In my last article I introduced the concept of Self-Directed IRAs.  The biggest advantage of setting up a self-directed IRA is that it will allow you to invest in non-traditional investments.  Some traditional stock brokerage houses will offer a type of a “self-directed IRA” that is not exactly what I’m talking about here.  They will let you pick which stocks, bonds, or mutual funds your IRA is invested in, but they won’t let you buy any other assets that don’t fit into that category.

So, how do I set up a real self-directed IRA?  First you must find an IRA custodian who will let you invest in alternative assets. Some custodians that I have worked with and trust include: IRA Services Trust Company, Sunwest Trust, Inc., and Equity Trust Company.  Second, you make an IRA contribution from your earnings or you can rollover an IRA or other retirement funds from a different custodian or retirement plan.  Finally, you instruct the custodian as to what investments you would like to make.  It really is as simple as that.

Each custodian will have a different fee schedule and provide different types and levels of services to you. We have developed certain relationships and structures that can significantly reduce the annual maintenance costs that your custodian will charge and can give you more immediate access and control over your retirement account through an “IRA LLC” or “checkbook control”.

What can you invest in?  One of the easiest investments to make is a private loan.  If you find someone whom you believe can repay the loan and just needs quick access to money for a short term project or need, you could become a lender.  Oftentimes, you can secure your loan against equity in the borrower’s real estate.  In essence, you become the bank and get a mortgage back from the borrower to protect your loan investment.  Many hard money lenders (this is what such a private lender is called in the lending and borrowing community) will get interest rates of 12% – 18% plus 2 to 5 origination points on their loans.  Instead of hoping and wishing that their retirement funds will return an average of 9% annually in the stock market over the long run, these action takers assure their profits by secured lending and making sure that they get their money back quickly.

Sounds good right? Well, there are a few things to watch out for.  A lot of people would like to personally borrow from or lend to their IRA.  However, that would violate the prohibited transaction rules.

The prohibited transaction rules mean that you’re not allowed to commingle your personal funds with your retirement funds, and you’re not allowed to engage in any transactions between your retirement account and yourself or your family members.
That would allow too much wiggle room for a tax abusive shelter.  In fact, you have to be careful as you’re not allowed to do any transactions with a business that you own or partially own, or a trust that you created or are the beneficiary of, or even with the spouses of your family members.

The prohibited transaction rules are quite complex and the penalties can be extremely harsh if you violate them—even if it were an honest mistake.  Prohibited transactions can be treated as a distribution from the IRA to you.  In addition to the 10% early distribution penalty for pulling out funds while under age 59 1/2, a prohibited transaction penalty starts at 15% and there could be an additional penalty of 100% if it’s not corrected.  So a severe mistake could cost you more than the amount of your retirement funds.  Until you thoroughly understand the prohibited transaction rules (and maybe even after that), you should seek expert advice before engaging in any self-directed IRA investments.

Despite the strict prohibited transaction rules, there is nothing preventing you from doing a transaction with a close friend who is not a family member and doesn’t co-own your business with you.  So if you have a trusted friend, there are many opportunities to profit tremendously by working together with each other’s retirement accounts and using creative, legal loopholes to exponentially grow your assets tax-deferred, or in some cases completely TAX-FREE!

If you would like to know more about how to set-up a self-directed IRA, or get specific guidance in creating an IRA LLC, or a consultation on prohibited and allowable transactions, please contact Okura & Associates Estate Planning Attorneys, Hawaii’s Law Firm for all your estate planning needs.