It is essential to understand the tax implications of self-directed individual retirement accounts (SDIRAs) before you start investing. The challenge is that the rules can be complex, so we have prepared this guide.
SDIRAs provide many tax advantages, including tax-deferred or tax-free growth, depending on your account type. While some accounts are taxed before contributions are made, others are taxed when you make qualified withdrawals, typically in retirement. Additionally, there are potential penalties for breaching the Internal Revenue Service (IRS) regulations.
We discuss how the IRS taxes the various SDIRAs, their benefits, the tax rules and penalties, reporting requirements, and tax planning tips to help you maximize savings.
How Self-Directed IRAs Are Taxed
The IRS taxes SDIRAs based on the type. Here is an overview:
1. Traditional SDIRAs
These are funded with pretax money like traditional IRAs, so the income generated is tax-deferred. You generally pay taxes on capital gains, dividends or interest earned on investments when you make qualified withdrawals in retirement. You can start taking withdrawals when you turn 59 ½. These distributions are taxed as ordinary income. It may also provide a tax deduction in the year of contribution.
2. Roth SDIRAs
These are post-tax IRAs that allow you to make contributions with after-tax dollars. You do not receive tax deductions for contributions, but qualified withdrawals are tax-free, provided you meet certain conditions. For example, you must hold the account for at least five years and be 59 ½ or older.
3. Simplified Employee Pension (SEP) SDIRAs
An SEP allows contributions of up to 25% of the employee’s salary, which is pretax. Income within the account grows tax-deferred and may provide a tax deduction in the contribution year. Generally, employees can take distributions once they turn 59 ½, taxed as ordinary income.
4. Savings Incentive Match Plan for Employees (SIMPLE) SDIRAs
Like SEP and traditional SDIRAs, contributions made to SIMPLE SDIRAs are tax-deferred. Similarly, you may deduct contributions. You do not pay income or capital gains taxes while the money is in the account. Once you turn 59 ½, you pay taxes on withdrawals as an ordinary income.
The same rules applicable to traditional, SEP and SIMPLE IRAs also apply to solo 401(k)s.
Tax Benefits of Self-Directed IRAs
SDIRAs offer a range of tax advantages, including the following:
1. Potential Tax-Savings
Depending on your income and participation in other retirement plans, you may deduct the contributions to traditional, SEP and SIMPLE SDIRAs. This tax deduction reduces your taxable income, potentially lowering your tax liability.
2. Compound Growth
The earnings generated in traditional, SEP and SIMPLE SDIRAs are only taxed when withdrawn in retirement. This feature allows the investment to grow without the immediate impact of taxes, which is ideal for long-term planning.
3. Tax-Free Withdrawals
A Roth SDIRA can be particularly beneficial for individuals anticipating a higher tax bracket during retirement. Since qualified withdrawals are tax-free, you may withdraw larger amounts without incurring tax liabilities.
Self-Directed IRA Tax Rules
The IRS has established rules to govern the use of SDIRAs. These rules cover diverse areas, including the following:
1. Contributions
The IRS sets contribution limits that you must not exceed. These amounts are revised annually, so it is crucial to note this. You must make contributions with earned income, such as income from wages, self-employment or other sources of compensation. Finally, as earlier mentioned, contributions made to traditional, SEP and SIMPLE IRAs are tax deductible.
2. Withdrawals or Distributions
Withdrawals from SDIRAs are subject to specific rules. First, you cannot keep funds in the account indefinitely. This requirement is called required minimum distributions (RMDs). For traditional, SEP or SIMPLE IRAs, you must start withdrawing funds once you turn 72. Roth SDIRAs do not require withdrawals until the account holder dies, but their beneficiaries must comply with the RMD rules.
Second, the IRS taxes withdrawals from traditional, SEP and SIMPLE SDIRAs as ordinary income. If you withdraw funds before age 59 ½, you may incur a 10% penalty plus regular income tax. For Roth SDIRAs, the distributions are tax-free if you hold the account for at least five years and make qualified withdrawals after age 59 ½.
