Edward A. Zurndorfer, Certified Financial Planner

Although the income tax filing season has just started, individuals have until April 17, 2012 to make their IRA contributions for tax year 2011.

As a result of having "earned income" -- salary or wages -- during 2011, all federal employees are eligible to contribute to some type of IRA for tax year 2011. This includes a traditional deductible IRA, a traditional nondeductible IRA, or a Roth IRA. The maximum individual collective contribution to all IRAs for 2011 is the lower of $5,000 ($6,000 if an individual was at least age 50 as of Dec. 31, 2011), or the employee's (or spouse's, if higher) 2011 taxable wages as shown on the employee's 2011 W2.

An IRA may be established at a bank, a credit union, a brokerage or with an insurance company. All IRAs are required to have a custodian. Most IRA custodians are banks and broker- dealers that limit the holdings of the IRA. In other words, the IRA custodian limits the type of investments that the IRA invests. Typical IRA investments include bank certificates of deposits, individual bonds and stocks, mutual funds and real estate investment trusts.

But another type of IRA -- called a "self-directed" IRA - offers individuals the opportunity to invest in riskier assets including real estate, promissory notes and tax lien certificates.

The Security and Exchange Commission (SEC) issued a formal alert in September 2011 advising investors to be aware of fraudulent promoters pushing self-directed IRAs. While self-directed IRAs have the potential to offer investors high investment returns, self-directed IRAs also come with several risks, including a lack of disclosure and liquidity, and, as the SEC indicated, sometimes the risk of fraud.

What should federal employees be on the lookout for with respect to self-directed IRAs?

The SEC explains that "low risk" investments generally mean low yield, while "high risk" investments typically involves (promised) high yield. In particular, there are some self-directed IRA promoters who try to fraudulently convince potential investors that extremely high returns are "guaranteed". For additional information about the potential fraud associated with self-directed IRAs, investors who are interested in contributing to an IRA should check out the SEC blog at http://www.sec.gov/investor/alerts/sdira.pdf (5-page PDF). Among other things, this blog contains a brief summary of recent court cases involving fraudulent investments made through self-directed IRAs.

Besides fraud, there are other potential problems associated with self-directed IRAs, which are sometimes invested in nontraditional assets. Employees who plan to contribute to an IRA should note that as a result of IRS rules there are a number of investments that are "off limits" for IRAs, including life insurance and collectibles such as stamps, antiques and artwork.

Even if a particular investment for an IRA is permitted, there are certain tax benefits available in non-IRAs investments that are lost if the same investment was made inside an IRA. For example: Real estate, an allowable investment for an IRA and one of the more common holdings in a self-directed IRA, as explained in the following example:

A rented office building is held within a self-directed IRA. Here are three problems associated with this type of arrangement:

• No depreciation deduction. A non-cash item that offsets part of a real estate investor's rental income is depreciation. But if held within an IRA account, depreciation is not permitted.
• Sale of property at a capital gain and taxes. The sale of a capital asset such as an individual bond or a stock held within an IRA would not result in an immediate tax liability. However, once the IRA funds are withdrawn, the funds will be subject to ordinary income tax rates. On the other hand, if the property were held outside of an IRA, any capital gains incurred on the sale of the property (owned for at least one year) would be taxed currently at lower ("preferential") capital tax rates.
• No "step-up" in cost basis for heirs. If a property is held outside of an IRA and was not sold during the owner's lifetime, then heirs to the property would receive a "step-up" in cost basis upon the owner's death, thereby eliminating any capital gains tax on appreciation before death. But there is no step-up in cost basis on property in an IRA. When the property is sold at a gain and the property sale proceeds - including any capital gains - are distributed, the proceeds will be taxed at ordinary tax rates.

Other potential problems associated with real estate invested with an IRA: Valuation and liquidity. Starting when a traditional IRA owner reaches age 70.5, the owner is required to take an annual required minimum distribution (RMD). In order to determine the RMD, one needs to know the IRA's December 31 prior year-end balance. For a self-directed IRA invested in real estate, that means paying an appraiser annually to determine the property's fair market value. Liquidity will also be needed - not only for the RMD - but will also be needed to pay annual maintenance, real estate taxes and other expenses the property incurs. Note that the IRA itself -- not the account owner's outside bank account -- must pay these expenses. In general, an IRA invested in real estate typically has no "liquidity" in which to pay these expenses.

In short, a self-directed IRA -- even if permitted and with the potential for long-term growth -- is not worth the risk and added expense as well as the possibility that the IRS and/or  the SEC may disallow it as a legitimate IRA investment, imposing possible penalties and lost tax benefits.

Posted: 01/30/2012

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.