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IRA Investment Pitfalls

Avoid costly missteps when using nontraditional (and even some plain-vanilla) investments in an IRA.

Natalie Choate, 02/15/2013

Whether your client's IRA investments are plain or fancy, danger lurks. An IRA investment mistake can lead to a costly and stressful cleanup process or even disqualify the IRA.

Question: My client is bored with investing her IRA in mutual funds, publicly traded stocks, and government bonds. She is considering diversifying her investments by having the IRA buy real estate (an apartment building) and a private equity fund partnership, via a "self-directed IRA." Are there any problems to be aware of in using nontraditional investments in an IRA?

Answer: Yes. There are many. Self-directed IRAs and alternative investments are perfectly legal for IRAs. They just come with risks you need to be aware of.

Fraud. Start with the fact that both the IRS and the SEC have warned that self-directed IRAs are a frequent vehicle for fraud. Not all self-directed IRAs are fraudulent; far from it. But the majority of IRA frauds are perpetrated through self-directed IRAs.

Real estate traps. Next consider the risks of direct IRA investment in real estate. Unless an unrelated professional real estate management company is placed between the IRA owner and the apartment building (so that the IRA makes payment only to, and receives payments only from, the management company), it is very difficult to avoid "commingling" of the IRA owner's personal funds and her IRA funds. For example, if she goes to the hardware store to buy cleaning supplies for the IRA-owned building, and pays for the supplies with her personal credit card (intending to have the IRA pay the credit card bill when it arrives), she may have made an "extension of credit" to her IRA, which would be a prohibited transaction (and that would disqualify the entire IRA).

Other drawbacks of direct IRA investment in real estate are:

--Loss of the tax deductions that are normally one of the benefits of real estate investment

--Possible income tax on "unrelated business taxable income" if the IRA-owned building is financed by a mortgage

--Prohibited transaction risks if the IRA hires the IRA owner or family members or allows the IRA owner or relatives to use the IRA-owned real estate

A knowledgeable and careful IRA owner properly guided by expert advice can successfully navigate all these potholes. Is your client knowledgeable, careful, and willing to pay for expert advice?

Hedge funds and private equity. The typical slipup with this type of investment is titling. John Doe withdraws money from his boring vanilla IRA held at the ABC Mutual Fund Company and sends the cash to the XYZ Hedge Fund, instructing them that this is an IRA rollover investment. The Hedge Fund dutifully opens a partnership account in the name of "John Doe IRA." The problem is that title to IRA assets must be held by a bank. Simply registering title in the name of an IRA does not meet this requirement of the Internal Revenue Code.

So John needs to find a bank that is willing to serve as custodian or trustee of his self-directed IRA and hold the XYZ Hedge Fund partnership interest as an investment. Then the account can be held and properly titled in the name "Big Old Bank, as custodian [or trustee] of John Doe IRA."

Many individuals have fallen into this trap. The way out is to beg the IRS for a waiver of the 60-day rollover deadline to allow the money to be transferred into a properly titled IRA. The IRS routinely grants such waivers if the IRA owner was misled by erroneous advice from his professional advisor or from the financial institutions involved. But that remedy requires not only time, professional fees, and IRS filing fees, it requires the hedge fund investment to be cashed out so that cash can be rolled into the new, properly titled IRA. (Since cash was distributed originally from the old IRA, only cash can be legally rolled over into the new IRA.)

It sounds like clients should stick with traditional IRA investments to be safe, right?Unfortunately even "vanilla" IRA investments can cause problems.

Standard brokerage agreement causes prohibited transaction. For example, attorney Timothy Berry of the Tax Academy was troubled by the standard printed brokerage firm account agreements his IRA clients were being asked to sign. The agreements  called for all of a client's accounts to cross-collateralize each other with respect to margin debt in any account. That looked rather like an "extension of credit" between the IRA and the non-IRA accounts, which would cause a prohibited transaction for the IRAs.

When the financial institutions pooh-poohed Berry's concerns, he asked the Department of Labor (DOL) for its opinion. The DOL issued advisory opinions confirming that indeed by signing these standard printed agreements, the IRA owner was committing a prohibited transaction if he had both IRA and non-IRA accounts at the firm in question.

How do we know who sought this ruling? Because DOL opinions, unlike IRS private letter rulings, are not private. The DOL publishes the name of the ruling applicant along with all the juicy details for all the world to read.

The IRS subsequently created a temporary exemption for these situations, holding there would be no prohibited transaction unless the cross-collateralization was actually triggered. The DOL may issue a class exemption.

Bank CDs. Here's another common snafu with that most boring of all possible IRA investments: the bank certificate of deposit (CD). With stocks, bonds, and mutual funds, the client typically has a single IRA account (for example, at a brokerage firm), and that account holds all the various investments. When a particular investment is sold or a bond matures, the proceeds are added to the cash balance of the account, and perhaps reinvested (still inside the account). Funds do not leave the account for any reason except a distribution to the IRA owner or an intentional transfer to a different IRA.

In contrast, when the IRA owner buys a CD for his IRA, the bank typically considers the certificate to be an entirely new individual retirement account with its own unique account number. Then when the certificate matures the bank closes that IRA and sends the owner a check for the proceeds. The IRA has now been closed and fully distributed. The owner then has to take the initiative to "roll over" those funds into another IRA, either a pre-existing account he has somewhere or perhaps a new CD (which the bank will consider to be a new IRA). Of course he has only 60 days to get that done. Even aside from the difficulty of complying with that short deadline (especially onerous if the IRA owner is sick, busy, or traveling), the IRA owner may not have the technical knowledge to even be aware that his IRA has been closed. He may call the bank and tell them to roll the CD proceeds into a new CD, and nobody mentions the fact that this new CD must also be a new IRA. The result is an unintended taxable distribution, which the owner may be able to correct via the costly and time-consuming process of applying for a waiver of the 60-day rollover deadline.

The bottom line: An IRA is like a fragile crystal glass. The glass is full of messy water (taxable income). If the holder and his advisors are not very careful, the glass will break and spill taxable income all over the client.

Resources: For more discussion of IRA investment issues, see Chapter 8 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011), which may be purchased through Ataxplan or Amazon.com. For SEC and IRS pronouncements on self-directed IRAs, see http://www.investor.gov/news‑alerts/investor‑alerts/investor‑alert‑self‑directed‑iras‑risk‑fraud and the instructions for IRS Form 1099-R. For typical IRS private letter rulings granted a waiver of the 60-day rollover deadline for the titling mistakes in self-directed IRAs, see PLRs 2007-37047, 2007-37048, 2009-19066 (real estate limited partnership), 2009-21038 (limited partnership), 2009-31063 (investment pool), and 2010-05058. The DOL Advisory Opinions on standard brokerage agreements are numbers 2009-03A (10/27/09) (http://www.dol.gov/ebsa/regs/aos/ao2009‑03a.html) and 2011-09A (10/20/11) (http://www.dol.gov/ebsa/regs/aos/ao2011‑09a.html). For the IRS reaction, see IRS Announcement 2011-81.

What do practitioners say about Natalie Choate's book Life and Death Planning for Retirement Benefits? "I sleep with your book under my pillow." "We regard your book as the ultimate authority." "I wish more people wrote books the way you do." "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "It's paid for itself already." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about Life and Death Planning for Retirement Benefits, visit www.ataxplan.com.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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