What Makes an Investment Right or Wrong for Your IRA?

When you think about IRAs, you're probably thinking stocks and bonds. But private equity investments can open new doors to some retirement savers.

Your Individual Retirement Account (IRA) is a tax aberration. The law grants IRAs a very narrow and strictly construed income tax treatment for a singular purpose: encouraging people to save for retirement.

Perhaps you’ve accumulated a large IRA by “rolling over” funds from your company retirement plan. Your IRA might hold several hundred thousand to $1 million or even more. I will wager that you’ve thought about using that money for investments other than stocks and bonds. Perhaps you’ve been offered, or envisioned, a real estate opportunity or a joint venture with potential for greater returns. For those entrepreneurial people who have more than enough saved for their retirement lifestyle, I’m here to encourage you to do just that.

But first, you must learn more about IRAs.

What can I hold in an IRA?

A traditional IRA is funded with pre-tax dollars and any earnings are tax deferred. Distributions are required at age 70½ and are taxed as ordinary income. A Roth IRA is funded with after-tax dollars, but its earnings and distributions are tax-free and there are no required distribution rules. Both IRA varieties are subject to strict contribution limits and investment rules. Outside of actual retirement distributions and a few rare exceptions, you’re not allowed to benefit in any way from that money.

Most brokerage firms limit IRA investments to publicly traded securities, such as cash, stocks and bonds, to reduce risk and their own exposure to liability. But some custodians offer self-directed IRAs for which you are solely liable for all decisions. Under a special agreement, your IRA, as an investor completely separate from you, can purchase and own various other offerings: private companies, partnerships, real estate, oil and gas royalties, even fishing rights and livestock. However, even then, IRA rules greatly limit whom your IRA buys from and sells to, what it buys and owns, and who can use or benefit from its assets.

What are these strict rules and investment limitations?

Your IRA can’t own: S-Corp stock, life insurance, most collectibles or “any other tangible personal property specified by the [IRS].” Your IRA can invest in a very limited selection of U.S. minted coins and certain bullions, but only if you purchase and hold them in very specific ways.

“Self-dealing,” “prohibited transactions” and “disqualified persons” are the key terms you must learn. To oversimplify, your IRA can’t borrow from or lend to, buy from or sell to, or benefit any disqualified person in any way — even indirectly. As the IRA owner, you, of course, are a disqualified person, as are your spouse, ancestors, lineal descendants, and any spouse of a lineal descendant.

What is a prohibited transaction, and what is self-dealing?

Our IRA clients often have great investment ideas for their IRAs that we must refuse. Typically, these ideas sound like this:

  • “We’re starting a business and I need my IRA to invest as a partner.”
  • “I want my IRA to buy life insurance on me.”
  • “My father left us kids the family farm and I want my IRA to buy us all out.”
  • “I want my IRA to buy paintings at auction that I will display in my home.”
  • “I bought a restaurant franchise with friends and I need my IRA to invest, too.”

No. No can do. No. No, sir. And, um, no.

The Department of Labor calls such great ideas “prohibited transactions” because they involve the wrong people (disqualified persons) or are self-dealing. But the DOL might find that even the right investment with the right people, that avoids breaking a rule at the time of the purchase, becomes a prohibited transaction years later due to some subsequent activity.

For example, let’s say that your IRA purchases a rental beach house. Looks good. But if the seller, the real estate agent, the closing attorney or any present or future realty manager, maintenance or lawn care company — or any one of the dozens of weekly renters each year — happens to be a disqualified person, from that point on your IRA has broken the rules. For instance, your IRA can never rent or lend the beach house to your son or daughter. Also, no disqualified person may perform services at the beach house, even without pay. So, your daughter can’t paint the beach house and your son can’t install a new countertop in the kitchen.

Is it easy to get caught, and if so, what is the penalty?

A prohibited transaction may potentially avoid discovery, even by the IRA owner, for years. These transactions are often discovered by IRS audits that are either random or triggered by the owner’s death. If no exception applies, every disqualified person who participated may pay a 15% tax. Then, those same people may be charged an additional 100% tax on those assets if the transaction is not corrected within the tax year.

The IRA owner and the beneficiaries face a different but more severe tax penalty for a prohibited transaction: The IRA ceases to be an IRA on the first day of the tax year the transaction occurred, even if it was many years ago, and the entire IRA balance must be included as ordinary income on that year’s tax return. Then, years of past-due taxes and early distribution penalties may apply. This is a brutal penalty, and there is no correction period.

How can I safely invest in outside marketable securities for my IRA?

It’s actually quite simple. Your IRA can safely purchase a qualified asset from anyone not related in any way to you and can contract to maintain those assets with any service provider that is not related in any way to you — provided that you, and no other disqualified person, ever engages in any activity related to or benefiting from those IRA assets.

What kind of assets are we talking about?

A proper private equity investment can be any share or interest in an operating business if none of the other investors or employees are related parties (with some exceptions). One example could be a group of college students operating a software coding company in their home under contract to a gaming company. They might come to you for capital to rent commercial space, install data lines, improve their servers and hire coders. Your IRA might buy a small percentage of the company, providing the needed cash in return for a percentage of the net profits.

Your IRA may benefit greatly if this company grows exponentially, is later sold or is taken public. All that growth and income is tax deferred until you take distributions. If it is a Roth IRA, those distributions are generally tax-free. But, if the company tanks, so goes your retirement savings.

Who would be a good candidate for this strategy?

Investing qualified retirement funds in private equity carries greater risk than a diversified portfolio of marketable securities. The average taxpayer would be foolish to risk retirement savings in this way. Every investment carries risk, but prudent investors ameliorate those risks through age-appropriate asset allocation and diversification.

However, if your qualified retirement and other savings exceed your lifestyle needs and the entrepreneurial spirit that fueled your success hasn’t abated, private equity may be a smart addition to your tax-deferred or tax-free IRA. But be careful. Seek expert guidance to vet every opportunity if you decide to navigate this complex terrain.

About the Author

Timothy Barrett, Trust Counsel

Senior Vice President, Argent Trust Company

Timothy Barrett is a senior vice president and trust counsel with Argent Trust Company. Timothy is a graduate of the Louis D. Brandeis School of Law, 2016 Bingham Fellow, a board member of the Metro Louisville Estate Planning Council, and is a member of the Louisville, Kentucky and Indiana Bar Associations, and the University of Kentucky Estate Planning Institute Program Planning Committee.

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