A Self Directed IRA or 401(k) is intended for passive investments. If you are using, or considering using, your IRA or 401(k) for an investment that is not exactly passive, you may want to pause and read further. Examples of such “investments” include: purchasing, repairing, and flipping homes; and soliciting, making, and servicing loans (occasionally foreclosing on loan security).
Internal Revenue Code §§ 511-513, especially 511(a)(2), and 408(e)(1), make tax exempt entities, including self directed IRAs and 401(k) plans, taxable on income generated from unrelated business activities. This tax in known as unrelated business income tax (UBIT). Under IRC §513(a), an “unrelated trade or business” is one that is not substantially related to the exempt purpose or function of the exempt entity. With respect to retirement plans and accounts, that means any trade or business regularly conducted by the retirement plan or account. IRC §§ 408(e)(1) and 511(a)(2). Passive investment income is specifically excluded from UBIT, unless is it is from a leveraged investment or a controlled entity. IRC § 512(b). UBIT rates are between 15% and 39% but reach 25% after only $50,000 in unrelated business taxable income; 34% after $75,000; and 39% after $100,000. See instructions to IRS form 990-T.
Another thing to keep in mind is that a retirement plan participant or IRA owner is a “disqualified person” under IRC § 4975(e)(2). Investments that involve a high level of activity or participation by a disqualified person run the risk of being “prohibited transations.” See IRC § 4975(c). Prohibited transactions will lead to the imposition a penalty of as much as 100% of the amount involved. IRC § 4975(a)&(b).
If you are involved in an investment activity that may be deemed a trade or business, you may want to consider, as an alternative, using it to sponsor a self-directed 401(k), then loaning yourself up to $50,000 from the plan, and using that money to fund the business.