Category Archives: Self-Directed Roth IRA

Can I or When Can I Take Tax Free Penalty Free Distributions From My Converted Traditional to Roth IRA?

Question: My 35 year old son is converting $160,000 form a tradtitiional IRA to a Roth. Assuming a $50,000 tax bite, and assuming he pays the $50,000 with outside money so he converts the whole $160,000, can the $160,000 be accessed penalty free immediately because it becomes the basis and the tax has been paid?

Answer: Unfortunately not.  Assuming the conversion represents the only Roth money your son has, the conversion amount cannot be removed within 5 tax years without paying the premature distribution penalty of 10%.  The ordering rules for distributions from a Roth IRA are 1) contributions 2) conversions, and 3) profits.  So if your son has made contributions to a Roth IRA he can withdraw those at any time without penalty.  Beyond the contributions, conversions can be removed only after 5 years without penalty, unless he meets one of the other exceptions to the penalty rules (most commonly 59 ½).  Profits can only be withdrawn tax and penalty free as qualified distributions, meaning your son has had a Roth IRA somewhere for at least 5 years and meets one of four other tests (again, most commonly 59 1/2).  You may find the description of the ordering rules beginning on page 66 of IRS Publication 590, which you can review and download from the IRS at www.irs.gov.  Good luck with your investing!

Follow Up Question: Thank you for a quick response. I did go to the irs.gov. site. From the website and your email, this is what I understand. Please forgive any repetition. I have received very different answers from seminars and regional offices, so your  expert help is hugely valuable! I want my son to be clear and comfortable as he is concerned about accessible, penalty free rainy day money prior to age 59 1/2. I also want to be able to deliver correct information to other investors. Is this correct: if my son converts $160k of traditional IRA money and pays the taxes out of pocket, in 5 tax years he can access the $160k without penalty at approximately age 41?  He currently has $15k in an existing Roth he has had for 7 years. The contribution portion of the $15k can be taken today penalty free and the profit portion will be penalized if accessed prior to age 591/2. Correct? Any profit is subject to regular Roth rules and those conditions are clearly defined and I understand them. I will not continue to bother you, but knowledgeable experts are hard to find.

Follow Up Answer: Yes, according to the paragraphs describing the additional tax on distributions beginning on page 64 of the 2009 IRS Publication 590, your son must pay the 10% penalty for distributions of his conversion contribution from his Roth IRA made within 5 tax years of the conversion – in other words, if he converts in 2010 and takes a distribution before January 1, 2015 he will be subject to this penalty to the extent that this distribution exceeds his regular contributions to his Roth IRAs.  To figure the taxable part of any non-qualified distribution (as opposed to the penalty) use the Worksheet 2-3 on page 67 of Publication 590.  You will see from that worksheet that the amount of his regular Roth IRA contributions are not includible in income (line 12 subtracts these amounts out) and are therefore not subject to the 10% premature distribution penalty either (see the paragraph entitled Other Early Distributions  at the top of page 66, which indicates “you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions”).

 
Having said this, as you know from the disclaimer at the bottom of my prior emails you are not able to rely on this email as tax advice, so you should absolutely contact your own tax advisor to verify the implications for your individual tax situation.  I would be curious to learn what you have heard from seminars and regional offices if you care to share it.  I know there is a lot of confusion out there on this topic, even by some professionals such as CPAs.  Perhaps the most confusing thing is the fact that there are 2 different 5 year clocks when it comes to Roth IRAs, one being the 5 years necessary for a distribution to be a qualified distribution and the other being the 5 year clock for conversion contributions before you can escape the 10% premature distribution penalty, as we have been discussing here.  Anyway, thank you for your question.  Let me know if I can assist you further. Have a great day!

Can I invest my IRA into an Oil and Gas drilling project????

Question:

I am interested in investing a small portion of my Roth IRA into an oil drilling project.   I understand the potential risk of loss and am willing to take that risk.  There is substantial opportunity for profit which I would like to shelter from taxes to the extent possible.

