5 Self-Directed IRA Mistakes to Avoid

I'm sure many of you have heard that you can invest your IRA in a lot more than just stock, ETFs, and mutual funds on Wall Street. Your IRA, even Roth IRA or 401, can invest in real estate, your best friend's small business, or loan money to local real estate flippers, invest in a syndication, all sorts of investments. The list goes on and on. However, one bad self-directed IRA mistake can blow up years of tax-free or tax-deferred growth. And I'm not talking about a little paperwork problem. I'm talking about a mistake that could disqualify the IRA, create a taxable event, trigger penalties and turn what you thought was a wealth-building strategy into a very expensive lesson. So why do we have to know these rules? Why do we want to self-direct our IRA in the first place? Because we can make a lot more money than an ETF or a mutual fund. That's why. So what do we do? Well, we learn the pitfalls and mistakes that could happen, and then we go out and make some freaking money. My name is Mark J. Kohler, CPA, attorney, author, small business advocate, IRA investor. And in this video, I'm going to break down 5 most common self-directed IRA mistakes you need to avoid. And by doing so, we're going to unlock your IRA's wealth-building potential. Let's break it down. Mistake number 1: Committing to a deal before the IRA is ready. This first mistake is essentially putting the cart before the horse. Let's say you find a great real estate deal. You find a private placement or syndication. You find someone that needs a loan, a note, a startup or some other alternative investment, and you get excited. You sign documents personally, you wire earnest money, you shake hands, you may even sign some important documents, and you tell the seller, "Don't worry, I'm going to move my IRA money over later because my IRA is really going to do the investment." Well, as soon as those words come out of your mouth, we know we now have a problem. The IRA is the one doing the deal. So you have to, right out of the gate, find the deal, source it, but you cannot sign any documents or start closing the deal in any way, shape, or form without allowing your IRA to be the investor. Now, before we go any further too, I want to step back and clarify something. When we're talking about an IRA, I'm talking about a Roth, a traditional IRA, a 401, a Roth 401, even a health savings account or a Coverdell. Any of those tax-preferred vehicles can be self-directed. From now on, when I say IRA, just know it could be any of those structures. So back to this deal that you're going to be looking for. Make sure that right from the beginning, you're just representing, you're self-directing what your IRA is going to do. The letter of intent, the contract, the subscription agreement should never be in your name. The LLC, the closing documents, the loan documents should never be in your name. All of the investment documents should be in the name of your IRA. How did they get to be in your IRA? The process starts a lot earlier than even you looking for a deal. You're going to roll your old 401 or your old IRA money to a self-directed IRA custodian or trust company. Like Directed IRA, the company I've been working with for years. You're going to move your money over there, open a new IRA account that can be self-directed. See, all these investments, if you just called Fidelity or Schwab and said, hey, I want to loan my brother-in-law some money for his business, they go, you can't do that. Well, the reality is you can. It's just they can't do it. So you've got to move your money with no penalty or taxes from a broker-dealer like a Fidelity or a Merrill Lynch to a company like Directed IRA, where on day 2 we call you up and go, hey, we got your money here. What do you want to invest in? So you may do direct investments out of the IRA. You might form an LLC. Oh, there's so much. The point is, as you get the IRA prepared to invest and you're looking for deals at the same time, which you should be doing, just don't sign anything until the IRA is structured properly and ready to do the investment. Now, for example, what might those documents look like? Instead of it saying Mark Kohler personally or my trust or my LLC is doing the deal, it may say something like, Directed Trust Company, FBO, for and behalf of Mark Kohler's IRA, account number 12345. Once you have that IRA account number set up on all of the documents, if you're investing directly out of your IRA and not an LLC owned by your IRA, a whole other topic, the document would say Directed Trust Company, FBO, Mark Kohler's IRA, account number blah, blah, blah. That means the IRA is the investor. The partner, the member, the lender, any of those terms. It's just not you personally. The distinction matters because your IRA is a separate legal tax bucket. Your IRA is the one that is doing this investment rather than buying stock or a mutual fund or an ETF or bond in Wall Street. So you may have been investing your IRA for years, so day trading it away, doing different things with Wall Street products. Well, now your IRA can do other investments. And once you catch that vision and understand all those investments that are available to you, you've just got to make sure the timing is right when you come out of the gate. This is not your personal