It's common for clients to hold a significant amount of their wealth within individual retirement accounts. It's also becoming more common for clients to develop an interest in managing their own investments — often, in nontraditional investments like virtual currency.
Self-directed IRAs can allow clients to invest in real estate, venture capital funds and even cryptocurrency if they're careful. However, it is critical to understand the rules governing self-directed IRAs before engaging in any investment strategy. Violating the prohibited transaction rules has serious consequences, and it's possible that the IRA could lose its tax-qualified status altogether, generating income tax liability and penalties.
Impermissible IRA Investments
Certain types of investments cannot be made with IRA funds (whether self-directed or not) because of Internal Revenue Service rules on permitted investments.
Impermissible investments include life insurance and collectibles (certain gold, silver, palladium and platinum bullion are permitted, however). Additionally, the IRA owner cannot pledge the account as security for a loan. Unlike with 401(k)s, IRA account owners cannot take loans from IRA balances.
Clients should also be advised that the definition of "collectible" is evolving and that the IRS has announced that it intends to tax nonfungible tokens as collectibles. Pending release of formal guidance, the IRS will use a look-through analysis to determine whether an NFT should be taxed as a collectible.
Making an impermissible investment or using IRA funds for a "loan" will cause the IRA to lose its tax-favored status entirely. That means the entire account becomes taxable.
Other types of investments can generate problems that aren't related to formal IRA-related prohibitions. For example, clients who wish to invest IRA funds in S corporations should be advised that the investment will cause the S corporation to lose its S-status.
IRAs are permitted to invest in privately held C corporations, LLCs, partnerships and even private equity firms and hedge funds. They can also invest in complex derivatives, options and other financial products that are typically unavailable as traditional IRA investments. However, IRA owners should be advised about self-dealing rules that prohibit them from essentially using the tax-preferred funds to do business with themselves and certain related parties or entities.