Can you tell me:

1.  Is this an acceptable Roth Self Directed IRA use?
2. If so, how long will it take to set up such an IRA if I transfer assets from an existing Roth IRA?
3.  Any idea’s on cost to do this would be appreciated.

Answer:

1. Yes
2. 24-48 hours for us to set up the Roth IRA, and however long it takes your current custodian to process the transfer request (typically 2-3 weeks, unless you move the money by doing a 60 day rollover, which is faster but only can be done once per year per source of funds)
3. $50 to set up the Roth, $95 transaction fee, $30 for a wire or $5 for a check, and an annual administration fee which is either a flat $295 or is based on the value of the account (I have attached our fee schedule for your reference)

The only other thing you should be aware of is that if you take a working oil and gas interest into your Roth IRA then the investment may subject your IRA to Unrelated Business Income Tax (UBIT), whereas a royalty interest would not.  You didn’t mention if your proposed investment was a working interest or a royalty interest, and we don’t give tax, legal or investment advice, but I wanted to make you aware of the issue in case it was important to you.  You can find out more about this topic by reviewing IRS Publication 598.  Please note that just because something may cause your IRA to owe taxes does not mean you shouldn’t do it.  You simply have to take taxation into account when making a decision.  After all, if the after tax revenue from the investment still is a very good return, it would be foolish to not make the investment simply because of the UBIT implications.

I realize the answer to this email may cause more questions, and you may call our offices on Monday and either speak with Nathan Long (800.320.5950 ext 117) or Ryan Kimura (214.800.3488)  in our Dallas office.  Good luck with your investment!

Can I Invest My IRA Internationally???

Question:

I am looking at establishing either a self directed IRA or a Roth IRA. Question # 1 is: I am looking a buying into a Hong Kong private company. Is this allowed by the IRS? When there is a distribution of profits back to the 401(k) or the Roth IRA are these distributions taxable? Question #2. If I do buy a portion of the Hong Kong company with my 401(k) and later wish to convert this to a Roth IRA – can it be done? Will I just pay the 40% tac on the initial investment or what?

Answer:

To answer your first set of questions, yes, the IRS allows you to invest in a Hong Kong private company (or more properly, the IRS doesn’t restrict you from investing in a Hong Kong company), although the investment is reported to the IRS each year on IRS Form TDF 90-22.1 (Report of Foreign Bank and Financial Accounts).  When there is a distribution back to the 401(k) or IRA the distribution isn’t taxed from the U.S. side, but you would have to check with the law in Hong Kong to see if they would tax the distributions. 

To answer your second set of questions, if you have an Individual 401(k) and buy the company stock with it, at this time conversion to a Roth IRA is only possible if you have a distributable event such as termination of your employment or termination of the plan (there have been some proposals to allow conversions within a 401(k) plan but as far as I know they haven’t gotten through Congress as of this writing).  However, if your plan has the Roth 401(k) feature and you have the ability to direct the investment into that portion of your plan, then qualified distributions from the Roth 401(k) are tax free to you.  Whether your plan has a Roth 401(k) feature and whether you have made any contributions to that portion of your plan is something you will need to figure out from your plan document and/or your plan administrator.  Whenever you do a Roth conversion, the value of the assets converted is added to your taxable income for the year in which you did the conversion (except for 2010, when you can divide this “conversion income” 50% into 2011 tax year and 50% into 2012 tax year if you like).  If I understand your last question correctly, you would pay tax based on the value of the stock at the time of conversion, not the value of your initial investment.

I hope this answers your questions.  I realize that sometimes the answer to a question raises more questions, so please feel free to contact Nathan, Ryan or myself if you need more information about self-directed IRAs or Individual 401(k)s.  Thank you for your inquiry, and have a great weekend!

Managing My 70 yr old Mother Account????

