment by negotiating that investment purchase in the LLC’s name. The transaction is going to be between the seller and that limited liability company. And if we’re talking about a real estate deal, you’re just going to write the purchase sale agreement between the seller and the limited liability company. The taxpayer’s manager is going to sign a note for the money, write a check, whatever. You’re going to open an escrow as you normally would and buy the property. If you’re buying notes, you just have that written up between the borrower and the limited liability company. It’s a beautiful process. It works very well for people who want to go out and make time-sensitive investments, or do things that are timely or require some management.
A self-directed or solo 401(k) is going to work the same way. We’re going to have a plan. The plan has its own EIN. It’s going to have a bank account in the plan’s name and EIN. Typically, the trustee of the plan is trusted. They’re going to be signer on the bank account. You make that investment and it’s going to be in the plan’s name. You write a check out of that account, and any investment yield goes into it.
No matter whether we’re talking about checkbook IRAs or solo 401ks, I had a client today send an email to me asking about their plan to go build something now. And they said, “Well, these charges are coming in. You know who needs write the check?” Look at it this way: Whether we’re talking a 401(k) plan or a checkbook IRA, either case, those are not you. Treat it like it’s Mary down the street. It’s somebody else, it’s something else, it’s not yours. Any expenses incurred have to be that LLC’s or have to be that 401(k) plan’s. Any income is not yours. It’s the plan’s or the LLC’s.
That’s the best piece of advice I can give you. That’s why when we put a checkbook IRA together for someone, we don’t want to see their name on the name of the limited liability company. It helps if it is something unique, because then any time the investor goes to make an investment with that account, it is clear. Anytime they pull out a check, they understand this thing is not them, it is a retirement account—whether it’s a 401(k) or a checkbook IRA.
Truly understanding what your retirement options are takes the help of an expert. A simple call to IRA Advantage will get you the advice you need. Give us a call today, 503-619-0223.