Third, there are exceptions to the early withdrawal penalties. For example, if you have a traditional, SEP and SIMPLE SDIRA, you can make early withdrawals in the following instances:
- Up to $5,000 distribution per child for qualified birth or adoption expenses
- When the account holder dies
- When the account holder has a disability
- When the money is used for qualified higher education expenses
3. Prohibited Transactions
Prohibited transactions occur when you engage in certain activities that the IRS disallows. A classic example is a transaction involving a disqualified person, such as:
- Selling, leasing or exchanging a property
- Extending money or lending money
- Furnishing goods, services or facilities
Disqualified persons include your spouse, ancestors or lineal descendants. Fiduciaries, people providing services to the plan and employers with employees covered by the plan are also disqualified persons. You may incur significant fines if you violate the rules.
4. Unrelated Business Income Tax (UBIT)
UBIT applies to income generated from a trade or business activity not substantially related to the IRA’s tax-exempt purpose. If the SDIRA invests in a business activity or engages in certain types of investment, the income generated may be subject to UBIT. An example is income from debt-financed property, like real estate purchased with a mortgage. UBIT is taxed at the corporate tax rate, which can be higher than the individual tax rate.
Note that the rules provided are not exhaustive. For example, there are no tax ramifications when you transfer an IRA with another custodian into the SDIRA. You only pay taxes when you move funds from a traditional to a Roth SDIRA. Also, you do not pay taxes on investment losses. It is vital to consult a tax professional for tailored advice.
Self-Directed IRA Tax Filing Requirements
The IRA custodian and account holder have tax filing obligations. For example, the custodian must file Form 5498 annually to report contributions made to the IRA. Account holders who withdraw funds must also report them on their personal tax returns using Form 1040. Similarly, account holders may report on their individual tax returns when claiming deductions for traditional, SEP and SIMPLE SDIRA contributions.
Maintaining records of all contributions, withdrawals and transactions conducted within the account is essential. You may need them during IRS audits.
Tax Planning Tips for Self-Directed IRAs
Following best practices can help you make the most out of your SDIRA. Here are a few tips to consider:
1. Diversify Your Investment
SDIRAs allow you to invest in alternative assets like private placement and real estate in addition to conventional options like stocks, bonds and mutual funds, so take advantage of that. This strategy lets you access tax advantages specific to those investments.
2. Time Contributions and Withdrawals
Maximize your contributions to reduce your taxable income, especially if you have a traditional, SEP or SIMPLE SDIRA. Also, time withdrawals to prevent penalties. A helpful strategy might be withdrawing within the exceptions, like taking distributions to pay for higher education tuition.
3. Align IRA Investments with Retirement Goals
Select an SDIRA depending on your retirement goals and financial projections. For example, if you foresee earning more in retirement, a Roth SDIRA might be ideal. Investing in an income-generating asset might be suitable if you aim to create a steady income stream in retirement.
4. Work with Professionals
The SDIRA tax regulations are complex, so working with a professional can be helpful. Financial or tax experts can provide valuable insights. They can assist you in planning your investment and ensure compliance. Leveraging their experience could save you lots of money.
Learn More From Accuplan Benefits Services
SDIRAs are taxed depending on their type. For example, traditional, SEP and SIMPLE SDIRAs are tax-deferred, meaning you pay taxes when you withdraw during retirement. However, contributions to Roth SDIRAs are taxed now and grow tax-free. There are also complex rules governing SDIRA, which is why working with experienced custodians is best.
Accuplan Benefits Services provides SDIRA services with dedicated professionals who are ready to assist. Our team has years of industry experience and manages over $1.5 billion in assets. Contact us now to learn more!
Our information shouldn’t be relied upon for investment advice but simply for information and educational purposes only. It is not intended to provide, nor should it be relied upon for accounting, legal, tax or investment advice.