Question:  

Quincy, my mom is 70 yrs.  She doesn’t make very much money.  I was wondering if i opened up an account in her name can I work or manage the account? Instead of my handing her the cash in the account, would this be beneficial to us both?  I’m also thinking about converting her IRA to a Roth IRA.

Answer:  

There could be substantial benefits in doing so.  The good news is that her contributions to the account may be removed at any time tax and penalty free, regardless of her age or the length of time the account has been open.  She may not contribute more than her earnings, so you will have to be careful there.  She can make the contribution all the way up until April 15 of next year for this year.  Because she can withdraw the contribution amount at any time, contributing money to a Roth IRA is a great way for your Mom to save.  Because she is over 59 ½ there would never be a penalty for removing funds from the Roth IRA.  However, if she removed more than her contribution amount (in other words, she took her profits) before she has had a Roth IRA established somewhere for her benefit for at least 5 tax years, the distribution may be taxable even though it is from a Roth IRA.  The magic happens once she has satisfied the 5 year aging requirement.  At that point all distributions are completely tax free.  If she doesn’t end up withdrawing all of the money before she passes away and you inherit the Roth IRA, then you can take tax and penalty free distributions from the account for the rest of your life, regardless of your age.  The bottom line is that in my mind, at least, there would be benefits to both of you if you helped her open and work a Roth IRA.  The key to the benefit is that you actually work the account and not just let it sit there doing nothing. 

Let me know if we can help any further.  Have a great day!

Can I use self directed IRA to pay off the property that I’ve already own?

Question:

I have a situation where I bought a rental property with 2 step loan. The first loan is IRA loan, actually from Quest IRA, Inc. client. Then when it comes to refinance, it seems like I might have a problem that I could not be qualified for loan. So, I am wondering if I set up IRA, could I use that money to pay off the first loan?

Answer:

Unfortunately, the answer to your question is no, you cannot.  It is a prohibited transaction to use your IRA for your personal benefit right now, as opposed to taking distributions from the IRA when you retire.  If you are under age 59 ½ you can take a distribution from your IRA to pay off the mortgage, but of course that would mean you would have to pay a 10% premature distribution penalty in addition to any taxes owed if the IRA were a traditional or other pre-tax plan.  If you are over age 59 ½ the only issue is whether or not the distribution is taxable, which depends on what type of IRA it is and whether you have any after tax basis in the account.  As you already know, you can use your self-directed IRA to loan money to other investors, but not to yourself or any other disqualified person.

Top Ten Things You Need to Know When Investing in Real Estate Notes in Your IRA

By H. Quincy Long

Many self-directed IRA clients, including me, invest in notes within their IRAs, mostly secured by real estate.  In my years of experience as a hard money lender personally and as a third party administrator for self-directed IRAs, I have seen some common mistakes made.  As a result, I have developed some guidelines for lending your IRA (and non-IRA) money out secured by liens on real estate.  I wish someone had shared these ground rules with me before I made some of the loans in my portfolio, although fortunately I have not been hurt too much by my mistakes.

1) Do not loan on something you wouldn’t be excited for your IRA to own if the borrower defaults.  Loaning money out of your IRA at relatively high interest rates secured by real estate is inherently more risky than leaving the money in a bank certificate of deposit, but it is also more profitable.  We routinely see yields from these loans at 12% and higher.  However, if you would be upset if the borrower defaulted and you had to take the property in foreclosure you probably should not make the loan.  With a properly secured hard money loan the worst thing that can happen is that the borrower pays you back!

2) Generally, do not advance money for repairs until the repairs are done, and then have the repairs inspected before advancing the money.  This is one of the biggest mistakes I see clients make with their IRAs.  They fund the full loan amount expecting the repairs to be done on the property, but the borrower just needs a little more money on another project and diverts some of the loan proceeds to that project.  When the loan goes bad, the IRA can end up with a property which has not had the repairs completed on it.

