Self-directed IRAs give you the widest possible range of investment options compared to other tax-advantaged retirement accounts. As compared to an IRA with a traditional custodian, a self-directed IRA with a custodian such as Quest Trust Company allows you to invest in assets such as real estate, private loans, private equity, and precious metals.
As compared to a 401(k), the increased choices you’ll have with a self-directed IRA are even more pronounced. Employer-sponsored 401(k) plans are generally quite limited in terms of investment choice, and you can’t invest in publicly traded stocks or even mutual funds that aren’t offered by the 401(k) plan sponsor.
But this doesn’t mean you have unlimited freedom with investments in your self-directed IRA. For example, you can’t use funds from your account to buy life insurance policies, invest in artwork, or invest in collectible coins. And perhaps more importantly, you can’t use the funds in a self-directed IRA to engage in any transaction that would be considered “self-dealing.”
“Self-dealing” is considered by the IRS to be making any investment that provides a current benefit to the account holder, or engaging in any business or transaction with a “disqualified person” (which include family members such as your parents, grandparents, children, grandchildren or spouse, as well as any corporation, partnership or other legal entity in which the account holder has a controlling interest).
The notion of a current benefit to the account holder is construed broadly. For example, you can purchase real estate with a self-directed IRA, but you can’t engage in any personal use of that property yourself, nor can any disqualified person. This type of use would constitute self-dealing even if you (or the disqualified person) pays fair market value for the rental use of the property.
By the same token, when you make an investment with your self-directed IRA, the asset or investment property you purchase cannot be something that you already own. So if you currently own a piece of real estate as a taxable investment, you can’t sell that property to your self-directed IRA, even if you’re IRA pays fair market value for it. Nor can your account to purchase the property if it’s owned by a disqualified person.
Staying aware of the prohibition on self-dealing with a self-directed IRA is important, because the penalties for noncompliance can be significant. Engaging in such transactions could put the entire set of tax advantages of your account at risk, such that it would no longer be considered a self-directed IRA.
Furthermore, engaging himself dealing could potentially result in the IRS declaring that you have been deemed to take a distribution of the relevant assets from your account. For example, personal use of a vacation home held by your self-directed IRA might lead to that property being forcibly distributed to you individually. If this occurs when you are not yet in retirement, this could trigger a significant current tax liability (depending on the age of your account and whether it is set up as a traditional or Roth account), as well as a 10% early withdrawal penalty on the phone.