Note: If passed into law, pending legislation could substantially change Roth IRA regulations after Dec 31, 2021 – especially relating to distributions and backdoor rollovers.
The idea of an SDIRA (self-directed IRA) has become rather trendy among certain circles. An SDIRA may sound appealing to you if you believe that there is a higher return available outside the securities market for the funds in your SEP (self-employment plan), SIMPLE (savings incentive match plan for employees), traditional or Roth IRA. What is not so common is full knowledge about SDIRAs. And it’s this lack of knowledge that can be the precursor of huge tax headaches down the road. That is because it is not infrequent for this vital information not to be publicized or even mentioned by those who advocate SDIRAs. And especially when it relates to UBTI (unrelated bases taxable income) or UDFI (unrelated debt-financed income).
Well, as it turns out the IRS allows IRAs to invest in “Publicly traded securities and not owe current taxes because gains from the sale of C corporation stock, dividends and interest income are exempt from UBTI.”[i]
But if an SDIRA investment results in profits not related to a C corporation, there could be a reportable UBTI. And that UBTI must be reported.
All that to say this. UBTI may become problematic for those who are not aware of it and it’s ramifications as related to your SDIRA. Keeping your SDIRA compliant, with the current Internal Revenue Code you may require a 990-T form to be filed. And the sad fact is, “It is common for IRA custodians to receive tax documents and send copies to SDIRA owners without mentioning the potential UBTI tax consequences.”[ii]
Another consideration involves UDFI. As most advocates of SDIRAs will tell you, an IRA can invest in almost anything. Therefore, real estate is a common alternative to invest your SDIRA funds when you are looking for higher returns than what securities and Mutual Funds might offer. “Rent from real property is normally exempt from UBTI and thus is not currently taxable when earned by a SDIRA.” But income derived from debt-financed property IS taxable under the UDFI rule.” [iii] Therefore, failure to file your return properly, even when no tax is due, can become problematic for the SDIRA owner.
As with everything, sound knowledge, solid bookkeeping and a straight systematic approach to SDIRAs will most commonly prevent future headaches. Even though SDIRA may sound great, become knowledgeable before you make the switch. Because, “If it has something to do with money, gains, interest or taxation, the IRS has something you need to know before you move forward.” Besides, how much money you build up inside a qualified plan, be it an SDIRA or not, there is always the concern of getting it all out without paying more in taxes.
We, at Life Benefits, realize that not everyone has the opportunity to fund simple IRA, Roth IRA or SEP. And rolling these plans over into a SDIRA may not therefore even be a possibility for you. But don’t feel bad because…
Whether you are contributing to a plan where you receive an employer match, such as in a 401k or 403b, or whether you are the sole contributor to your retirement plan, as in any of the other plans mentioned here, it should be common knowledge, but it isn’t, that you may be better off taking responsibility for that money yourself by paying the taxes this year and managing those funds yourself instead of paying fees to someone else to manage, or act as custodian of, your funds. After all, during your working career your income taxes will be less on money you save and manage yourself, than if you let it grow tax deferred and have to pay the taxes during your retirement where the growth and the deferred contributions will face taxes combined during the distributions phase.
[i] Journal of Accounting, Warren Baker JD, 9-30,2013, Self-directed IRAs: A tax compliance black hole