3) Do not loan money to someone you would feel uncomfortable foreclosing on.  William Shakespeare wrote in Hamlet, “Neither a lender nor a borrower be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.”  For the most part I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity.  However, the part about a loan losing a friend is absolutely correct, in my opinion.  If foreclosing on your borrower would cause you heartache, it is best not to make the loan.  I have seen friendships destroyed over a loan gone bad.

4) If the loan goes into default, take action immediately.  No one wants to admit they have made a mistake, but delaying action can be costly.  You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it.

5) Collect interest monthly so you will know if the borrower is getting into trouble.  Many borrowers, especially investors, would love to just pay interest at the end of the loan, but this can expose the lender to additional risk.  The purpose of collecting payments monthly is both to make sure the borrower remembers he has to do something with that property in order to avoid the pain of the payment and to let you know if the borrower is in trouble because he starts missing his payments.  Also, unless you have contracted for monthly payments, you may not be able to foreclose even if you find out through other means that the borrower is in financial trouble because the loan may not be in default.  This actually happened to some of our clients.

6) If you are unsure about how to evaluate the loan, hire a professional to help you.  Although a hallmark of the self-directed IRA is that it is “self-directed,” meaning that you make your own decisions and find your own investments, most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time to properly evaluate a loan transaction.  My solution is to hire a professional to help me with the deals.  He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place, and generally evaluates the loan.  Naturally he charges a fee for this service, which is passed through to the borrower, on top of any interest and fees that my retirement plan may charge.  This increases the cost of the loan, but in this case the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”

7) Get title insurance for the loan.  The purpose of title insurance is to shift risk away from you and to the title company.  In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy.  Regardless of the cost, making sure that your IRA is protected from title flaws is very important.

8) Verify that hazard and, if necessary, flood insurance is in place naming your IRA as an additional insured.  It is very easy to miss this issue when you are trying to get everything done right before a closing.  Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured.  But if something goes wrong, you will want to make sure your IRA is named on the check.

9) Insist that the borrower provide you evidence of payment when property taxes and homeowners association fees become due.  The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills.  Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.

10) Get a personal guarantee if lending to an entity or to an individual with some weakness.  When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this.  However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt.  I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions.  Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he was unable to satisfy the note I would pursue legal action against him and the borrower.  A week later a cashier’s check showed up satisfying the lien.

This list of suggestions is not meant to be exclusive.  Other issues you will need to understand include your lien position (personally I only invest in first lien loans), any state usury laws that might apply to the loan, and at least a general idea of what the foreclosure process is in your state in case the loan goes into default.  Always get good legal counsel to assist you with loan documentation.  Especially since the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents.

Lending can be an excellent investment in an IRA.  It is relatively easy to do and if done correctly has a comparatively low risk.  Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well.

H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Quest IRA, Inc., serving clients in the State of Texas with offices in Houston and Dallas.  He may be reached by email at Quincy@QuestIRA.com .  Nothing in this article is intended as tax, legal or investment advice.

Can I invest my IRA into a company that my husband is the president and owns 23% of the stock?

This was a question that came in and I thought that the question was good enough to post on my blog as I get this question alot from my clients.

Question: I have an ira currently invested the stock market. My question is around self directed iras and disqualified persons. My husband is the president of a corporation, and owns approx 23% of the stock. What I would like to do is turn my ira into a self-directed ira and invest it in a deed of trust secured by the land the coporation owns (in other words, a mortgage loan). Would this be a disqualified transaction? I’ve found the rules on disqualified persons to be a bit confusing.

Answer:  Thank you for the excellent question.  You are correct when you state that the rules on disqualified persons (and prohibited transactions) are confusing.  Unfortunately, I DO believe that if your proposed transaction were looked at  it would be considered to be a prohibited transaction.  While it’s true that the corporation your husband is President and a 23% shareholder of is not a disqualified person as to your IRA (assuming that no other disqualified family members own more than 27% of the stock), your husband is a disqualified person to your IRA.  The prohibited transaction rules of Section 4975 say that there can be no direct or indirect benefit to any disqualified person from an investment in your IRA.  It is this indirect benefit rule that would most likely lead to problems for you because your husband would indirectly benefit from the private loan made by your IRA to a company he works for and owns a substantial interest in.  Another issue is that the corporation is an entity in which you have an interest in which would affect your best judgment as a fiduciary for your IRA.  A benefit to a person in whom you have an interest which would affect your best judgment as a fiduciary can be deemed to be an indirect benefit to you, and of course you are a disqualified person to your own IRA. 