investment account. It's your IRA. And if you personally sign the deal first and then try to move it to the IRA, you may have already created what's called a prohibited transaction, and then it starts to get messy and that could be devastating. So the better approach is simple. Just set up the right account first, move the money over, fund the account, give yourself some time while you're looking for deals, have the account ready to go. Before you commit to the investment and then do the documentation correctly. So let's move on to number 2, buying or selling assets out of your IRA with yourself or a disqualified person. Now, this is probably one of the biggest misunderstandings in the self-directed IRA world. People hear my IRA can invest in real estate. Well, that's great. I'll have my IRA go buy a rental property that I've got a big built-in gain in it. And in fact, it's even a Roth IRA. Oh, that's great. My Roth IRA can buy this property that I've owned for a long time. From me at a deal and then I'll sell it and there won't be any gain because it'll all be in my Roth IRA. Well, the concept is great. I want you to buy real estate, sell it for a profit, pay no tax in your Roth IRA, but you cannot buy something you already own, a personal asset of yours, and sell it to your IRA. Can't do that. You can't buy or sell or trade back and forth with your own assets with your IRA. Your IRA is only allowed to buy new investments. So you see a new real estate deal, instead of you doing it, You let your IRA do the deal. You could still get an incredible rate of return. Don't get greedy and frustrated and be like, well, if I can't sell my real estate that's got this huge gain into my IRA, it's not worth it. Okay, knock yourself out. Go keep investing in that mutual fund and make 8%. You don't want to do that. Keep your eye out for real estate. If real estate's your gig, it may be crypto, it might be syndications, it might be loaning money to transactions to a real estate investor. Any of those things, your IRA is allowed to do new deals. It just can't transact with you personally. Now, that brings up other disqualified persons. It's not just you, it's these other people. Those are going to be generally your family members, your spouse, your parents, your spouse's parents, your grandparents, your children, your grandchildren. And so anything kind of up and down. Now, brothers and sisters are going to be fine, but it's anything going lineal up or down and any companies they may own. So you may say, well, I'll, I'll just have my IRA buy it from my company Well, that counts too. If you own 50% or more of a company, it's really like dealing with you. So that company would be disqualified, including your spouse's company, your parents, grandparents, or your kids or grandkids. Now you may say, what the heck, this sucks. Why? What's the big deal? What's the problem? Well, the IRS kind of knows that if you're going to be doing a deal that could be incredibly beneficial for your IRA or Roth and screw over the IRS and you're doing that deal with your family, who do you think is going to get the short end of the stick? You're going to stick it to the IRS, right? Right? Well, the IRS kind of knew that. What they're doing is they're using a third party as the watchdog. For example, let's say your dad owns a property that's worth $250 grand. He's doing okay and he wants to give you a deal. So he'll sell it to your Roth for $200 grand. So right away you've got this gain that just got moved to your Roth IRA and you could sell it tomorrow and not pay any tax on that. Well, it's your dad. Of course he's going to give you a deal. And so the IRS is like, Well, would your dad give anybody that deal? Because if he will, I'm that third party. I'll buy it for $250,000. Oh, well, no, I won't give it to you, Mark, for $250,000, but I'll give it to my son's IRA for $250,000. And see, that's the watchdog effect. They want third-party deals to kind of control the scenario because we're not going to give some stranger on the street the same deal we give a family member. So that's why family members are disqualified. The moral of the story and the rule is, is that if you're going to do deals, which you will inside your Roth IRA, for example, you're going to have to do those deals with arm's length third parties. Buy new property, invest in new deals, do new loans, and still make an incredible rate of return. Just don't do deals with those family members and certainly not yourself. That would be a disqualified transaction. And if you do a disqualified transaction, the whole IRA again can be penalized in a way of making it immediately distributable. Taxable penalties, it's not pretty. So we don't want to do those types of transactions. And once you do them, you can't really unwind them. So let's try to stay away from any deal that your IRA would get the best end of the deal in doing a transaction with you or your family members. That's that second mistake we want to avoid. Mistake number 3, personally using or benefiting from your IRA-owned assets. So let's say your IRA invests in a short-term rental. And you put it out there on Airbnb and rent it to third parties. Well, you think, well, I'm going to go stay there. I'll pay rent like anyone else, but I'm going to stay in that property, maybe even fix it a little