IRA Investments—Are there restrictions?
By Tammy Schultz, CISP, CHSP, QPA
We are considering offering additional investment options for IRAs. What are the limitations?
The IRS allows many types of investments in an IRA. The Internal Revenue Code specifically prohibits two types, life insurance and collectibles. You might wonder why they chose those two investments as prohibited. Think about the purpose of life insurance—to provide a payout and financial support to a named beneficiary. The purpose of the IRA is to fund the owner’s retirement not to provide for a named beneficiary.
The purpose of prohibiting collectibles is less clear. This may be because of the valuation process for a collectible. The value of a piece of art is determined by the price that someone will pay for it. The IRS may have prohibited collectibles from being an allowable investment in an IRA because this market value is skewed by the price someone might pay for it.
Are life insurance and collectibles the only two investments prohibited in an IRA?
Those are the only two investments called out by name. However, Internal Revenue Code section 4975 has additional rules prohibiting “self-dealing.” Self-dealing is defined several ways. The money needs to be invested to benefit the IRA and not a disqualified person.
A disqualified person is the IRA owner and certain family members of the IRA owner, such as the IRA owner’s spouse, and the IRA owner’s ancestors and lineal descendants. A prohibited transaction could also occur if the IRA enters into a transaction with a company in which the IRA owner or other disqualified person has a majority ownership.
If the investment situation is questionable, the financial organization's IRA representative should ask the IRA owner to consult with a legal advisor and get a written opinion on the investment. If the representative still feels uncomfortable with the transaction, he has the right to decline to act as the trustee or custodian for the investment.
What types of investment would be considered traditional investments?
The industry would include in the common traditional investment category any investment that has a readily available fair market value. This could include certificates of deposit, publicly traded stocks, annuities, and many others. The trustee or custodian easily could find the fair market value for these investments.
Alternative assets, also known as “hard-to-value,” are illiquid assets, unique assets, or special assets. Some of the more common types of alternative investments include real estate, promissory notes, limited liability companies, and certain types of coins. These are the assets that have a greater potential for causing a prohibited transaction. Alternative assets require additional scrutiny by the financial organization because of their unique nature and potential for administration issues. These issues include valuation, unrelated business taxable income from the investment in a business, investment management, and valuation of the assets and other possible tasks based on the type of investment.
Although these assets come with challenges, they also come with the potential for greater return. And with the potential for a greater return comes greater risk. For example, if I invest in rental property that is currently worth $300,000, the IRA owner may expect the property to increase in value each year. The IRA owner needs to keep in mind that the value could also drop.
Financial organizations should never provide tax or legal advice to an IRA owner. The owner should discuss the investment options and how to invest the IRA assets with a competent tax or legal advisor before making any investment decisions.