Question of the Week: Illiquid IRA Investments

By Jeffery Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott

This week the Ed Slott and Company IRA Discussion Forum featured a question about the illiquid investments in an IRA and how they may affect RMDs. Do you have these types of investments in you IRA? Read on to find out some of the major items you need to be aware of…

One of the major benefits of an IRA (as opposed to most company plans) is that other than a few exceptions (i.e. life insurance, collectibles), you can invest in just about anything. But that doesn’t mean you don’t have to consider the possible side effects on an investment. What do we mean by side effects? Well, just so we are all on the same page, let’s define side effects like this – a side effect of an IRA investment is any impact the investment has on the IRA or administration of the IRA other than its gains or losses in value.

Many of you probably have your IRAs invested in highly liquid items like stocks, bonds, mutual funds and cash. However, not all investments share the same levels of liquidity – and some may not even be liquid at all.

So what are some of the possible side effects of investing in illiquid assets within your IRA? Well, for starters, there’s the obvious danger of needing access to your retirement money but not being able to get to it. But that’s not really a side effect of having an illiquid asset within your IRA – that would be the case even if that same investment was held outside of an IRA as well.

One possible side effect – specifically of an illiquid investment within your IRA is that it may complicate taking your required minimum distributions (RMDs). Although the tax code allows for RMDs to be distributed in kind (i.e. stock moved from IRA to individual brokerage account), some custodians may not make this an easy process. In addition, it’s also possible that your interest in a particular investment may not be able to be divided. In such cases, you may find yourself subject to a 50% penalty on the amount of the RMD that should have been taken.

Another possible side effect of illiquid investments within an IRA can occur after the death of an IRA owner when multiple beneficiaries don’t agree on how to move forward. For example, suppose you plan to leave your IRA to your three children in equal shares. Upon your death, the total value of your IRA is $300,000, but $250,000 is invested in a rental property. Two of your children want to keep the property, but one child wants to sell it and use the money to buy his own new house. Such situations can pit family members against each other in ways the IRA owner never intended.

So does this mean that you should never invest in an illiquid asset within your IRA? Absolutely not. It just means that you have to be aware of these complications when you do. Maybe that means eliminating illiquid assets within your IRA by the time you reach 70 ½. Maybe you only put a portion of your IRA into these types of investments. Or maybe you leave IRA assets to some beneficiaries and other assets to different beneficiaries. These are the types of conversations you should be having with a qualified advisor now to make sure that you and your heirs aren’t hit with any surprises.

Concerned about other possible side effects your IRA investments may expose you to? Check back next Friday to learn about another one!

Got more questions?? Want to see what other people are asking? Check out the Ed Slott and Company IRA Discussion Forum.