With an explosion in interest in alternative investments, it seemed worthwhile to lay out the actual rules with regard to what you can and cannot do with an IRA. You may discover that many retirement plan providers, whether those plans are 401(k)s or IRAs, have significant additional limitations above and beyond what the IRS actually allows. This is often to reduce their hassle, reduce their costs, and earn them more money. For example, many 401(k)s won’t allow you to make Roth contributions or Mega Backdoor Roth IRA contributions or accept IRA rollovers even though the IRS allows it.
So if you want to invest in something or do something unique with an IRA, your first step should be to see whether your desired action/investment is actually prohibited by the IRS. We’re going to go through two lists today — a list of prohibited investments and a list of prohibited transactions.
Investments Prohibited in an IRA
#1 Life Insurance
You cannot put life insurance in an IRA. You can, however, put it in a 401(k) if the amount is “an incidental amount.” Basically, the premium can’t be more than 50% of the annual employer contribution for a whole life policy or 25% if it is a universal or variable life policy.
Collectibles are also specifically disallowed. This includes art, antiques, furniture, porcelain, alcohol (wine), stamps, baseball cards, comic books, Beanie Babies, and similar investments.
As a general rule, you cannot own physical gold coins in an IRA. There are exceptions to this, though. Basically, the idea is if the coin is very pure in quality and not considered a collector’s coin, you can invest in it. So American Eagle coins are allowed but Krugerrands are not. Basically, the coins need to be currency and not collectibles.
As a general rule, you can’t invest in options or in derivatives either. Technically, only derivatives with unlimited risk are prohibited. So you could still invest in covered calls but not naked call writing.
#5 Personal Real Estate
You can own real estate in an IRA, but you can’t use it. You can’t put your home or vacation home in it. All expenses for the real estate have to come out of the IRA, and all income must go into the IRA. Your IRA can’t buy real estate from you or your family, and it can’t sell it to you or your family either.
Unrelated Business Income Tax
Charities and other tax-exempt entities (like IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs) are subject to Unrelated Business Income Tax (UBIT). If your IRA invests in a business such as a Master Limited Partnership (MLP) or a Limited Partnership (LP), the income from that business will be subject to tax at corporate tax rates (21% as of December 2021), even if the partner is an IRA. Dividends and interest are typically excluded, but the income that shows up on a K-1 usually is not. These investments are generally better held in a taxable account.
So while leveraged equity real estate, small businesses, and energy MLPs are not technically prohibited IRA investments, it’s really not a good idea to have them in your IRA. Do yourself a favor if you really want these investments: put them in a taxable account. You’d avoid this hassle, and you could also take advantage of the depreciation-associated tax breaks that these investments qualify for.
Transactions Prohibited in an IRA
#1 Borrowing from the IRA
Unlike a 401(k), you can’t borrow from an IRA at all. A 401(k) will allow you to borrow the lesser of $50,000 or 50% of the account value. At times, that amount may be temporarily lifted. In 2020, for example, you could borrow $100,000 or 100% of the account value. You can borrow the money for the shorter of five years or until tax day next year. But that’s not an option with an IRA. You can make a withdrawal, but you can’t get a loan.
#2 Borrowing Against an IRA
Unlike cash-value life insurance, your home, or your car, you can’t pledge an IRA as collateral for a loan.
#3 Buying and Selling Personal Property
As mentioned earlier, your IRA cannot buy your property or that of your family members (and family member is pretty widely defined to include spouses of your children and even your great-grandparents). You also can’t sell property to you or your family members.
#4 Renting Property to You
You and your family members cannot use the property owned by the IRA, even if you pay the IRA rent for it. So if you bought an apartment building with IRA money, you could not turn around and hire your child as a live-in manager in the property.
The penalty for any of these prohibited transactions in an IRA is pretty severe. Basically, the next January 1 after you do it, the account stops being an IRA at all. It’s considered 100% distributed to you, and you will owe a 10% penalty on all of it.
The theme here is clear. There are a lot of investments that you can invest in that maybe you shouldn’t, and there are a lot of investments you can put into an IRA that maybe you shouldn’t. But if you know and follow the rules, you shouldn’t get yourself into too much trouble using retirement account money for alternative investments.
This content was originally published here.