Traditional and Roth IRAs are already powerful tools for estate planning, but a “self-directed” IRA can take their benefits to the next level. They can allow you to invest in alternative assets that might offer higher returns but they also come with their own set of risks that could lead to unfavorable tax consequences.
It’s important to handle these investments with caution.
Exploring alternative investments
Unlike traditional IRAs, which usually offer a narrow selection of stocks, bonds, and mutual funds, self-directed IRAs allow for a variety of alternative investments. These can include real estate, closely held business interests, commodities, and precious metals. However, they can’t hold certain assets like S corporation stock, insurance contracts, and collectibles (like art or coins).
From an estate planning perspective, self-directed IRAs are particularly appealing. Imagine transferring real estate or stock into a traditional or Roth IRA and allowing it to grow on a tax-deferred or tax-free basis for your heirs.
Risks and tax traps
Before diving in, it’s crucial to have an understanding of the significant risks and tax traps of self-directed IRAs:
- Prohibited Transaction Rules. These rules restrict interactions between an IRA and disqualified persons, including yourself, close family members, businesses you control, and your advisors. This makes it challenging for you or your family members to manage or interact with business or real estate interests within the IRA without risking the IRA’s tax benefits and incurring penalties.
- Unrelated Business Income Taxes. IRAs that invest in operating companies may face unrelated business income taxes, payable from the IRA’s funds.
- Unrelated Debt-Financed Income. Investing in debt-financed property through an IRA could create unrelated debt-financed income, leading to current tax liabilities.
Proceed with caution
Remember, if you’re considering a self-directed IRA, it might offer increased flexibility, but it also demands a higher level of due diligence and oversight.
Assess the types of assets you’re interested in carefully and weigh the potential benefits against the risks. Reach out to your Smolin advisor to determine if a self-directed IRA is right for you.