The Estate Planning Potential of Self-Directed IRAs
Posted by Robert Ingrasci on July 04, 2024
Traditional and Roth IRAs are well-regarded tools for estate planning. However, a self-directed IRA can enhance these benefits by allowing for investments in alternative assets with potentially higher returns. Despite the advantages, self-directed IRAs come with risks that necessitate careful management to avoid unfavorable tax consequences.
Exploring Alternative Investments
Unlike traditional IRAs, which are generally limited to stocks, bonds, and mutual funds, self-directed IRAs can hold a wide range of alternative investments. These can include real estate, closely held business interests, commodities, and precious metals. However, they cannot hold certain assets such as S corporation stock, insurance contracts, and collectibles like art or coins.
From an estate planning perspective, self-directed IRAs offer significant advantages. For instance, transferring high-potential assets like real estate or closely held stock into a traditional or Roth IRA allows these assets to grow on a tax-deferred or tax-free basis, benefiting your heirs.
Recognizing Risks and Tax Traps
It is crucial to understand the risks and potential tax traps associated with self-directed IRAs before proceeding:
- Prohibited Transaction Rules: These rules restrict interactions between the IRA and disqualified persons, including you, close family members, businesses you control, and your advisors. This restriction can complicate or prevent management, employment, or financial dealings with IRA-held business or real estate interests, risking the IRA's tax benefits and triggering penalties.
- Unrelated Business Income Tax (UBIT): IRAs investing in operating companies may incur UBIT, which must be paid from the IRA’s funds, impacting the overall value of the IRA.
- Unrelated Debt-Financed Income (UDFI): Investments in debt-financed property can generate UDFI, resulting in current tax liabilities for the IRA.
Proceed with Caution
When considering a self-directed IRA, it is vital to assess the types of assets you intend to invest in and carefully weigh the potential benefits against the associated risks. For personalized advice and more information, contact us.
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Bob is an experienced tax professional who devotes his professional time to structuring tax strategies in the areas of compliance, consulting, and planning. Bob works closely with a broad range of high-net-worth individuals and multi-generational families, specializing in the areas of gift and estate planning, charitable gift planning, trust and estate administration, individual taxation, and wealth preservation. Bob serves as a practice leader in the Family Wealth and Estate Planning group. Bob joined Lumsden McCormick in 2008 and was named partner in 2022.