The investment options for owners of individual retirement accounts (IRAs) sometimes seem limitless. The key to a rational investment choice, however, is to consider not only different investment classes and each investment's likely long-term performance, but also IRS rulings regarding buying and holding a certain investment as an asset in your IRA.
DOL, IRS and IRA Management
The U.S. Department of Labor (DOL) is the principal authority that determines which investments are allowable for an IRA, but its interest in IRAs is minimal. In most instances, the DOL does not classify an IRA as a pension plan so it's not covered by Title I of ERISA. The DOL does, however, serve as the principal authority for prohibited transaction issues (and exemptions) involving IRAs under IRC section 4975(e).
ERISA and IRA Asset Guidelines
ERISA sections 404 and 406-408 establish the concept of asset guidelines as they apply to qualified plans, but there are no asset diversification guidelines for IRAs similar to ERISA section 407 instructions for qualified pension plans. Consequently, government agencies and the U.S. courts system must provide guidance.
IRS IRA Asset Guidelines
The Internal Revenue Service (IRS) offers little, if any, guidance regarding holding one IRA investment, rather than another. Instead, the agency's focus is the rules and regulations related to deduction limits and minimum distributions.
IRC sections 219, 408 and 4975 are the laws that affect IRA investments. Those laws and their historic application offer investors some leeway in electing one investment, rather than another, based on what's absent in those laws. So the topic of permissible IRA investments is subject to interpretation as is the scope of permissible IRA investments.
IRA Investment Restrictions
Like other IRS restrictions, those related to IRA investments are straightforward. For instance, the agency frowns on collectibles – IRC Section 408(m) – and looks disapprovingly toward "self-dealing" with your IRA funds – IRC Section 408(e) – and life insurance.
One fact that influences many IRS perceptions and resulting restrictions is that liquid assets are essential to a retiree's ability to live a long and fulfilled life. If the majority of the retiree's cash is tied up in illiquid assets, such as real estate or collectibles, she may lack cash when she needs it for a health emergency or some other life event.
Allowable IRA Investments
The regulations pertaining to collectibles and private equity as investments are less clear than those related to securities and mutual funds. The same is true of the related enforcement procedures surrounding some investments. This situation offers some flexibility for IRA owners, particularly those interested in private equity investments.
Read More: Is An IRA a Liquid Asset?
When you invest in private equity, you commit some or all of your IRA capital to a company or small business. For entities that seek cash, gaining access to funds held in a self-directed IRA is a simple and quick process relative to getting a loan from a bank. In turn, as a self-directed IRA owner, you might receive a higher return from this investment than that from a stock, bond or CD.
The IRS says you can diversify your retirement portfolio by making private loans to a limited liability company, a C corporation, private stock and partnerships as well as private placement memorandums. Be aware, however, that some investments, such as a master limited partnership (MLP), can generate tax liabilities for an otherwise tax-deferred account.
To best understand private equity investment with IRA funds and their potential tax consequences, ask your CPA to review the past IRS letter rulings, DOL ERISA opinion letters and prohibited transaction exemptions to identify trends that you should consider before committing your funds to a certain investment. Alternatively, you can answer some of your questions related to allowable IRA investments by searching the DOL and IRS websites. Also, if you can wait three to six months for an answer, it's possible to get an IRS letter ruling beforehand.
- The Entrust Group: Investing in Private Equity with a Self-Directed IRA
- The Tax Adviser: Alert for IRAs Holding Master Limited Partnerships
- TaxAudit.com: Is income from a Limited Partnership held in an IRA taxable?
- U.S. Department of Labor: History of EBSA and ERISA
- Cornell.edu: 29 U.S. Code § 1104.Fiduciary duties
- Cornell.edu: 29 CFR § 2550.407a-1 - General rule for the acquisition and holding of employer securities and employer real property.
- Findlaw.com: 26 U.S.C. § 219 - U.S. Code - Unannotated Title 26. Internal Revenue Code § 219. Retirement savings
- Info.gov: USC Code 2011 Title 26
- Cornell.edu: 26 U.S. Code § 4975 - Tax on prohibited transactions
- IRS: Issue Snapshot - Investments in Collectibles in Individually-Directed Qualified Plan Accounts
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.