As interest and access to private markets continue to expand, self-directed IRAs have emerged as a popular vehicle for enabling individual investors to tap into alternatives.
While other IRAs generally limit investments to stocks, bonds and mutual funds, self-directed IRAs can open the door to a wider range of assets, including those outside of public markets. This added flexibility can offer investors new avenues for portfolio diversification and resilience.
However, with expanded choice comes increased responsibility. The Internal Revenue Service has established rules designed to keep retirement accounts tax advantaged and compliant. These include specific guidelines surrounding the types of transactions that are allowed as well as which individuals can participate in transactions. Understanding how these rules work is essential for anyone managing a self-directed IRA.
What is a self-directed IRA?
A self-directed IRA (SDIRA) is a type of IRA that allows investors to hold assets beyond traditional stocks or bonds. An SDIRA can be a Roth, traditional or SEP IRA and would follow the same contribution limit, tax treatment and eligibility rules for each. The key differentiator of self-directed IRAs is their ability to hold a much wider array of assets, including private market investments like venture capital, private equity and private credit. Specialized custodians administer these accounts and ensure compliance with specific IRS rules, but the investor retains control over investment decisions.
This ability to explore nontraditional investments is one of the biggest advantages of self-directed IRAs. It can allow investors to align their retirement strategies with personal expertise, interests or financial goals. Adding private market assets via a self-directed IRA can help enhance portfolio diversification and resilience by reducing correlation with public market performance.
Types of prohibited transactions to avoid in a self-directed IRA
Prohibited transactions are specific activities that the IRS has determined could create conflicts of interest or provide improper personal benefit from retirement funds. Because IRAs receive tax advantages, the IRS requires that all transactions clearly serve the retirement account itself rather than the owner or related parties. When a self-directed IRA engages in a prohibited transaction, the account risks losing its tax-advantaged status.
Prohibited transactions generally fall into several categories. These include selling property to the IRA, using IRA assets for personal benefit, transferring income or assets improperly and involving a disqualified person in a way that provides direct or indirect financial gain.
Buying or selling property to or from the IRA
The IRA owner cannot sell personal property to the IRA nor can the IRA sell assets directly to the owner. For example, if an investor owns a rental property personally, that property cannot be transferred into their self-directed IRA. Similarly, if the self-directed IRA holds real estate, the investor cannot purchase that property for personal use or ownership. These restrictions ensure that transactions are made at arm’s length and are not used to shift assets inappropriately for tax advantage.
Using IRA assets for personal benefit
No part of an IRA’s assets can be used to benefit the account owner or family members financially or personally outside the context of the retirement account. For instance, if a self-directed IRA owns a vacation home as an investment property, the account owner cannot stay in the home even for a single night. Any personal use converts an otherwise legitimate investment into a prohibited transaction.
Providing goods or services to the IRA
An account owner cannot perform compensated work that benefits their IRA investment. For example, if a self-directed IRA owns a rental property, the owner cannot perform repairs themselves. Hiring an unrelated third party ensures the transaction remains impartial and compliant.
Lending or extending credit
The IRA owner cannot lend money to the IRA or borrow money from it. This includes guaranteeing loans for IRA assets. For example, if the self-directed IRA invests in real estate, the account owner cannot personally guarantee the mortgage. The IRA must remain financially independent to preserve its tax status.
Who qualifies as a disqualified person for a self-directed IRA?
To protect the integrity of retirement accounts, the IRS restricts certain individuals from participating in transactions involving the IRA. These disqualified persons include those who are most likely to influence or benefit from decisions related to the account.
The IRA owner and their spouse
The account holder and their spouse are automatically considered disqualified persons. Any transaction that benefits them directly or indirectly falls under prohibited transaction rules.
Lineal ascendants and descendants
Parents, grandparents, children and grandchildren are disqualified persons. So are their spouses. For example, a self-directed IRA cannot purchase property that a child owns nor can it rent a property to a parent. These family relationships create a risk of self-dealing that the IRS seeks to prevent.
Fiduciaries and service providers
Anyone who has authority over managing or advising the IRA can be a disqualified person. This includes custodians, financial advisors and certain business partners. If a fiduciary has the ability to influence how IRA funds are used, they cannot personally benefit from those transactions.
Entities controlled by disqualified persons
Corporations, partnerships or trusts in which disqualified persons own significant interest are also considered disqualified entities. For example, if an investor owns 60 percent of a company, their self-directed IRA cannot invest in that company. This rule prevents indirect attempts to move retirement funds into personal ventures.
How the IRS enforces self-directed IRA regulations
The rules governing self-directed IRAs primarily come from the Internal Revenue Code and are enforced by the IRS. While custodians facilitate transactions and provide administrative oversight, they are not permitted to give tax or legal advice. It is ultimately the responsibility of the account holder to ensure compliance. The Department of Labor also plays a role in defining prohibited transactions under certain sections of the tax code.
Consequences of violating prohibited transaction rules
The consequences for breaking these rules can be severe. If a self-directed IRA engages in a prohibited transaction, the IRS may consider the entire account distributed as of the first day of the taxable year in which the transaction occurred. This means the full value of the IRA becomes taxable income. If the account owner is under age 59½, they may also owe a 10 percent early distribution penalty. Additional taxes, interest and reporting penalties can apply depending on the circumstances.
Because of the magnitude of these consequences, even small or unintended violations can have significant financial impact.
Best practices to maintain self-directed IRA compliance
Account holders can take several steps to keep their self-directed IRAs compliant and well protected.
- First, they should work with a self-directed IRA custodian. While custodians cannot provide legal advice, they can help clarify whether certain activities may raise compliance questions and suggest when an investor should consult with a tax professional.
- Second, investors should keep clear, detailed records. Documentation helps show that transactions were conducted at arm’s length and exclusively for the benefit of the IRA.
- Third, account holders should avoid any transaction involving themselves or immediate family members. When in doubt, assume that personal involvement creates risk.
- Finally, consulting a knowledgeable tax professional or attorney before entering into complex transactions can help prevent costly mistakes.
Self-directed IRAs can be a powerful tool for investors to diversify beyond traditional stocks and bonds, but realizing their full value depends on staying vigilant and understanding the rules that govern these accounts.
