Updated on September 7, 2007.>
MOST FOLKS DON'T get too funky with their IRA investments. A few mutual funds, some stocks maybe some bonds that's the typical fare.
But it turns out that you can get a lot more creative with your investments than that. Just about the only things that are flat-out banned are life insurance policies and certain collectibles, such as works of art, rugs, antiques, metals, gems, stamps, coins and alcoholic beverages. You can> however, buy certain gold and silver coins minted by the U.S. or by U.S. states. You can also invest in high quality gold, silver, platinum, and palladium bullion, among other things. (However, any such bullion must be kept in the physical possession of your IRA trustee.)
Now, in this article we won't address whether it's a wise> decision to allocate your IRA (and we're talking about any type of IRA here: traditional, SEP, SIMPLE and Roths) to any of these alternative investments. But we will cover what you can hold and how to do so, if you feel so inclined. Keep in mind, though, this is pretty tricky stuff. So be sure to talk to your tax pro before pulling the trigger.
Be Prepared to Find the Right Broker
Not every trustee (often a brokerage firm, although it could be a bank or other IRS-approved outfit) will be thrilled about helping you invest your IRA in something other than the mundane. That's because should you invest in something not permitted by the IRS rules (we cover the specifics below), you lose the tax advantages of IRA investing. Unfortunately, what is and isn't allowed by the IRS can get pretty vague, which is why many trustees simply don't want to deal with the potential hassle.
That said, some outfits specialize in functioning as IRA trustees for folks interested alternative investments. The easiest way to locate suitable trustees is by doing an Internet search using the key words "self-directed IRA." Once you have a list of contenders, do some due diligence to find one that's reputable. Then check their fee schedules carefully. Having an IRA with alternative investments inevitably costs more than the garden-variety version.
Once you find a trustee that's willing to work with you, suitable alternative investments can potentially include:
This is not an exhaustive list, but as you can see, some of these options are inherently illiquid, which can cause problems. If you have too much of your account balance tied up in illiquid investments, you won't be able to dip into your IRA for cash anytime you please.
At the very least, you want to be sure to maintain enough liquidity to take your annual required minimum distributions after age 70 1/2. Why? Because if you fail to take these minimum distributions, the IRS can penalize you for 50% of the difference between what you should have withdrawn from your account each year and what you actually withdrew (if anything). Thankfully, Roth IRAs are not subject to the required minimum distribution rules until after the account owner dies.
Real Estate for Your IRA
Want some real estate in your IRA? First, your IRA must own the real estate strictly as an investment, which means no use by you or certain family members. The IRA trustee must also hold legal title to the property. And finally, your IRA must have sufficient liquid assets (either from other investments in the account or from your annual contributions) to cover any costs associated with owning the real estate.
Keep in mind, you lose some tax advantages by holding real estate in a traditional IRA, SEP IRA or SIMPLE IRA. Specifically, you won't benefit from the 15% maximum federal income tax rate on long-term real-estate gains (25% for long-term gains attributable to depreciation), and you can't claim deductions for mortgage interest, property taxes, depreciation and so forth. However, if you use a Roth IRA to invest in real estate, the property can be sold with the gain eventually distributed federal-income-tax-free (and maybe state-income-tax-free, too) to you or your heirs, assuming the rules for tax-free Roth IRA distributions are met. Now that's a great deal!
Unmortgaged rental properties are a good choice for IRAs as are real-estate mutual funds and REITs.
Mortgaged real estate, on the other hand, is less advisable because leveraged property can potentially create "unrelated business taxable income," or UBTI, and a resulting federal income tax bill for your IRA. (We cover the details of this nasty little tax hit below.) Your IRA must have enough liquidity to service the debt, pay for any other expenses related to the property, and pay any UBTI tax bills. Using an IRA to invest in a real-estate partnership may also trigger UBTI problems.
Bottom line? Consult with your tax adviser before using your IRA to invest in mortgaged real estate or a real-estate partnership. For a large transaction (i.e., one involving equity of hundreds of thousands of dollars), your tax pro may recommend asking for an IRS private letter ruling on this issue.
Keeping the IRS Happy: Look Out for the Prohibited Transaction Rules
When investing in alternative investments, you need to watch out for two problems: You must avoid the "prohibited transaction rules" and avoid triggering the "unrelated business taxable income." Here's what you need to know on each front.
First, let's go over the prohibited transaction rules. As boring as this may sound, you need to pay attention here because if these rules are broken, your IRA's tax-favored status may be lost. Should that happen, your entire IRA balance would become taxable. You would also be hit with a 10% penalty tax if you're under age 59 1/2. Not pretty.
The prohibited transaction rules are intended to prevent so-called "self dealing" where the IRA owner uses the account's money to meet personal financial objectives considered to be inconsistent with the IRA's status as a tax-favored retirement account. In other words, you can't have a conflict of interest in what you buy for your IRA. Unfortunately, trying to interpret this area of the tax law is more of an art than a science. Examples of what the IRS (or the Department of Labor) may consider to be prohibited transactions include the following.
Avoiding "Unrelated Business Taxable Income"
The other tax snag you want to avoid: triggering "unrelated business taxable income" (UBTI). Basically, certain types of income (not including investment income) are prohibited in IRAs. When this happens, your IRA may owe federal income tax, which defeats the whole purpose of the account. The UBTI rules are intended to prevent IRAs from investing in income-producing businesses via direct ownership or via ownership of a partnership or LLC interest. An example might include using an IRA to buy an interest in a cattle-breeding partnership.
Leveraged assets can also generate UBTI for an IRA. So investing in a partnership that owns leveraged assets could cause UBTI problems.