Understanding Key Terms for Self-Directed IRAs (SDIRAs) and Other Retirement Accounts

When it comes to retirement planning, various account types and terms come into play, each designed to cater to different needs and investment strategies. This article will explore the common terminology associated with Self-Directed Individual Retirement Accounts (SDIRAs), IRAs, and other retirement plans, providing clarity on how each term is used and offering expanded examples for better understanding.

Individual Retirement Account (IRA)

An Individual Retirement Account (IRA) is a tax-advantaged account designed for retirement savings. It allows individuals to set aside money for retirement while receiving tax benefits. There are two main types of IRAs: Traditional IRAs and Roth IRAs.

• Traditional IRA: Contributions to a Traditional IRA are typically tax-deductible in the year they are made, and earnings grow tax-deferred. For example, if you contribute $5,000 to a Traditional IRA, you can reduce your taxable income for the year by $5,000, and you will pay taxes when you withdraw the funds in retirement.

• Roth IRA: Contributions are made with after-tax money, meaning you don’t receive a tax deduction when contributing. However, the earnings grow tax-free, and withdrawals in retirement are also tax-free, provided certain conditions are met. For example, contributing $5,000 to a Roth IRA means you won’t get an immediate tax break, but your funds can grow and be withdrawn tax-free when you retire.

Self-Directed Individual Retirement Account (SDIRA)

A Self-Directed IRA (SDIRA) is an IRA that offers more flexibility in investment options. Unlike a traditional IRA, which generally restricts investments to stocks, bonds, and mutual funds, an SDIRA allows for investments in a broader range of assets such as real estate, private equity, and even cryptocurrency.

• Example: If you have a SDIRA, you can use the funds to purchase rental properties or invest in private companies, providing you with more control and a wider variety of potential returns compared to a standard IRA.

SEP IRA and SIMPLE IRA

• SEP IRA (Simplified Employee Pension): This plan is typically used by small business owners and self-employed individuals. Employers contribute to their employees' SEP IRAs, and the contribution limit is higher than a traditional IRA. For example, a business owner can contribute up to 25% of their compensation, helping their employees save for retirement.

• SIMPLE IRA (Savings Incentive Match Plan for Employees): Designed for small businesses, a SIMPLE IRA allows employers to make contributions that match employees' contributions, usually dollar-for-dollar up to 3% of their salary. For example, if an employee contributes $2,000 to their SIMPLE IRA, their employer would match that amount.

Solo 401(k)

A Solo 401(k) is a retirement plan designed for self-employed individuals or business owners with no employees, except possibly a spouse. It allows for higher contribution limits since the account holder can contribute both as an employer and an employee. For example, a sole proprietor can contribute up to $20,500 as an employee, and the business can contribute up to 25% of the compensation as the employer.

Investment Terms

• Investment: An investment is the act of putting money into assets with the expectation of making a return. For example, if you purchase shares of stock with your IRA funds, you are making an investment, hoping the stock value will increase over time.

• Alternative Investment: SDIRAs allow for investments beyond traditional options like stocks and bonds. These might include real estate, precious metals, or even cryptocurrency. For example, using your SDIRA to purchase a rental property is considered an alternative investment.

Asset and Ledger

• Asset: An asset is anything of value held in your IRA, including real estate, private equity, or precious metals. For example, a rental property bought with SDIRA funds is an asset within your IRA.

• Ledger: The ledger is a record of all cash transactions within the IRA. Every time money is deposited, withdrawn, or used for an investment, it is recorded in the ledger. For example, if you make a contribution of $6,000 to your SDIRA, the ledger will reflect this as a new entry.

Transfers and Rollovers

• Transfer In/Out: This term refers to the movement of assets between IRA custodians. For example, if you move your IRA from one custodian to another, it is a Transfer In. Similarly, transferring assets from your current IRA to another custodian is a Transfer Out. Both transactions are non-taxable.

• Rollover: A rollover involves moving funds from one retirement account to another while maintaining the tax-deferred status. For example, if you change jobs and roll over your 401(k) from your previous employer into your IRA, the funds maintain their tax-deferred status.

• Direct Rollover vs. Indirect Rollover: A direct rollover occurs when retirement funds are moved directly from one account to another without you receiving the funds. An indirect rollover happens when the funds are given to you first, and you must deposit them into another retirement account within 60 days to avoid taxes and penalties. For example, if you withdraw your 401(k) funds and deposit them into your IRA within 60 days, it would be considered an indirect rollover.

Prohibited Transactions and Disqualified Persons

• Prohibited Transaction: These are transactions disallowed by the IRS between an IRA and a disqualified person, such as buying a property that you or a close family member already owns. For example, using your SDIRA to purchase a home for personal use is prohibited and considered self-dealing.

• Disqualified Persons: Disqualified persons include the account holder and their immediate family members. For example, you cannot use your SDIRA to purchase real estate from your immediate family or to lend money to them.

Forms and Statements

• Form 1099R: This is a tax document that reports distributions from your retirement account, which you will need for annual tax filing. For example, if you take a distribution of $10,000 from your IRA, you will receive a Form 1099R to report that income.

• Form 5498: This form reports annual contributions to your IRA and the fair market value of the assets in your account. For example, if you contributed $6,000 to your IRA in the previous year, this amount will be reported on your Form 5498.

Non-recourse Loans and Checkbook IRAs

• Non-recourse Loan: This is a loan where the borrower is not personally liable beyond the collateral securing the loan. For example, if you take out a non-recourse loan to purchase real estate through your SDIRA, the lender can only claim the property if you default, not your personal assets.

• Checkbook IRA (ICO): A Checkbook IRA gives account holders direct control over investments by allowing them to write checks directly from their IRA’s LLC. For example, using a Checkbook IRA, you could quickly purchase a piece of real estate without waiting for custodian approval.

By understanding these key terms, individuals can better navigate the complex world of retirement accounts and make informed decisions about managing their retirement funds, especially in the context of Self-Directed IRAs (SDIRAs). Whether you're looking to invest in real estate, cryptocurrency, or other alternative investments, knowing how these terms relate to each other will help you maximize your investment potential and stay compliant with IRS rules.