There's no questioning the popularity of IRAs and other tax-advantaged retirement accounts. According to the Investment Company Institute, assets held in retirement accounts reached $14.5 trillion in 2005, representing nearly one-third of all household financial assets. Given the importance of saving enough to retire comfortably, it's not surprising that many people take advantage of retirement accounts' tax benefits.
As a savings vehicle, IRAs are extremely flexible. You can generally open an account with nearly any financial institution and choose a wide range of investments, including stocks, bonds, mutual funds, and other tradable securities. In addition, some financial companies have responded to the boom in real estate by offering IRAs that allow you to invest in land, commercial buildings, and other types of property. However, there are some things you're not allowed to do with IRAs. If you're not careful, trying to do something you shouldn't with your IRA can create a big problem for you and your taxes.
The big temptation
People may try to push the envelope with their retirement accounts because those accounts often represent their largest source of potential liquidity for investing. If, for example, a trusted colleague comes to you with a proposal for creating a new and highly profitable business, or investing in lucrative real estate, you may want to participate. But most people don't have a lot of spare cash to invest, and selling other investments in taxable accounts to raise cash can create a big tax headache. In addition, it can be difficult and expensive for an unproven new business venture to obtain financing from banks or other traditional sources. If you have fairly large balances in your retirement accounts, it's only natural to wonder whether you can use them for private investments such as these.
You may be able to tap into your retirement accounts for these sorts of investments -- but you've got to know and follow the rules involved. Otherwise, you could risk paying tax on the entire value of your IRA.
IRS rules for IRAs
While IRAs allow many different types of investments, some are strictly forbidden. The IRA rules prohibit buying life insurance contracts and collectibles, although there's an exception for certain bullion coins issued by federal or state governments. In addition, you generally can't use IRA assets in any transaction personally involving yourself or a relative. Prohibited transactions listed in the rules include trading or leasing property between yourself and your IRA, lending IRA money to yourself or a disqualified relative, using personal property to furnish a rental property owned by an IRA, or using assets within your IRA for personal use.
While the rules list some specific examples, they also apply to general situations in which people attempt to use their retirement accounts for personal gain. Owning shares of your own closely held company in an IRA would potentially be considered self-dealing. The main idea is to keep people from abusing the retirement account provisions in situations in which they could directly influence the value of an investment.
IRAs and real estate
Even with the recent downturn in the housing market, real estate is still a popular investment. The easiest way to get exposure to real estate in an IRA is to buy into real estate investment trusts like Boston Properties (NYSE: BXP ) or Vornado Realty (NYSE: VNO ) . If you're looking for a more diversified portfolio of REITs, you can buy shares of a REIT ETF like the Vanguard REIT Index ETF (AMEX: VNQ ) . However, some investors prefer the potential for greater rewards that direct real estate investing offers.
If you're interested in investing directly in real estate through your IRA, the first step is to find a financial institution that's willing to act as the trustee of your IRA. Because real estate investing in an IRA is more complicated, and requires some additional work that isn't required for most IRA assets, many financial institutions don't offer customers the ability to purchase real estate in an IRA. However, the rise in popularity of real estate investing has spawned a new niche of IRA trustees willing to hold real estate. Expect to pay somewhat higher fees for their services than you would for a regular stock or mutual fund account.
Once you have a trustee, pay careful attention to how you structure your real estate transaction. In particular, potential pitfalls may apply if you intend to make only a down payment on property with IRA funds. The safest IRA investment in real estate involves property in which the IRA owner has no personal interest whatsoever; if an unrelated party is responsible for decisions concerning property management and sales, it's likely that the investment won't violate any of the IRA rules. On the other hand, the more contact the IRA owner has with the property, the greater the likelihood that some form of prohibited personal benefit will cause problems with the IRS.
IRAs are primarily designed to help you save for a sound retirement, and their governing rules encourage prudent investing. Attempting to use your IRA for more speculative ventures may be permissible, but the minefield of IRS regulations makes it a risky proposition.
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Fool contributor Dan Caplinger is buying real estate, but he'll keep it out of his IRA. He doesn't own shares of the companies and funds mentioned in this article. The Fool's disclosure policy has a "can do" attitude.