How Do I Avoid Taxes With a Self-Directed IRA?
Self-directed IRAs allow investors to invest in non-equity assets outside of the stock market, such as real estate and promissory notes. It is the responsibility of each investor to scout investments carefully and steer clear of prohibited transactions.
Breaking one of the IRS’ rules could cost your entire account in taxes and penalties, including living in property purchased with your IRA or hiring unqualified people to perform work on properties owned by it.
1. Invest in Alternative Assets
Alternative investments have become an increasingly attractive form of retirement investing, offering increased returns with lower volatility and potential tax efficiency. They include private equity, credit, real assets and hedge funds as alternative investments.
Investors can take advantage of this opportunity by working with a custodian that allows self-directed IRA (SDIRA) accounts, as well as consulting an investment advisor specializing in SDIRAs to ensure compliance and avoid prohibited transactions.
An illegal transaction takes place when an IRA, or someone acting on its behalf, deals with an entity with which either your IRA is directly or indirectly related or owns 50%. Other prohibited transactions include buying life insurance on yourself and investing in physical gold.
Along with avoiding illegal transactions, you should also make sure to be mindful of fees related to account management or the asset in which you’re investing – this may include property management costs, storage charges and insurance premiums as well as maintenance expenses.
2. Donate Your RMDs to a Qualified Charitable Organization
Owners who must take required minimum distributions (RMDs) from their IRA can avoid paying tax by making direct donations to charity through qualified charitable distribution (QCD). They can do this by submitting a QCD form directly to an eligible nonprofit.
QCDs are an excellent way for those wanting to avoid taxes while meeting their annual charitable giving goals. IRA owners can make QCDs up to their total RMD amount each year.
However, when applying the QCD rule there are certain considerations to keep in mind. Self-dealing and other illegal transactions must be avoided to maintain its efficacy.
An IRA owner who holds an equity stake of 50% or greater must ensure that proper records are kept for any LLC they hold a 50% or greater stake in; usually this role falls to the LLC manager. Furthermore, this entity must file Form 1065 with the IRS as well as complete Schedule K-1 forms for every IRA owner who owns shares in that LLC.
3. Donate Your RMDs to a Non-Profit Organization
Real estate investments are one of the more popular nontraditional assets that self-directed IRA owners invest in, yet to avoid unrelated business income (UBTI) and unrelated domestic fiduciary income (UDFI), there are certain rules you must abide by to purchase or rent an investment property from an IRS perspective.
Some taxpayers try to lower their tax bills by “bunching” charitable donations in one year in order to take advantage of higher deduction limits on individual tax returns, but doing this could prove costly if you don’t abide by IRA rules regarding prohibited transactions such as real estate purchases and sales.
Additionally, it is critical that you strictly abide by IRA rules on self-dealing and personal gain. This includes not providing services to your IRA investments or using funds within it for personal expenses, such as purchasing an investment property mortgage or fixing toilets – actions known as prohibited transactions which could incur penalties from the IRS.
4. Invest in Real Estate
To minimize fees when investing in alternative assets, the most cost-effective method is to focus on stocks, ETFs and mutual funds as these often offer lower account management and trading fees than real estate does. Real estate can often have fees that erode profits significantly
One major expense you need to be wary of are property maintenance costs, like repair bills, homeowner association dues and insurance premiums. Furthermore, be mindful of taxes; annual income from real estate and alternative assets must be reported as income on your tax return, with potential unrelated business income taxes (UBIT) payments required on portions of profits earned if financed via loans.
SDIRA rules must also be strictly observed, such as those prohibiting dealings with disqualified persons and transactions prohibited by the government. Failure to abide by such regulations could incur an IRS fine and cause you to forgo future tax benefits from your retirement savings account.
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