[Over the next several months, attorney Warren L. Baker will be posting an article series he wrote on investing retirement funds into "non-traditional / alternative assets" (e.g. real estate) using a "self-directed IRA".]

To start with, what is a “self-directed IRA”?  The vast majority of people that have a retirement plan, whether it’s in the form of an IRA, 401(k), 403(b), etc. have their money invested in “traditional” types of investments, e.g. stocks, bonds, mutual funds.  However, the general rules governing an IRA allow for any type of investment except for investments into “life insurance contracts” and “collectibles” (e.g. rare coins, antiques, wine, etc.).  The most common investments for self-directed IRAs include real estate, loans, tax liens, and privately-held companies.  That sounds great in theory, but in order for an account holder to actually invest retirement funds into assets outside of the stock market the account holder will need his or her retirement plan custodian to allow this type of investment.  In other words, the financial institution that holds the retirement account must be willing and able to facilitate the investment or the account holder is out of luck.  The reality is that most large financial institutions have traditionally not allowed investments outside of publicly-traded securities.  Thus, one of the first steps in the process of forming a self-directed IRA is generally to “roll” or “trustee-to-trustee transfer” some (or all) of the retirement account to a new IRA custodian.  But before we get to that issue, a few other steps will need to occur.

Step #1 – Can the funds be moved?: Prior to selecting a new IRA custodian (discussed more in Step #2), the retirement account owner needs to determine whether his or her retirement account is even eligible to be moved from its current location.  For example, many 401(k) plans significantly restrict the movement of money while the retirement account owner is still working for the company that sponsors the plan.  In other words, if the 401(k)’s underlying “plan document” will not allow the account owner to move their money, transferring funds into a self-directed IRA might not be possible (at least until a “separation from employment” occurs).  This is an issue that the account owner needs to resolve with their current plan administrator.  In general, if the current retirement account is structured as an IRA (or a 401(k) from a previous employer) it can be moved (in whole or in part) to a new custodian without incurring current tax consequences. 

Step #2 – The new custodian: Once the account holder determines that they are eligible to move some (or all) of their retirement funds, they need to select a self-directed IRA custodian.  Often, an experienced professional will help in this selection process.  Although there are an increasing number of IRA custodians that are willing to hold “non-traditional” IRA assets, there are dramatic differences between these custodians.  Some custodians offer very minimal customer service, but have lower fees.  Other custodians claim to offer the opposite.  Another issue to consider is whether the custodian will allow the IRA to purchase a Limited Liability Company (“LLC”), which could be important if the client wants maximum control over the structure (see Step #4). 

Step #3 – Rollover or transfer?: After setting up a new self-directed IRA, the structure needs to be funded, which can be done in one of two ways.  One option is for the account holder to request a “rollover” – meaning that the old retirement plan administrator sends a check to the account holder that is made out to either the account holder personally or the new IRA custodian.  The account holder must then deposit the check into the new IRA within 60 days.  If the client fails to deposit the check in time, the entire amount will generally be treated as a taxable distribution.  The second option involves the account holder requesting a “trustee-to-trustee” transfer – in which the funds move from the old custodian to the new custodian without the client coming into physical possession of the funds.  For numerous reasons, the second options is preferred in most cases.

Step #4 – IRA or IRA/LLC: Let’s assume for a moment that the account holder’s goal is to invest into a piece of residential rental real estate.  Once the new self-directed IRA is funded, the account holder needs to decide whether he or she is going to invest the money directly out of the IRA (i.e. the IRA custodian buys the property on behalf of the IRA) or whether the IRA is going to purchase an LLC and invest using the LLC’s name and bank account.  With the account holder serving as the “Manager” of the LLC, the latter option allows the purchase of property using a check from the LLC, which depending on the custodian’s ability to move quickly, will likely speed up the property purchase.  Also, the IRA/LLC model will reduce the future costs due to reduced custodian involvement (i.e. lower fees).  For tax purposes, because the LLC is a “flow-through” tax entity, investments made using either method are normally tax-deferred (note: there are major exceptions to this tax-deferred treatment; for example, if the LLC operates an active business and/or uses debt-financing, the IRA will incur income that is not entirely tax deferred and the IRA must file a tax return).  However, the control and flexibility allowed by the IRA/LLC creates problems if the client does not operate the structure in a legal fashion.  For example, if the IRA/LLC structure interacts with certain individuals (aka “disqualified people”), the entire IRA can lose its tax-exempt status and be taxable to the IRA account holder all in one year.

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