or just kind of check on it. Can't do that. You cannot vacation in your rental property owned by your IRA, even if you pay fair market value rent. It's not allowed. Let's say your IRA owns a piece of land. Well, you cannot go park your RV on it and go enjoy that land because it's your IRA's asset. It's not your asset. And then let's say your IRA invests in a private company, your best friend's company down the street. Well, you cannot own 50% or more of that company because it's going to benefit you. This is called the personal benefit trap. And this is where a lot of people say, Mark, come on, it's my IRA, it's my money. I get it. But for tax purposes, it's not your money right now. It's your retirement money sitting inside a tax-advantaged account for the future. That means the benefit has to stay inside the IRA until you hit that retirement age. Using the property is like taking money out of your IRA. You're not allowed to take money out of your IRA until that 59 and a half mark. Now, for some of you that are younger, I want to digress for a minute too. Some of you may say, well, Mark, this is why I hate IRAs, because I can't have access to the money right now. Yes, and that's a good thing. Because so many people— you don't know how many people I meet that are in their 50s, 60s, 70s that are scared to death with no retirement at all. When you're in your 20s, 30s, and 40s, that's when we want to be socking this money away and we want it to be tough to get it out. We want a penalty if we pull it out because we need to let it grow. We need to let it snowball and eventually be worth, frankly, worth millions. We have clients, hundreds of clients with $10, $20, or $30 million IRAs. You can do it faster than you realize. So you're not allowed to use that money while it's growing or have the benefit of that asset while it's in the IRA. Let's do another example. Let's say you are into real estate. Real estate is just a simple way to look at it. And you're going to buy this rental property by a college so your kid can go live in it and save you the cost of paying money to a university dorm room that just goes down the toilet. Really good strategy. I love it when parents buy rental properties where their kids are going to college all the time. Do it, buy it in your own name. Let your kids stay there and live there while they go to college. But your IRA cannot do that. Same rule of disqualified parties. You can't have the benefit of your IRA's assets. And same with your parents and grandparents and children and grandchildren. That lineal list of all those disqualified parties, they can't use the assets of the IRA either. If you were to buy that college rental with your IRA, your kids couldn't stay there and benefit from it. Now there's a flip side to that too. The sword cuts both ways. Not only can you not use the asset while it's in the IRA, you cannot go personally and work on it. You can't go paint the house, install new cabinets, put on a new roof, fix the landscaping. Why? It's almost like you're contributing to the IRA with services, which would be equivalent to a dollar amount. So you remember you can only put so much money into your IRA every year. This year, $7,500. That means you can't put services in either, making your IRA more valuable by running over there on the weekend and putting in a new sprinkler system. Not allowed. Using the asset or providing services to make the asset better is also not allowed. Now, all of a sudden I feel like I'm just saying all the bad things you can't do and not telling you how awesome the self-directing strategy is. And so I'm going to say that right now. Let's say you go do buy a rental property. And why would you do that? It's because you're going to get equity growth. That property, that rental property by the college, is going to go up in value. Your LLC that owns it is going to get cash flow. And even if that LLC is owned by your IRA, there's going to be cash flow. There's going to be equity growth. The tenant is going to pay the rent, which pays down the mortgage. So the property is going up in value and the mortgage is going down. That's a benefit. And then when you go to sell it, there's no taxes. Your rate of return on that rental property could be 20% or more, which is 3 times what you're going to get in a mutual fund. There is so much opportunity for your IRA to invest in cryptocurrency, lend monies, invest in small business, do this real estate stuff and get such a great rate of return. But you can't get greedy. You got to follow a few of these rules. So what's the solution? You hire a property manager, you pay a property manager, you pay a handyman. You can still be the manager of the LLC. You can still make the decisions. You just can't put on a tool belt and go work on it and go do all that manual labor. Don't step in personally and start treating it like your own property and you'll be fine. That's the rule. And so let's keep in mind, bottom line, a self-directed IRA gives you so much more investment control, so much more investment opportunity, but it doesn't give you permission to blur the line between personal assets and retirement assets. That line matters. Okay. Mistake number 4: paying IRA expenses with personal money or taking IRA income personally. This rental property example seems to be working well, so