I have attached a couple of legal opinions, one from the Department of Labor and one from tax court, which may help you or your legal counsel to decide what to do.  Unfortunately, I cannot give you tax, legal or investment advice.  Good luck with your investing, and thank you for contacting me.

Attachments: Rollins v. Commissioner & DOL Advisory Opinion 88-18A

Thanks again for you question. Anyone, please feel free to submit your questions to me on this blog. Who knows, your qusetion may be helpful to others that are thinking about investing with a Self-Directed IRA.

Top Ten Mistakes

Top Ten Mistakes I See People Make With Their Self-Directed IRAs

1) Not understanding the “self-directed” part of self-directed IRAs.

Unlike more traditional brokerage style IRAs, self-directed IRAs do not come with any tax, legal or investment advice, nor do self-directed custodians and third party administrators offer or endorse investment products.  Self-directed means just that – it is self-directed and you must find your own investments and decide how you want to structure those investments.  If you make a million dollars in your self-directed IRA all the glory belongs to you, but if you lose everything you have there is no one to blame but yourself.

2) Not investing in what they know best, but rather investing in something they know nothing whatsoever about.

One of the primary benefits of a self-directed IRA is that it allows you to invest in what you know best, especially if that is not the more traditional IRA investments like stocks, bonds, mutual funds or annuities.  Some people get very excited about the idea of self-direction and invest in something they know nothing about, which often leads to an investment disaster.  Most of my mistakes in investing have been because I have strayed from what I know how to do best.

3) Not understanding the disqualified persons and prohibited transaction rules.

Disqualified persons are those persons who are deemed to be too close to make a transaction within your IRA an arms-length transaction, which means these persons cannot enter into transactions with your IRA nor can they benefit from those transactions, either directly or indirectly.  Prohibited transactions are what your IRA cannot do with any disqualified person.  The penalty for entering into a prohibited transaction is DEATH (of the IRA that is) along with taxes and penalties.  If you have a self-directed IRA you must have a good basic understanding of these rules as they apply to your investing strategy.

4) Not vesting assets correctly – all assets in self-directed IRAs should be vested as follows:  “Quest IRA, Inc. FBO Your Name IRA #Your IRA Number.”

A lot of time is spent in attempting to get clients, title companies, and investment providers to understand that all assets must be vested in a specific way in order to be held within a self-directed IRA.  Common errors include failing to vest in the name of the custodian or administrator at all, or only putting the client name after the “FBO” so that it appears we are holding the asset on behalf of the individual instead of the individual’s IRA.  Another common mistake is where the client attempts to use their own Social Security Number instead of that of the IRA or the administrator or custodian’s trust tax identification number.

5) Failing to submit proper paperwork to allow smooth opening of IRAs and processing of transactions.

Another large time waster is chasing down paperwork from improperly completed documents for opening the IRAs, for transferring money into the IRAs and for transactions.  This leads to a frustrated client and frustrated staff.  Taking the time to learn how to properly submit paperwork and allowing yourself enough time to do so is critical in successfully navigating the self-directed IRA world.  Remember, it is better to ask questions in advance than to submit incorrect paperwork and cause a delay.

6) Not understanding what they are investing in.

