One of the most famous Self-Directed IRA investors is Mitt Romney. Why? Romney supposedly made close to $100 million by investing his IRA funds into numerous private equity investments.
So why did Mr. Romney elect to make these types of private equity investments in a Self-Directed IRA? The answer comes down to tax savings.
Using an individual retirement account (IRA) or 401(k) plan to make investments is seen as a tax-attractive option because the gains from the investment would flow back to the retirement account without being subject to tax. Additionally, in the case of a Self-Directed Roth IRA, the income or gains has the potential to be fully exempt tax.
What is Private Equity?
Private equity is just a term used to describe pools of money from numerous investors that are established through a passthrough entity, such as a partnership or LLC, which are then used to acquire stakes in companies. Common types of private equity investments include:
- Venture Capital
- Investing in privately owned healthcare companies
- Investing in privately owned or pre-IPO infrastructure companies
- Certain types of real estate
Related: New SEC Rules on Investing in Private Equity with an IRA
What is the difference between private equity and venture capital?
Private equity and venture capital investments are similar; however, private equity typically invests in mature type and revenue-generating companies in need of some revitalization. Whereas venture capital typically invests in very early-stage companies with little to no revenues.
Both private equity and venture capital funds typically raise money from wealthy accredited investors, family offices, banks, and financial institutions, other investment funds, pension funds, and even IRAs.
Private equity funds make money by charging a small fee for managing the fund, typically around 2%, and then taking a cut of the gains from the investments above a certain set threshold. This is known as the carried interest and is typically 20%. The fees associated with investing in a private equity or venture capital fund are steeper than investing in a mutual fund or ETF, but the hope is that the returns will more than make up for the associated costs.
Benefits of Investing in Private Equity in an IRA
Private equity investments have multiple benefits, often influenced by the industry. Among these benefits include:
- The ability to invest in new companies
- The ability to invest in disruptive technologies
- The ability to avoid quarterly reporting pressures
- The ability to invest in new ideas
- The ability to invest in emerging businesses
- All gains flow back to your retirement account tax-free or tax-deferred
- Diversification
- The ability to invest in something you know and understand
- In some cases, private equity investments can also have a higher rate of return. However, the rate of return would depend on the investment. Hence, it is important to do your due diligence before making any investment.
Private Equity Investments with an IRA – How Does it Work?
A self-directed IRA is a type of vehicle that allows one to use his/her IRA funds to invest in private equity or venture capital transactions. A self-directed IRA can be used with a pre-tax IRA, Roth IRA, SEP IRA, or SIMPLE IRA.
There are two types of self-directed IRA structures that can be used to purchase a private equity investment:
- Custodian Controlled Self-Directed IRA: This structure allows you to make alternative asset investments, such as private equity, but with the consent of a Self-Directed IRA custodian. With a custodian controlled self-directed IRA, the IRA funds are generally held with the IRA custodian. At the IRA holder’s sole direction, the IRA custodian will then invest the IRA funds into a house that will be owned by the IRA care of the IRA custodian. This is a popular structure for retirement investors who wish to make alternative asset investments that do not involve a high frequency of transactions.
- “Checkbook Control” Self-Directed IRA: With this structure, a special purpose limited liability company (LLC) is established, which the IRA owns, and the IRA holder (you) manages. As manager of the LLC, you have full authority to make IRS-approved alternative asset investment decisions on behalf of your IRA. No custodian consent is necessary. All of your funds will be held at a local bank in the name of the IRA LLC. As a result, simply write a check or wire funds directly from the IRA LLC bank account to make an investment.
The custodian controlled Self-Directed IRA is more popular for private equity and venture capital investments. The investments are so passive in nature and generally require a few transactions over a period of several years.
Related: Most Popular Self-Directed Investments
*Did you know that if you are self-employed you can invest in private equity with a Solo 401(k)?
Self-Directed IRA Prohibited Transaction Rules
When it comes to purchasing private equity funds with a Self-Directed IRA, you must be mindful of the IRS prohibited transaction rules under Internal Revenue Code Section 4975. In general, the IRS has restricted certain transactions between the Self-Directed IRA and a “disqualified person.” Disqualified persons include, but are not limited to the IRA holder and any of his/her lineal descendants.
Furthermore, Internal Revenue Code Section 4975(c)(1)(D) and (E) outlines rules that relate to self-dealing or conflict of interest transactions that involve an investment that could directly or indirectly personally benefit a disqualified person. The self-dealing or conflict of interest prohibited transaction rules have the broadest application especially when it comes to private equity investments.
The prohibited transactions rules tend to become more of an issue when the person using the retirement funds or any disqualified person related to the retirement account holder has a personal interest or relationship with the investment fund investment. In other words, a retirement account holder can generally make an investment into any private equity fund in which neither the retirement account holder nor any disqualified person has any personal ownership or relationship with. The issues begin to arise from an IRS prohibited transaction standpoint when the retirement account holder wishes to use retirement funds to invest in a fund where her or she or a disqualified person is either an owner, employee or, in some cases, has a professional relationship with the fund in question.
In general, if structured correctly, there may be a way for one to use his/her retirement funds to invest in a private equity that one is personally involved in. The key is to make sure that the retirement account investment into the fund will not personally benefit the retirement account holder (directly or indirectly) or any disqualified person since that type of investment would likely trigger a prohibited transaction.
Triggering a prohibited transaction is based on the facts and circumstances involved. The retirement account holder must prove that he/she did not personally benefit from the retirement account investments (directly or indirectly). Failure of proof can trigger very steep taxes and penalties.
Related: Benefits of a Self-Directed IRA
Unrelated Business Taxable Income (UBTI)
Retirement investors can use a Self-Directed IRA for private equity investments, as well as venture capital investments if the IRA owner or another disqualified person does not benefit from the transaction in any way. However, if the private equity or venture capital fund will be invested in a business operated through a passthrough entity, such as an LLC, the income from the business generated by the private equity fund could trigger an unknown tax called the unrelated business taxable income tax or UBTI or UBIT.
For example, if the private equity fund invests in a shoe factory that is operated through an LLC, the income from the shoe factory allocated to the private equity fund could be subject to the UBIT tax, which can be as high as 37%. Note – if the underlying business owned by the private equity fund is operated by a C Corporation, such as Apple or Google (almost all public companies are C Corporations), the UBTI tax would not apply.
However, it would be wise to speak to the general partner of the prospective private equity firm about the potential application of the UBTI tax before investing.
Learn More: Self-Directed IRA Private Placement Investment Rules
Putting it All Together
Private equity investments are one of the more popular investment options for Self-Directed IRAs. Private equity investments are generally very passive and do not offer many prohibited transaction risks, assuming you or any disqualified person is actively involved in the fund. However, the application of the UBTI tax rules in connection with private equity investments should be considered in light of the common practice for private equity firms acquiring portfolio companies operated through passthrough entities, such as LLCs.
Related: Retirement Investors Bet Big on Private Businesses
Why IRA Financial
IRA Financial has helped over 15,500 self-directed IRA investors invest over $4.5 billion in alternative assets. IRA Financial has significant experience assisting private equity and venture capital clients navigate the IRS rules in connection with all types of domestic and foreign investments.
For additional information on using a self-directed IRA to make private equity or venture capital investments, please contact one of our self-directed IRA Experts at 800-472-0646.
