Common Mistakes To Avoid With Self-Directed IRAs

Common Mistakes To Avoid With Self-Directed IRAs

A self-directed individual retirement account (IRA) offers a fantastic way to diversify your retirement portfolio beyond traditional stocks and bonds. It gives you the freedom to invest in alternative assets like real estate, precious metals, and private equity. However, this freedom comes with a greater responsibility to follow specific rules. Making a mistake can lead to significant penalties and taxes, potentially jeopardizing your retirement savings. This post covers five common missteps to avoid with self-directed IRAs.

1. Not Understanding the Rules and Regulations

The Internal Revenue Service (IRS) sets strict guidelines for self-directed IRAs, and not knowing them is a frequent pitfall. For instance, the IRS defines certain “prohibited transactions,” which are specific actions you cannot take with your IRA funds, such as borrowing money from the account or selling property to it. Misunderstanding these rules can result in the entire account being treated as a distribution, triggering taxes and penalties.

What “self-direct” means is that you, the account owner, are solely responsible for your investment decisions and for following all IRS regulations. Before you begin, take the time to learn the contribution limits, distribution requirements, and transaction rules that apply to your account.

2. Investing in Prohibited Assets

While self-directed IRAs open the door to a wide world of alternative investments, the IRS explicitly forbids certain asset types. You cannot use your IRA funds to invest in life insurance policies or collectibles. The collectibles category is broad and includes items such as artwork, antiques, gems, stamps, and most coins.

Investing in these prohibited assets can have severe consequences, including the disqualification of your IRA. Always confirm that an asset is permissible before committing your retirement funds.

3. Improperly Titling Assets

When you purchase an asset with your self-directed IRA funds, you must title it correctly. The asset must be held in the name of the IRA, not in your personal name. For example, if your IRA purchases a rental property, the deed should name the IRA as the owner, such as “[Custodian Name] FBO [Your Name] IRA.”

Improper titling suggests you have taken personal possession of the asset, which the IRS considers a distribution. This error can result in immediate tax and penalty liabilities on the asset’s value.

4. Failing to Document Transactions

Every transaction within your self-directed IRA needs a clear paper trail. This includes purchases, sales, and any income or expenses related to your IRA-owned assets. For instance, if your IRA owns a rental property, you must meticulously record all rental income and maintenance expenses.

Your custodian will report to the IRS based on the information you provide, so accurate and complete records are vital for compliance. Poor record-keeping can create major headaches during an audit and raise questions about the validity of your transactions.

5. Taking Premature Distributions

You generally cannot take distributions from your IRA before age fifty-nine and a half without incurring a 10 percent early withdrawal penalty on top of regular income tax. A common mistake with self-directed IRAs is engaging in a transaction that the IRS views as an indirect distribution.

For example, personally using a vacation property owned by your IRA for a weekend getaway constitutes a “prohibited transaction” and is treated as a distribution. This action can disqualify the IRA and make its entire value taxable.

Managing a self-directed IRA successfully requires diligence and a solid understanding of the rules. By avoiding these self-directed IRA errors, you can harness the full potential of your account to build a diverse and robust retirement portfolio. If you have questions about managing your account or want to explore your investment options, contact our team for personalized support.