An IRA can be a valuable tool in your retirement and estate planning arsenal, but what if you’re not satisfied with its performance? One option is to set up a “self-directed” IRA.

Unlike traditional IRAs, which typically offer a limited menu of stocks, bonds and mutual funds, self-directed IRAs can hold a variety of alternative investments that offer the potential to earn higher returns, such as real estate, closely held business interests, commodities and precious metals. They can’t hold certain assets, however, including S corporation stock, insurance contracts and collectibles (such as art or coin collections).

From an estate planning perspective, self-directed IRAs have considerable appeal. Imagine transferring real estate or closely held stock with substantial earnings potential to a traditional or Roth IRA and allowing it to grow on a tax-deferred or tax-free basis for the benefit of your heirs.

Before acting, it’s critical to understand the significant risks and tax traps involved with self-directed IRAs. For example:

  • The prohibited transaction rules restrict dealings between an IRA and disqualified persons, including you, close family members, businesses that you control and your advisors. This makes it difficult, if not impossible, for you or your family to manage, work for, or have financial dealings with business or real estate interests held by the IRA without undoing the IRA’s tax benefits and triggering penalties.
  • IRAs that invest in operating companies may generate unrelated business income taxes, which are payable currently out of an IRA’s funds.
  • IRAs that invest in debt-financed property may generate unrelated debt-financed income, creating a current tax liability.

If you’re considering a self-directed IRA, consult with your tax and estate planning advisors to help you steer clear of the tax traps and minimize your risk.

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Disclaimer: The THK Legal Blog is for informational purposes only and should not be relied upon as legal advice. In no case does the published material constitute an exhaustive legal study, and applicability to a particular situation depends upon an investigation of specific facts. You should consult an attorney for advice regarding your individual situation. All THK blogs are considered advertising material by the Indiana Bar Association.