Ira Investments: Understanding Fund Unavailability

Individual Retirement Accounts (IRAs) are retirement savings accounts with tax advantages. While almost any type of investment is permissible, there are a few limitations on the types of investments that can be held in an IRA.

The Internal Revenue Code and the IRS guidelines are exclusive rather than inclusive, meaning we're only told what we cannot invest in, not what we can. So, what are the investments that are off-limits?

Collectibles, such as artwork, antiques, and alcoholic beverages, are prohibited

Collectibles are often difficult to value and prone to counterfeiting, making them a risky investment. Additionally, they may not provide any investment income or dividends, and there may be high costs associated with storage, handling, and insurance.

Furthermore, the Internal Revenue Service (IRS) specifically prohibits holding collectibles in IRAs to prevent taxpayers from using these accounts to shelter assets from taxes. This ensures that IRA funds are used for retirement and invested sensibly.

While there are some exceptions for certain types of coins, the majority of collectibles are not permitted in IRAs. It is important for investors to understand the restrictions and potential risks associated with holding collectibles before making any investment decisions.

Life insurance contracts are not allowed

The reasoning behind this is that a certain degree of liquidity is important in retirement assets. If too much money is tied up in illiquid investments, such as life insurance contracts, the required cash flow may not be available to participants during retirement, or for their heirs, to make required distributions.

Additionally, the regulations, supervision, and enforcement procedures surrounding life insurance contracts are not as clear as those for securities and mutual funds. The latter offers more leeway for IRA owners.

There is one exception to this rule, known as the incidental benefit rule. This rule states that qualified plans are allowed to purchase a small amount of life insurance for a given plan participant, as long as the primary purpose of the plan is to provide retirement benefits, and the amount of the death benefit is considered "incidental" compared to the plan balance.

In summary, while life insurance contracts are generally not allowed in IRAs or qualified plans, there is a narrow exception for qualified plans that purchase a small amount of life insurance as an incidental benefit.

Transactions with disqualified persons, such as family members, are forbidden

Any LLC or other entity trust or partnership that is owned 50% or more by disqualified persons is also considered a disqualified person, as are your real estate businesses or other businesses.

If you are found to be in breach of these rules, your IRA ceases to exist and becomes distributed. You may also have to pay taxes and penalties upon the distribution.

Real estate for personal use is banned

The reason for this restriction is that the IRA owner cannot benefit directly from the property. This includes receiving rental income or living in the property. The property must be used solely for investment purposes.

If you violate this rule, you can disqualify your IRA, and all the funds in it will immediately become taxable.

No derivative trades with unlimited or undefined risk

The IRS prohibits any derivative trade with unlimited or undefined risk in an Individual Retirement Account (IRA). This is because IRAs are designed to provide retirement security, and speculative instruments such as derivatives are often disallowed. Derivative trades with unlimited or undefined risk can theoretically face unlimited losses, which can be realised as a total loss or bankruptcy.

An example of a derivative trade with unlimited risk is selling naked calls. In this case, the writer of the option will receive the option premium as their maximum profit. If the price of the underlying asset is below the strike price at expiry, the option writer gets to keep the premium as their profit on the trade. However, if the price rises above the strike price, they face unlimited losses.

While derivative trades with unlimited or undefined risk are theoretically possible, the trader doesn't have to assume unlimited risk. They can take steps to limit actual losses, such as hedging or setting stop-loss orders. For example, if the price rises above the strike price, the trader may decide to cut their losses and exit their options trade.

Many IRA custodians will prohibit the use of any type of derivative trading inside their accounts, except for covered call writing. Those who wish to trade derivatives inside their IRAs should look to more liberal custodians that permit the use of other types of alternative investments, such as hedge funds or oil and gas leases.

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