Legal Pitfalls to Avoid When Setting Up a Self-Directed IRA

By avoiding common pitfalls, you can protect your investments and secure your financial future.

If your retirement portfolio has stocks, bonds, and nothing else, it may be time to diversify. One solution is setting up a Self-Directed IRA (SDIRA). 

With an SDIRA, you can invest in alternative assets like real estate, precious metals, and even cryptocurrencies. If you set it up wrong, though, it can lead to severe penalties that can jeopardize your retirement savings. 

Let’s look at some legal pitfalls to avoid when setting up an SDIRA.  

Understanding Self-Directed IRAs

An SDIRA is a type of individual retirement account that includes more options than a standard IRA. It can be your ticket to navigating the real estate market, private businesses, and precious metals.

SDIRAs offer great potential for growth and diversification. However, they can be more trouble than they’re worth if not managed correctly.

The chief difference between an SDIRA and a traditional IRA is how you can invest. The ability to invest in alternative assets makes SDIRAs appealing to those looking to build generational wealth.

Understanding the IRS rules associated with these accounts can help you access these benefits while avoiding legal issues.

Common Legal Pitfalls

1. Prohibited Transactions

One of the most dangerous risks with SDIRAs is participating in a prohibited transaction. These include:

• Using IRA assets for personal benefit.
• Engaging in buying, selling, or leasing property between the IRA and disqualified individuals.
• Personally performing maintenance or improvements on properties owned by the IRA.

According to IRS Publication 590-A, doing any of the above can disqualify your IRA, resulting in the taxation of all assets, as well as potential penalties. 

Example: If you own a rental property through your SDIRA and decide to spend a weekend there, even briefly, it would be considered personal use, which could disqualify your IRA.

2. Dealing with Disqualified Persons

A major legal pitfall is not understanding who counts as a “disqualified person.” These include:

• You and your spouse.
• Your ancestors and lineal descendants (parents, grandparents, children, grandchildren).
• Entities (corporations, trusts, partnerships) where you hold significant influence.

Any transactions between your SDIRA and these individuals or entities are prohibited. Even indirect benefits to disqualified persons can trigger IRS penalties.

Example: Renting out a property owned by your SDIRA to your daughter at market rates still violates IRS rules because your daughter is a disqualified person. This transaction could lead to severe tax consequences.

3. Insufficient Asset Valuation

Reporting the wrong value of your assets can lead to more than a slap on the wrist. The IRS requires annual fair market valuations of assets within your SDIRA. Underestimating or overestimating asset values can mess up your required minimum distributions (RMDs) and potentially result in penalties.

To make sure you report the correct asset valuation:

• Obtain independent, qualified appraisals for hard-to-value assets like real estate or private equity.
• Keep thorough documentation of all valuations.

Expert Tip: Work with certified professionals experienced in valuing specific asset classes held in SDIRAs to ensure accurate reporting.

4. Overlooking Unrelated Business Income Tax

The Unrelated Business Income Tax (UBIT) applies to income generated from specific business activities within tax-exempt entities, including SDIRAs. If your IRA invests in an active trade or business or uses debt financing, the income may be subject to UBIT, which can be as high as 37%.

To manage UBIT:

• Consult a tax professional to understand when UBIT applies.
• Consider the tax implications before investing in businesses or leveraged real estate.

Example: If your SDIRA invests in a partnership that operates a business, the income passed through to your IRA could be subject to UBIT, reducing your overall returns.

Importance of Due Diligence

When selecting investments and service providers for your SDIRA, be sure to practice due diligence by:

• Researching your investment opportunities to understand the nature, risks, and legal implications.
• Choosing reputable companies. For instance, when dealing with investments like precious metals, carefully researching gold IRA dealers is essential to ensure you’re working with a trustworthy partner.
• Reviewing contracts and agreements for clauses that could lead to prohibited transactions or other legal issues.

Furthermore, if you are looking to buy a company, corporate documentation is one of the most important things to include in your due diligence checklist.

Record-Keeping and Reporting Requirements

Keeping good records is not just a good habit — it’s a legal requirement. The IRS asks SDIRA owners to keep detailed documentation of all transactions, valuations, and communications related to the account. Forgetting can result in penalties.

Best practices include:

• Saving all bank statements, investment documents, and correspondence.
• Keeping records of appraisals and valuations for assets, especially those that are not publicly traded.
• Ensuring that all required IRS forms, such as Form 5498, are accurately completed and submitted on time.

Example: An investor who neglected to keep proper records of rental income and expenses for a property in their SDIRA faced difficulties during an IRS audit, leading to penalties. Proper documentation could have prevented these issues.

Final Thoughts

Your SDIRA has the power to diversify your retirement portfolio and build wealth. However, navigating the legalities requires diligence and a thorough understanding of IRS regulations. By avoiding common pitfalls, you can protect your investments and secure your financial future.

Consider complementing your retirement strategy with other financial planning tools. For instance, exploring life insurance options, annuities, or long-term care coverage can provide additional security, ensuring that the wealth you’ve worked hard to build is protected and can support both your future needs and your family’s legacy.