Salesman vs. Estate Planners

There’s a big difference between a counselor and a salesman. This became evident to me while speaking to a client who opened a self-directed IRA so that he could hold non-traditional investments like real estate inside of a qualified retirement account.  

The salesman referred to the self-directed IRA as a great estate planning vehicle. While that might be true in a financial sense, self-directed IRA accounts can be problematic from a legal and tax perspective.  

At the time of our conversation, this particular client was past his Required Beginning Date (RBD) to take Required Minimum Distributions (RMDs) from his IRA accounts. This is when self-directed IRAs can get a little hairy. 

For most Traditional IRA account owners, once you attain age 72 you have RMDs that are calculated based upon a table and the December 31st fair market value balance of the account. If you have multiple IRA accounts, the total balance is used to calculate your RMD. You needn’t take the proportional amount from each account. So long as you take your RMD amount during the calendar year, even if all of it is from one of many IRA accounts, you have satisfied the distribution requirement.  

Failure to satisfy the RMD results in an excise tax equal to fifty percent (50%) of the shortfall, in addition to the income tax paid on the withdrawal. It’s a draconian penalty. 

Some financial planning companies pitch the benefits of Self-Directed IRAs. As mentioned earlier, you could contribute income producing real estate to a Self-Directed IRA, which defers appreciation and income until distributed. There are many rules regarding these types of investments, including who the custodian can be without an investment becoming a prohibited transaction.  

But even if you follow all of the rules, there’s a big problem once you turn 72. In order to calculate your RMD, you need to know the fair market value balance of the account at the previous year end. When all that you own happens to be cash or publicly traded securities, the fair market value is readily determined. When you own non-traditional assets such as real estate or partnerships that aren’t publicly traded, you need an appraisal of your interest to determine the fair market value. 

Further, unless you have sufficient liquid assets (publicly traded securities and cash) inside of other Traditional IRA accounts to satisfy your RMD requirement for any given year, you’ll have to figure out how to distribute a portion of the self-directed IRA account. There’s also the possibility that the IRS disputes the value that you place on the investment or the portion of the distribution since there’s no ready market for it. Any shortfall could result in a 50% excise tax. 

There are some workarounds. If you have sufficient cash to purchase the asset from the IRA and replace it with cash once the RMDs become an issue, you can always do that. If that’s your strategy you need to ensure that the plan allows for such an exchange, and whether you can continue to hold the asset outside of an IRA. When those assets are sold and held by third-party custodians, that may or may not be possible.  

When I examine Self-Directed IRA (sometimes they call these “Real Estate IRA” accounts) literature, the advantages are always highlighted but the disadvantages I point out above are rarely mentioned. And there’s the difference between a “salesman” and an attorney. Assuming you engage an independent estate planning attorney who isn’t earning management fees or commissions on the products, and further assuming he’s familiar with the offering, then he can give you an unbiased opinion. 

I mentioned Self-Directed IRAs to make a point for this article. But there are many financial products out there sold as estate planning solutions. Annuities and life insurance are other prime examples. I have an octogenarian chronically ill client who was sold a lifetime annuity. Because it has excessive early termination fees, he can’t easily cash out, and the annuity itself is a bad investment for him given the fact that he’s unlikely to live out a term necessary to achieve even a minimal return on his investment. This was sold to him as an estate planning solution. 

The lesson to be learned here: When you’re looking for estate planning solutions sold as financial products, or if a financial proposal looks enticing, first check with a qualified estate planning attorney who has no interest in whether you go forward or not for an honest opinion.  

© 2020 Craig R. Hersch. Originally published in the Sanibel Island Sun.