This is a big one.  It is almost incomprehensible to me how some people don’t have any understanding of what they are investing in at all.  For example, a person called the other day and thought she had a note and an option agreement.  Instead, she had a simple option where she had paid $28,000 for an option to buy 50% of the property for $10.  This was meant to help the owner out of foreclosure. The homeowner had the right to buy back the option at a profit to the IRA of about $5,000. The good news is that it worked for a time period and the homeowner got to stay in the house for an extra two years.  The bad news is that the homeowner still wasn’t fiscally responsible and the IRA lost every dime when the lien holder foreclosed. Since all the IRA had was an option (not a note as she thought) she could not even sue to recover some of her money, and even if she had exercised her option her IRA would have only owned half of the house.

7) Not understanding Unrelated Business Income Tax and how it may affect your IRA.

IRAs may be taxed in three circumstances.  First, if it runs a business, either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Second, if the IRA owns and rents out personal property (rents from real property are exempt from this tax).  Third, if the IRA owns debt-financed property, again either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Just to be clear, it is not necessarily all bad to make investments which cause your IRA to pay tax, especially within a Roth IRA or other tax free account, but it is something you should understand up front.

8) Trusting someone with your hard earned IRA money without doing proper due diligence and proper paperwork.

Let me give you a hint – con men are very good at what they do.  Make sure you understand what you are investing in, and do your due diligence on the investment and on the person you are investing with before making an investment decision.  Also, make sure you have proper paperwork.  I wouldn’t loan money to my own mother without proper documentation!  Proper paperwork protects both your IRA and the person your IRA is investing with.  Think about what would happen if either you died or the person you invested with died.  Would either party’s heirs understand what the investment was all about?  Even if you trusted the person you invested with absolutely, would their heirs know about your handshake deal and honor it?  Probably not!  An excellent rule of thumb in investing is that if it sounds too good to be true it probably is.  Also, a common thread in scams is that it must be done NOW or you will miss out on this incredible opportunity!  This is an attempt to draw you in without allowing you time to think about or due diligence on the investment.

9) Failing to follow proper strategy when loaning your IRA to other investors.

There are at least 10 simple rules to follow when lending your IRA money out (or even your personal money).  They are:

a)         Do not loan on something you wouldn’t be excited to own if the borrower defaults.

b)         Generally, do not advance money for repairs until the repairs are done, and then inspect the repairs before advancing the funds.

c)         Do not loan to someone you would feel uncomfortable foreclosing on!

d)         If the loan goes into default, do not delay – take action immediately!

e)         Collect interest monthly so you will know if the borrower is getting into trouble.

f)          If you are unsure about a loan, hire a professional to help you evaluate the deal (at the borrower’s cost, of course!).

g)         Get title insurance on your loan.  If done at closing the incremental cost to the borrower is very small.

h)        Verify that hazard and, if necessary, flood and wind insurance are in place naming your IRA as an additional insured.

i)          Insist on evidence that taxes, homeowners association dues and hazard insurance are paid when they come due during the term of the loan.

j)          Get a personal guarantee when lending to a non-individual borrower or a weak borrower.

10) Attempting to figure out how to get around the rules to get a benefit for themselves or other disqualified persons rather than simply investing within the rules.

It seems to be very tempting for people to want to use their own IRAs to make money or obtain some other benefit for themselves or other disqualified persons right now instead of letting all the benefits go to the IRA so that they have a nice retirement.  To make matters worse, a lot of gurus are teaching how to hide the fact that you are violating the rules instead of teaching people how to use the rules properly to their advantage.  My personal motto is, use the law to your advantage but don’t abuse the law.  After all, the “R” in IRA stands for Retirement. It is not an INA (or Individual NOW Account)!  To make money now, use OPI (Other People’s IRAs), and to make money for your retirement, use your own self-directed IRA.

11) Attempting to use a “checkbook control LLC” to get their hands on their IRA funds without having to deal with all that pesky paperwork and those silly prohibited transaction rules without understanding the extreme danger involved.

This is popular but is not wise.  However, to explain it fully would take a full weekend with me, Dyches Boddiford and CPA David Worley.  Come to think of it, we are explaining it all in August in Atlanta, Georgia if anyone is interested.