The self-directed IRA terms below are important to understand when you control the investing funds and decisions of your retirement and/or savings plan. The terms below apply to all accounts you can self-direct. This includes traditional, Roth, SEP, and SIMPLE IRAs as well as solo 401(k)s, ESAs, and HSAs.
TYPES OF SELF-DIRECTED ACCOUNTS AND INVESTING STRATEGIES
Self-directed IRA (SDIRA): An IRA that allows account owners to choose their own assets and to invest in alternative investments like real estate to build retirement wealth. It follows the same rules and regulations that conventional IRAs must follow.
Alternative investments: An asset class besides stocks, bonds, mutual funds, and other Wall Street holdings. Alternatives investments include, but are not limited to, real estate, gold, private equity, cryptocurrency, private lending, improved and unimproved land, and much more.
Traditional IRA: A retirement plan that allows contributions on a pre-tax basis. Distributions in retirement are taxed.
Roth IRA: Contributions to this retirement plan are made with post-tax dollars, and income grows in the account tax free. Distributions in retirement are not taxed.
SEP IRA: A Simplified Employee Pension (SEP IRA) is tailored to small businesses with few employees. Annual contribution limits are much higher than traditional IRA limits, and employers make contributions for themselves and their employees.
SIMPLE IRA: The Savings Incentive Match Plan for Employees (SIMPLE IRA) gives small business owners and/or the self-employed a way to save for retirement and lower the business’s tax liability through employee contributions. Employers either make matching contributions or non-elective contributions to their employees’ plans.
Solo 401(k): A retirement plan for small businesses, sole proprietors, and the self-employed. It provides the same retirement saving benefits typical 401(k) plans offer larger businesses and corporations.
Mega Roth: The ability to make Roth contributions to a solo 401(k).
Roth 401(k): Allows Roth options for employer contributions to a solo 401(k).
Real estate IRA: This is a common term used to for a SDIRA that invests in real estate.
Non-recourse loan: A loan your IRA can use to help buy an investment. The asset (most often real estate) is used as collateral. If the loan defaults, the IRA owner is not held responsible and only the asset used as collateral can be seized to recoup to satisfy the balance of the loan.
Partnering funds: Your retirement plan can partner funds with your personal funds, with another retirement plan, or with another person to invest.
Gold IRA: A common term for SDIRAs that primarily invest in gold and other precious metals.
Checkbook IRA: Also called a checkbook control IRA or IRA LLC, this investing structure that IRA owners the ability to write checks directly from their retirement funds to invest. The account owner also writes checks directly from the account to cover bills and other expenses related to investments.
Single-member LLC: To create a checkbook IRA, the SDIRA opens a single-member LLC and is the only member of that LLC. The IRA owner acts as the LLC manager and opens a checking account in the name of the LLC. They deposit funds from their IRA into the checking account. IRA owners write checks from this bank account to purchase investments for the IRA.
IRA LLC: Another term for a checkbook IRA.
OPENING AND MAINTAINING AN ACCOUNT
Rollover IRA: Common term used when you rollover funds from a pre-tax plan like an old workplace plan into a traditional IRA, which is also a pre-tax plan. There is no tax implication involved when rolling funds from one pre-tax plan into another pre-tax plan.
Roth IRA conversion: This transaction allows you to convert funds from a pre-tax plan into a post-tax Roth account. Conversions allow you to bypass the annual income cap for Roth accounts, but you’ll pay taxes on the money you move from the pre-tax plan into the post-tax plan.
Transfer: Moving your retirement plan from one institution into another. This transaction does not involve switching the type of retirement plan.
Buy direction letter: Required by your self-directed IRA services provider before they make an investment on your behalf for your account.
Sell direction letter: Submit this to your self-directed IRA service provider to sell an asset in your self-directed plan.
IRS RULES AND REGULATIONS
IRC 4975: Internal revenue code publication that defines prohibited transactions and explains penalties for retirement plans that perform a prohibited transaction.
Prohibited transaction: The IRS prohibits self-directed plans from specific transactions and dealings with disqualified persons. For example, you and any other disqualified persons are unable to live in or vacation in a home your retirement plan owns. Your SDIRA is also unable to invest in collectibles or life insurance contracts. These are prohibited transactions that trigger taxation, penalties, and even disqualification of the plan.
Collectibles: Are as defined by the IRS as any work of art, rug or antique, any metal or gem (with limited exceptions), any stamp or coin (with limited exceptions), any alcoholic beverage, or
any other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m).
Disqualified persons: People and entities who are unable to do business with your retirement plan. These people include you, your lineal ascendents and descendants, investment advisors, managers, and fiduciaries and anyone providing services to your account. Additionally, any entity in which a disqualified person has a 50 percent or greater interest is considered a disqualified person.
Self-dealing: When your self-directed account performs a prohibited transaction with the account owner (you).
Commingling: This occurs if you combine your personal assets with your retirement plan assets in any way. This prohibited transaction can cause disqualification of your account.
Sweat equity: A prohibited transaction that involves the self-directed retirement plan owner performing work on an investment. Your plan cannot pay you for any work, and if you perform that work for free it is called “sweat equity.” Sweat equity adds a non-quantifiable value to your asset that is prohibited since you are considered a disqualified person who cannot transact with your self-directed account.
Distribution: The term for withdrawing funds from your retirement plan.
Required minimum distribution (RMD): Distributions you’re required to take from qualified plans like 401(k)s and from IRAs (with the exception of Roth IRAs) when you turn a certain age.
Contribution: The term for depositing cash into your retirement plan. There are annual contribution limits for every retirement plan. You don’t have to reach that limit, but you may not exceed it.
Excess contribution: An amount you contributed to your retirement plan that exceeds the annual limit for the plan. Excess contribution trigger tax and penalties, but catching the error early helps avoid both.
Fair market value (FMV): The value of an asset. The IRS requires annual FMV reports for each asset in your retirement plan as of December 31 of the reporting year.
Roth IRA 5-year rule: You must own a Roth IRA for 5 years before withdrawing earnings to avoid a 10 percent penalty. (You can withdraw contributions at any time, penalty free.)
TAX IMPLICATIONS YOUR IRA MAY INCUR
UBIT: Unrelated business income tax (UBIT) is triggered when your retirement plan earns unrelated business taxable income (UBTI) or income from an investment that was purchased with financing.
UBTI: Unrelated business taxable income (UBTI) is earned if your retirement plan owns a business that is not taxed as a C-corp.
UDFI: Unrelated debt-financed income (UDFI) triggers a tax called UBIT (defined above). This happens if your IRA earns income from an asset it used financing (like a non-recourse loan) to purchase. Income is attributed to the percentage of the asset the debt purchased and is applied to that portion until the debt is paid in full. (Solo 401(k)s do not incur UDFI.)
While this list of self-directed IRA terms is extensive, there are other terms applicable to self-direction. You’ll learn them along the way, as you delve into the freedom of investing in alternative assets and ability to control your investment decisions in your retirement plan.
If you have any questions about this article, or want to learn more about self-directed retirement plans, please contact Advanta IRA.