let's stick with that. Your IRA buys that same rental property and lo and behold, there is a roof problem and there's a leak in the roof and you've got to go fix it yourself, which you can't do, or pay someone to go fix it, which is allowed. So you pay this roofing guy to go over there and patch it up and fix it, and you're about ready to write the check for this. Can you write the check for that? No. Essentially what you're doing is adding value again to your IRA. You paid for it personally. You've got to let the IRA pay for it. The IRA will start an LLC. You'll fund the LLC and buy the property. The rent will go in the LLC and the expenses will come out of the LLC. So you can write that check out of that LLC and it'll be easy for your LLC to manage the property and pay for the roofer. But you cannot pay for that repair personally. And that's this rule number 4. Let the IRA pay for its own expenses. And when the income comes in, the income has to go to the IRA. So you go over to the tenant and you're there on the weekend and stop in to just look at it. And the tenant comes running out and said, hey, here's this month's rent. Here you go. I wanted to pay early. You're like, uh-uh, I can't. No, you wouldn't do that and freak out your tenant. But what you need to be thinking inside is I can't take that check because it's not my property. Did you hear that? It's not your property. It's your IRA's property. So the IRA has to collect that rent and put it into the trust account, a directed IRA trust company, or have that cool LLC owned by your IRA. And that's where the rent goes. So money goes to the IRA, expenses come out of the IRA. Now, another example with this problem is let's say you're doing cryptocurrency. And you get into crypto, you're buying Bitcoin, and you start to learn about other tokens, and you're gonna maybe even start crypto mining. So you're gonna buy a couple CPUs and get some video cards. And by the way, I have 2 or 3 crypto mines. I think they're kind of cool. And you're gonna buy this equipment and start mining cryptocurrency, or mining to earn cryptocurrency. That's really what happens. And so your IRA forms an LLC and goes and buys all of this equipment so that your IRA can start crypto mining. Well, who's going to pay for the power bill? Who's going to pay for some of the maybe computer guy expenses to come over and rehook it up when there's a problem with the video card? And I've had to pay a guy to do that. You can't do it, nor can you pay for it out of your personal account. That crypto mine is owned by your IRA through an IRA LLC. So all of those Those expenses need to come out of the IRA and all the crypto needs to go into that IRA LLC. Now, for those of you that know crypto, that means the wallets would be dedicated to that LLC. Your wallets would be owned by the LLC. So an important point here you can already surmise is that you've got to have enough liquidity when you do this deal that your IRA's got a little cushion. When we have clients that use their IRA to go buy real estate or do crypto mining or whatever, If the investment costs $100 grand, we want to maybe make sure we have $120 grand there. We have a cushion to pay for expenses and deal with any unforeseen circumstances. Whether you're using an IRA LLC or just investing directly out of your IRA account, make sure you have a little cushion there to deal with the unforeseen circumstances. Bottom line, a self-directed IRA is not just about buying the asset, it's about operating the asset correctly after you purchase it. And that brings us to the final mistake. Mistake number 5, thinking checkbook control means no rules. Now, what does that checkbook control concept mean? If you're watching this video, you've probably heard of the checkbook IRA or IRA LLC that I've been referring to here. Now, I think the IRA LLC is super powerful. The IRA is going to form an LLC. You're going to be the manager of the LLC. You're going to help the IRA create this LLC. So when you call the law firm, you're like, hey, I got this IRA account, I've opened it up, but over at Directed, I rolled over my old 401, I've got a couple hundred grand in there and I really want to double down. I'm going to go do some crypto deals and some lending or some real estate deals. I'm so excited. You're shopping for deals. So you're being careful with rule number 1 and you're not going to go sign anything until everything's ready to go. But you want this process to be easy when you find that deal. You don't want to have to call Directed IRA, okay, send the money over, let's wire it. Oh, ACH this or whatever, which is fine. A lot of people do that, but some people want to be able to move quick. They see that deal and they're like, let's go. So what the IRA does is have that LLC. You're going to help the IRA open an LLC, put the $200 grand in that example into the LLC. The LLC will have its own bank account. You'll be the manager of that LLC and the signer on that bank account. Totally allowed. Now we know you can't go work on the rental property or fix the crypto mine or things like that. Remember, we already talked about use and contribution of services, but the IRS is okay with you being the manager of the LLC. Now you can move quickly on deals. You see that opportunity come up and you're like, send over the