Having a self-directed IRA can open up your retirement savings to a new set of investing possibilities. With this type of IRA account you can invest in real estate, make private equity investments, invest in tax liens and even make mortgage loans to unrelated third parties.
But because you have more control over the investments you make with your IRA assets, it's especially important that you don't run afoul of the prohibited transaction rules that govern all IRA accounts. In order to understand the full impact of not following these rules, let's take a look at the penalties for self-dealing in a self-directed IRA.
Self-Dealing Overview. Self dealing is generally considered to be doing business with any disqualified person, including engaging in any transaction that benefits the account holder. "Disqualified persons" include your spouse, any direct descendants (children, grandchildren, great grandchildren, etc.) as well as parents and grandparents. When you engage in self-dealing with your self-directed IRA, you risk facing the imposition of significant penalties.
Disallowed Tax Benefits. Prohibited self-dealing transactions put the statutory tax benefits of your entire account at risk. If your account is no longer considered to be a self-directed IRA, you'll have to deal with the consequences of having your account assets deemed to be immediately distributed to you, as well as face any applicable early withdrawal penalties.
Immediate Distribution. Perhaps most significantly, engaging in self-dealing could lead to your entire account balance being deemed distributed to you. If your self directed IRA is set up as a traditional IRA, this means that the entire value of your account will be included in your current year's taxable income, which will undoubtedly generate a significant tax bill. This might prove doubly problematic if the property held within your self directed IRA is not liquid - as is the case with real estate. If you don't have the cash or other liquid assets necessary to pay your tax bill, you might be force to sell the property in order to pay the taxes on it. If you originally made your investment decisions based on a very long-term outlook, having to sell them early just to pay the tax bill can damage your overall financial status even more.
Early Withdrawal Penalties. If they deemed distribution of your account assets occurs before you reach age 59½, then you may also be assessed a 10% early withdrawal penalty on the full amount of the distribution. This penalty is in addition to the taxes you'll owe on the distribution amount.
No Tax-Free Growth. If the tax-advantaged status of your account is disallowed, you'll miss out on the most powerful advantage of a self-directed IRA - the ability for your account assets to grow tax free. Over the years and decades that many retirement savers hold their accounts, this tax savings component often comprises a significant portion of their overall savings.
Having an experienced self-directed IRA custodian such enables you be confident that you'll never face any of these penalties at any point of time. This is a big relief!
Types of 401(K) Contributions
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