Truly Self Directed Retirement Plans

Hubert Bromma
January 4, 2008 — 1,825 views  
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Over the history of tax advantaged programs, qualified plans and individual retirement accounts have consistently been at the forefront of opportunities to defer tax. Within this context, self directed investment opportunities have not received the attention that standard IRA and Qualified Plan investments, such as stock, bonds, mutual funds and certificates of deposit, have had. Although non-standard investments in tax deferred accounts are relatively small as a proportion of overall US investments, such investments may be a significant part of anyone’s diversified portfolio. Self direction of plans and IRAs are straightforward as long as the IRS disqualification rules, unrelated business income tax, and other related tax sections are followed. This article provides a brief history of tax deferral in Qualified Plans and IRAs, and investing in non-standard opportunities using real estate as an example.

In 1974 Congress passed the Employee Retirement Income Security Act or ERISA to clarify and provide non abusive circumstances under which pensions could be created. Tax advantages to the employer and employee would become available and regulated with the intent of being fair handed.

Variously known as Keogh and HR-10 plans, these eventually became known as Qualified Plans, which are employer originated tax deferral retirement programs. (These include Defined Benefit, and Defined Contribution Plan. Defined Contribution Plans generally consist of Profit Sharing, with or without a 401(k) deferral option and Money Purchase Pension Plan).

In addition, Individual Retirement Arrangements, or IRAs, which are generally individually originated programs, were also included in this legislation. Employer contributions to IRAs could also be made following specific rules. Contributions to Qualified Plans could be made by employers to employee participants, and employees could, under specific adoption of tax code provisions, (401(k)), defer funds from their pay to their plan account. Individuals could also always make contributions to their Individual Retirement Accounts provided they had earned income.

From the day the ERISA became effective, January 1, 1975, all Qualified Plans and IRA contributions and deferrals could be invested in anything permitted by law. This included any asset anyone could sell or buy in the market place. The limits were and are covered by IRC Sections regarding Prohibited Transactions, and Unrelated Business Income Tax and Unrelated Debt Financed Income Tax.

Because of the abuse by the sellers of certain investments, Congress passed legislation effective on January 1, 1981 prohibiting such investments specifically gems, stamps, coin collections, works of art, antiques. In addition, that legislation also permitted the deductibility of IRA contributions. Significantly, all other investment opportunities were not excluded.

The other investment opportunities which became increasingly interesting to qualified Plan and IRAs included Real Estate, Notes, Options on Real estate, Private Placements, Investment partnerships, and Operating Businesses, just to mention a few.

Land, single family, multi family and commercial properties found their way into many portfolios, and the values of Plans and IRAs rose in direct proportion to property values. In some states, investments of $10,000 have returned routinely $100,000 in two years. Properties being rehabilitated offer 30% returns to the savvy investor. On some occasions, options on real estate can turn a tidy profit with a very small investment. Cash flow provides many retires tax-free income in Roth IRAs.

Plan participants and IRA owners discovered that leverage was a way to increase the income potential of the land or other property. Leveraged, or debt financed property, was subject to Unrelated Business Income Tax (UBIT) rules, as was operating income generated by assets. Significantly, acquisition debt for real estate in qualified plans is not subject to unrelated business or debt financed income tax. IRA acquisition debt for real estate was not given such generous treatment. In addition, tax payments for the debt financed income needs to be paid by the plan or IRA.

Depreciation expense, interest expense and certain maintenance expenses are allowed as deductions on the Form 990-T, Exempt Organization Business Income Tax Return for the affected debt financed asset or operating income asset. The implications of UBIT are consideration in making the investment decisions. Often the results are positive.

Debt financing requires the services of lenders willing to lend to an IRA or plan. Non-recourse loans are the only loans permitted for plan or IRA assets. This also precludes the beneficial owner to use their credit or sign on the loan. Any extension by an IRA owner or participant of a plan to their IRA or plan is specifically prohibited. There are a number of non-recourse lenders but some diligence is necessary to find such lenders.

Many individuals elected to partner with their plans and or IRAs, themselves and others, as undivided interests in real or other property. A growing number have established Limited Partnerships, C Corporations and Limited Liability Corporations. Each method has its advantages depending on the situation.

Steps to self direction are straightforward:

    1. Locate a plan sponsor or IRA provider which offers completely flexible investment options in their plan and trust document.
    2. Adopt that plan.
    3. Rollover from any existing IRAs or past qualified plans to the new self directed plan.
    4. Determine the appropriate diversification you desire and direct the trustee or custodian to make the asset purchases on behalf of the plan or IRA.
    5. Income and expense are treated on a prorated basis of ownership of the assets and recorded accordingly.
    6. Distributions must be made beginning age 70 ½ for all plans other than Roth IRAs. Distributions may also be made in kind.

In 2005, Congress expects the flexibility of plans and individual accounts will be expanded that contribution levels will increase and tax payments on new plans will be more advantageous. This will allow self direction to expand to include additional plan types and generate more savings and investments. Truly self-directed plans are slowly generating more interest, especially among high income, high net worth individuals and small business owners.

True Self-Direction of IRAs and plan assets is a method to increase diversification and grow retirement income. Following the rules is straightforward and with proper assistance from tax professionals, like you, sponsors, and Plan/IRA providers, the benefits can be enormous.

Hubert Bromma, CEO of Entrust Administration, the oldest administrator of truly self-directed retirement arrangements catered to individuals who wish to acquire real estate and other non-traditional investments in their IRA/401 (k). For more information, or to find an office near you, visit on contact Entrust at 888-340-8977.

Hubert Bromma

Entrust Bank & Trust