paperwork, blah, blah, blah, LLC. I'm the manager. I'll send over the money. Done. And you can really start cutting deals. We have a lot of clients that do transactional lending that they need to be able to move quick. And so you don't have to call the trust company or custodian with every little transaction. This could be a great strategy. I have a couple IRA LLCs with my wife and we have one with our kids and we're all kind of investing together. It's pretty cool. Well, people call this checkbook control because you have the checkbook for the LLC. Well, this doesn't mean you have free rein or rule-free control where you can just do whatever you want. And there's some people we meet sometimes that are like, Well, I'll just form an LLC so I can get around the rules. No, no, the LLC does not help you get around any of the first 4 pitfalls I talked about. All the same rules apply. The prohibited transaction rules apply. The disqualified person rules apply. The personal benefit rules still apply. And you've got to keep good recordkeeping still. The LLC is not a magic wrapper that makes bad transactions good. It's there to make make transactions more smooth. The IRA LLC gives you a steering wheel, but you still have to stay on the road. You still have speed limits, but you can drive that car yourself. And you're still going to see signs like stop signs and yield signs or whatever. And if you drive off the cliff or off the road, the LLC is not going to save you. But the beauty of this is you are in control. You're driving the car. You haven't give control of the car to some sort of investment advisor in Wall Street, which is not a bad thing either. You might want to have two cars on the road. Your investment advisor is driving one car, you're driving the other one. That's why the IRA LLC is so powerful, because you have all of that control. But of course, it comes with a rulebook, just like a driver's license and all of the rules that come with being on the regular freeway. This LLC is not the same as forming a regular LLC for a side hustle or a small business. It has to be structured properly. There's rules in the operating agreement. That has all the right retirement language. That's why our law firm sets them up for clients very affordably every day so that you can go to the custodian or trust company with the proper LLC. They're not just going to allow you to put that money that very much regulated by the IRS in any old LLC. Because if you roll that money over from Merrill Lynch, Fidelity, Schwab, whatever, into a trust company and say, hey, put that money in this LLC, they're going to go, send us a copy of the LLC. Let's make sure it's got all the right rules. So it's not something you'll knock out on LegalZoom, but once it's set up properly, you're going to set up that bank account that needs to be handled correctly. And you as the manager needs to understand what you can and cannot do. You'll learn how to document the investments. And like I talked about earlier, that LLC will be the name on a loan document or a promissory note if you're going to loan money, or it'll be on title if you're going to buy real estate. Or it's going to be the owner of that crypto wallet. All of these different things can be accomplished with the LLC, just faster and more efficiently. That's why they're pretty cool. So let's recap. Mistake number 1, committing to a deal personally on the documentation before the IRA is ready. Mistake number 2, buying or selling assets with your IRA and yourself or another disqualified person. Mistake number 3, personally using or benefiting from your IRA-owned assets. Mistake number 4: mixing personal money with IRA income or expenses. And mistake number 5: thinking that checkbook control means there's no rules. But again, I want to remind you, knowing these 5 rules, which are really 95% of what you need to know when it comes to the guidelines, unlocks the self-directed IRA as one of the most powerful investment tools you'll ever have in building your wealth. And especially if you want to invest in assets you already understand. There's so many stocks, bonds, mutual funds, and ETFs that I don't understand, but I understand real estate. I understand private deals, notes, funds, alternative investments, oil and gas. I mean, they're just, the list goes on and on. So if you understand a certain type of investment and you're making a lot of money doing it yourself anyway, let your IRA do the deal. This isn't about being scared of self-directing. It's about being prepared. And when you understand the rules, you can move forward with confidence. And when you ignore the rules, you can turn a great investment into a costly tax problem. Now, if you want to get help setting up your self-directed IRA and making sure you're investing the right way, there's a link in the description below where you can book a free call with one of my team members at Directed IRA. We help investors navigate the rules every day Avoid the mistakes and get your new account form right away so you can get off to the races with these new investments. And if you found this helpful, hit the like button, subscribe, and turn on notifications so you don't miss future videos on building wealth, saving taxes, and protecting your financial future. I'm Mark J. Kohler. Thanks for watching, and I'll see you on the next one.