If you’re interested in starting or funding an investment fund, don’t use your personal funds when there is a more tax-advantageous route. By using an individual retirement account or 401(k) plan, the gains from the investments generally flow back to the retirement account tax-free. Do you remember when news surfaced that Mitt Romney generated millions by investing with his IRA? Since then, more investors have looked toward the Self-Directed IRA to start or fund an investment fund.
It’s important to keep in mind that if you make an investment with a Self-Directed retirement account, you must be mindful of the IRS prohibited transaction rules under IRC 4975. The IRS does not state what investments you can make with your self-directed IRA, only the investments deemed prohibited. Essentially, you cannot do the following with your IRA:
- Perform certain transactions with disqualified persons, which are viewed as inherently suspicious by the IRS.
- Make investments that directly or indirectly benefit you or another disqualified person.
- Invest in life insurance or collectibles.
- Perform certain transactions with disqualified persons, which are viewed as inherently suspicious by the IRS.
- Make investments that directly or indirectly benefit you or another disqualified person.
- Invest in life insurance or collectibles.
One of the broadest rules set by the IRC are the self-dealing and conflict of interest prohibited transaction rules. They are made even broader when you make hedge fund type investments.
Hedge Fund and Private Equity Fund Investments
Sophisticated investors make hedge fund and private equity fund investments. The prohibited transaction rules become more complicated when making such investments when the IRA investor (or another disqualified person) has a relationship with the invest fund investment.
However, if you wish to investment in an investment fund you or another disqualified person is involved in, there may be a way you can use your retirement funds to make the investment. First, you must ensure that the retirement account investment will not directly or indirectly benefit you or the disqualified person involved, as this may trigger a prohibited transaction. The determination behind whether it will trigger a prohibited transaction is based on the circumstances, and it is up to you (the retirement account holder) to prove that you and the disqualified person did not benefit. Failure to prove this may result in steep taxes and penalties.
UBTI Tax
On another note, if you use retirement funds to invest in an investment fund (private equity or hedge fund) that is operated through a pass-through entity, such as an LLC or partnership that uses leverage, this can trigger a tax known as the Unrelated Business Taxable Income (UBIT) tax.
It is highly lucrative and perfectly legal to use a Self-Directed IRA or other retirement account to invest in investment funds. However, you must closely examine the prohibited transaction rules set forth by the IRS if you or another disqualified person has some involvement with the fund.
Get in Touch
If you are interested in using retirement funds to invest in a hedge fund or other investment fund and you are uncertain whether you will trigger the prohibited transaction rules, contact IRA Financial directly at 800-472-0646. You can also fill out the contact form to speak with a specialist.
