How NOT to Invest in an Alternative Investment in Your IRA

By Beverly DeVeny, IRA Technical Expert
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There are very few things an IRA cannot invest in. Those are collectibles, life insurance and S Corp stock. An IRA can invest in just about anything else. The key word here is that the IRA can invest in an asset. Here is the story of an investment gone wrong.

The IRA owner wanted to invest his IRA funds in a note, the debt of an unrelated party. You cannot borrow from or loan to your own IRA. You cannot make loans from your IRA to certain family members or individuals who act in a fiduciary capacity for your IRA. These transactions would be considered prohibited transactions. Engaging in a prohibited transaction with your IRA may result in the entire IRA being deemed distributed and taxable. This IRA owner was not going to fall into that of a trap.

His IRA custodian told him they did not want to hold a note as an asset. Not all custodians will accept alternative investments in an IRA. He needed a self-directed IRA. So, he took distributions from two of his IRAs and threw in $100,000 of his own money and closed on the note. There are supposed to be two notes, one for his IRA funds and one for his personal funds but he ends up with only one note. That note is titled in the name of his IRA. Now he goes to his financial advisor. Now it is too late.

What are his problems?

  1. You should not mix personal and retirement funds although, if it is done correctly, it could work.
  2. Titling an asset in the name of your IRA does not make it an IRA asset. Only an IRA custodian can hold an IRA asset.
  3. He cannot move the note into an IRA. When you take a distribution of cash from an IRA it can only be replaced with cash. You must rollover what you took out
  4. Because of the IRA one-rollover-per-year rule, he can only rollover one of his distributions.

What he currently has is a taxable distribution for the two withdrawals. If he is under age 59 ½, he could also owe the 10% early distribution penalty. He holds the note as a personal asset, not as an IRA asset.

How can he fix this?

If he can raise enough cash within 60 days of his receipt of the IRA distributions, he can do a 60-day rollover of all or part of the larger distribution. Any cash over and above the amount of the larger distribution can be converted to a Roth IRA. Yes, that is a taxable event but he was going to have to pay tax on it anyway. Remember, he can only rollover one of his distributions. Now for the genius part, the Roth conversion can be recharacterized. The funds get moved back to an IRA. Both the Roth conversion and the recharacterization do not count in the IRA one-rollover-per-year rule.

How should he have made this investment?

If the custodian of his IRA would not allow the note as an investment, he should have transferred his funds to a new IRA custodian who would allow the IRA to hold the note as an investment. He should have directed his new IRA custodian to disburse the funds directly to the “seller” and a note should have been issued to the IRA custodian listing the IRA as the note holder. This is the same procedure as when you invest in a stock, bond or mutual fund. The IRA custodian uses your IRA funds to purchase the shares of the investment in the name of your IRA. It is the only way to get an investment into your IRA.

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