U.S. tax codes require an IRA to be a trust or a custodial account built in the United States for the sole benefit of a person or the person’s beneficiaries. The account needs to be governed by written instructions and meet particular requirements in relation to holdings, distributions, contributions, and the trustee or custodian’s identity. These give rise to a special type of IRA known as a self-directed IRA (SDIRA).
Self-Managed vs. Self-Directed IRA – The Differences
In all IRAs, account owners can select from investment choices the IRA trust agreement allows, and to buy and sell those investments at the discretion of the account owner, as long as the sale proceeds stay in the account. The restriction on investor choice results from because IRA custodians being permitted to decide on the types of assets they will handle within the confines set by tax regulations. Majority of IRA custodians only accept investments in very liquid, easily valued products – for example, approved stocks, mutual funds, etc.
However, some custodians are willing to handle accounts that hold alternate investments and to equip the account owner with enough control to “self-direct” such investments within the limits of stax regulations. The list of alternative investments is extensive, limited only by certain prohibitions against illegal or illiquid activities as per self-directed IRA rules, and the keenness of a custodian to manage the holding.
The most frequently provided example of an SDIRA alternative investment is direct ownership of real estate, which may involve property redevelopment or a rental situation. Direct real-estate ownership contrasts publicly traded REIT investments, as the latter is usually available through more traditional IRA accounts.
Advantages of a Self-Directed IRA
The benefits associated with an SDIRA are related to an account owner’s capacity to make use of alternative investments to attain alpha in a tax-fortunate manner. Ultimately, SDIRA success depends on the account owner’s special knowledge or expertise in capturing returns that, after being modified for risk, beat market returns.
An overarching premise in self-directed IRA rules is that self-dealing, where the owner or manager of an IRA uses the account for personal satisfaction or in a way that disrespects the tax law, is not allowed. Major elements of self-directed IRA rules and regulations and compliance include identifying disqualified people and the kinds of transactions they are not allowed to initiate with the account. The effects of disobeying transaction rules can be severe, such as the whole IRA being declared by the IRS as taxable at its market at the start of the year in which the prohibited transaction took place, which means the taxpayer may need to pay settle deferred taxes, besides a 10% early withdrawal penalty.
Other than the IRA owner, self-directed IRA rules define a “disqualified person” as any person controlling the assets, disbursements, receipts and investments, or those who have an influence on investment decisions.