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IRS Rules

The key benefit of IRA and 401(k) retirement plans is the
tax-sheltering of income they provide.

This sheltering allows you to grow your savings over time by reinvesting and compounding investment gains, rather than seeing gains eroded by taxation.

The trade-off for this tax-sheltering in a retirement plan is that the funds are set aside for your future benefit after retirement age and are not for your personal benefit while inside the plan.

In order to maintain the tax-sheltered status of the plan certain IRS rules must be followed. The same rules apply to all IRA and 401(k) plans, whether self-directed or conventional. When you are investing inside the narrow scope of publicly traded assets in a conventional plan, however, you really do not need to be aware of most rules as there is little chance of breaking them. Once you start taking more direct control in a self-directed retirement plan, you need to be aware of and understand the rules.

In exchange for the additional flexibility and control provided by self-directed IRA and Solo 401(k) plans you need to become familiar with, and take responsibly for following the relevant IRS rules.

A key piece of any self-directed investment strategy is having access to qualified guidance with respect to IRS rules.

At Safeguard Advisors, our team of consultants and attorneys are very well versed in the IRS rules and how they apply in non-traditional asset investing. Our focus on client education and ongoing consulting support is the most valuable component of the services we provide.

Navigating the IRS rules for investing with a self-directed IRA or Solo 401(k) starts with a few basic concepts.

IRS Rules Overview

Following is an outline of the key concepts to understand when investing with a self-directed retirement plan. Click on the linked terms to explore each concept in detail.

  • Prohibited Investments include a handful of assets such as collectibles, life insurance and S-corporation stock that are not allowed.
  • The Exclusive Benefit Rule stipulates that all activities of a plan must be for the exclusive benefit of the plan beneficiaries.
  • Disqualified Persons are those individuals or entities with whom the plan may not interact.
  • Prohibited Transactions occur when the exclusive benefit rule is violated or when there is a transaction or exchange of benefit between the plan and a disqualified party.
  • Significant Tax Penalties apply when a prohibited transaction occurs.

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The Right Mindset Matters

Self-directed IRA and 401(k) plans are a means to take more control of your retirement investing. By investing in what you know, and being more directly involved in executing plan investments, you can potentially achieve better results for your retirement savings. Growing your savings is entirely and exclusively what these plans are about.

Self-directed retirement plans are not a means for you to gain access to your retirement savings personally at the current time. Any attempt to structure transactions that benefit you or close family will likely create a prohibited transaction and the risk of significant tax penalties.

A self-directed IRA is not a way for you to invest in real estate or other alternatives and have access to plan capital to do so. Rather, it is simply a means for your retirement plan to diversify.

The best approach is to think of yourself as a fund manager for your future self. You can put your tax-sheltered savings to work today in those ways you think will best provide for your golden years.

Taxes that can Apply on Allowable Transactions

There are some transactions types that are in full compliance with IRS rules, but that may generate taxable income within the envelope of an IRA or Solo 401(k) plan. While one does not need to be concerned about rules violations, per se, it is important to your investment strategy to understand the rules that apply in these cases.

When a tax-exempt retirement plan uses debt-financing as part of an investment, this can generate Unrelated Debt-Financed Income. Purchasing an income property with a mortgage is a common example of when this type of taxable income is created. The gains the IRA receives that are directly attributable to the IRA capital deployed in the transaction (the down payment) are fully sheltered. The income the IRA receives that comes from the non-IRA capital (the borrowed amount) is considered taxable. The tax cost of UDFI is generally not significant, and in most cases the end result of a leveraged property investment will be a post-tax cash-on-cash return that is higher than a comparable all-cash transaction.

Participation in a trade or business activity on a regular or repeated basis can generate Unrelated Business Taxable Income (UBTI) for a tax-exempt IRA or 401(k) plan. Investments that can have this type of tax exposure include property flipping or new development and certain kinds of venture capital or business equity investments. The concept behind this tax is to level the playing field for tax-paying businesses and protect them from unfair competition. The tax cost that can occur with UBTI generating investments can be significant, and merits close examination. While not always a barrier to good overall return from an investment, this tax can make some opportunities non-beneficial to an IRA investor.

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