A self-directed IRA is one of the few retirement vehicles that truly put you in the driver’s seat, but you still need to follow the rules of the road. Like other retirement plans, self-directed IRAs have rules and regulations that you must follow if you want to avoid penalties. Understanding these self-directed IRA tax rules can help you make the most of your account and grow wealth without the fear of penalty.

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Choosing a Self-Directed IRA Tax Structure

Like standard IRAs, self-directed IRAs (SDIRAs) can be structured in one of two ways: Roth or traditional. Before you choose, keep these things in mind.

Roth IRA

Pros

  • Roth SDIRAs are funded with after-tax dollars and qualified distributions are tax-free, making them ideal if you think you’ll be in a higher tax bracket at retirement.
  • You can withdraw from Roth IRA contributions without penalty at any time, as long as your account is 5 years or older (and age 59 ½ or older).
  • Roth IRA holders do not need to take required minimum distributions (RMDs), meaning you can leave funds in your account to grow as long as you feel is necessary.

Cons

When you invest in tax liens, earnings come from the interest applied to the lien

Traditional IRA

Pros

  • Contributions are made with pre-tax dollars, with taxes applied upon distribution.
  • Traditional IRAs are only subject to standard contribution rules and may be a better fit if your tax-filing status or income limits exceed contributions under a Roth structure.

Cons

  • Taxes are deducted at the time of distribution, unlike a Roth (There is no minimum withholding out of a Traditional IRA at the time of distribution. Withholding can be elected but not required. The full amount, withholding or not, is taxable, though).
  • RMDs are required starting at the age of 73.
  • Withdrawals are typically penalized before the age of 59 ½, though there are some exceptions, such as to purchase your first home.

Once you choose a self-directed IRA tax structure, you will need to be aware of a few reporting requirements around tax time.

Self-Directed IRA Reporting Requirements

Form 5498

If you open an IRA, you’ll likely receive Form 5498 in the mail each year you contribute. This form is good to keep for your records, but this is one IRS form you don’t have to worry about filling out. Your custodian or the entity that manages your account must file Form 5498 with the IRS to report all contributions you made in that year.

FMV of Account

The value of some assets, like stocks and bonds and precious metals are easy to track, but that’s not the case for some of the alternative assets commonly held in an SDIRA. As such, SDIRA custodians require account holders to send an update on the fair market value (FMV) of their assets. The FMV of an asset is based on how much an informed buyer would pay for an asset at the time.

Your custodian will likely ask you to submit an FMV update if you hold the following assets in your portfolio:

  • Real estate
  • LLCs
  • Private placements
  • Promissory notes

UDFI

Unrelated Debt-Financed Income, or UDFI, comes into play if you finance the purchase of an asset. As such, this is most commonly associated with SDIRAs that hold real estate.

For instance, if you want to invest in a property but don’t have enough money in your IRA account, you can finance a portion of the purchase using a non-recourse loan. If you earn income off that property, you’ll be required to pay taxes based on the portion of the property that was financed.

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5 Tips to Maximize Your Self-Directed IRA Tax Benefits

1. Open a Roth SDIRA

In many cases, a Roth SDIRA is an ideal option because withdrawals are tax-free, and the structure is often more advantageous for popular SDIRA assets, such as real estate.

However, before you open an SDIRA, review the additional contribution limits to ensure that you’ll be able to make regular contributions over the years. If you’re unsure, consult with a financial expert. They can help you determine if a Roth is really the best option for your situation.

2. Rollover All Existing Retirement Accounts

Dormant funds sitting in old 401(k)s, IRAs, or other retirement plans can be put to work in an SDIRA. If you have other retirement accounts, consider rolling them into your new SDIRA. Doing so will make it easier to diversify your portfolio by investing in assets that have higher earning potential.

3. Maximize Your Contributions

The 2024 IRA contribution limit is $7,000 (up $6,500 from 2023), and if you’re 50 or older, you can make an additional “catch-up” contribution of $1,000, bringing the annual contribution limit to $8,000. Maximizing your contribution will not only lead to higher earnings over the years but will expand your investment options as your account balance grows.

4. Avoid Prohibited Transactions and Early Withdrawals

Prohibited transactions are those forbidden by the IRS and will result in penalties–often a 10% tax. There are two types of prohibited transactions to keep in mind when investing with an SDIRA:

  • Engaging in a transaction with a disqualified person, such as yourself, a spouse, descendent, ascendent, or your account fiduciary. For instance, you can’t use your construction business to complete work on a property held in your IRA or rent out a residential property to your son.
  • Purchasing prohibited assets. The IRS specifies several assets that can’t be held in an SDIRA. This includes life insurance, alcohol, and collectibles (e.g., stamps, art, and gems).

5. Taking Your RMD (Traditional IRA)

If you have a traditional IRA, you have to start taking a required minimum distribution (RMD). An RMD is the minimum amount of money you must withdraw from your account. RMDs must be taken by April 1 following the year you turn 73, though it was 72 prior to the passage of the SECURE 2.0 Act.

RMD amounts are determined by the value of your traditional IRA and a life expectancy factor determined by the IRS.

Understanding self-directed IRA tax rules will help you make wiser investment decisions and avoid costly penalties that deprive you of your valuable retirement funds.

FAQs

Do SDIRAs require an EIN?

In general, you do not need an EIN to open an SDIRA, but a SSN will be required. However, if you intend to invest in an LLC or gain checkbook control through an SDIRA LLC, then you will need to apply for an EIN.

Are there exceptions to early withdrawal penalties?

Yes, there are exceptions to early withdrawal penalties. The exceptions include:

  • Birth or adoption of a child.
  • Death of the account owner.
  • Recovery from a federally declared disaster.
  • Qualifying higher education expenses.
  • Qualified first-time home purchases.
  • Unreimbursed medical expenses.
  • Rollovers

For a full list of early withdrawal exceptions and qualifications, see the most current IRS guidance.

What expenses related to SDIRAs are tax-deductible?

If you have a traditional SDIRA, you may be able to take a tax deduction under the following circumstances:

  • You (and a spouse, if applicable) are not enrolled in a retirement account with your employer.
  • You (and a spouse, if applicable) are enrolled in a workplace retirement account but fall below the income limits set by the IRS. In this case, you may be able to fully or partially deduct contributions. For instance, if you are single or head of household and make less than $73,000, you can fully deduct your contribution, but if you make more than $73,000 but less than $83,000 annually, you can make a partial contribution. If you have a Roth IRA, contributions are never tax-deductible.