IRA Investments

The range of investments available to IRAs is seemingly endless. While contributions must be made in cash, IRA assets may be invested in any number of financial instruments. Most financial institutions provide custodial services for IRA accounts, including commercial banks, savings and loans, mutual savings banks, mutual funds, credit unions, life insurance companies, and stock brokerage self-directed accounts.

For purposes of deposit insurance, IRAs are treated separately from a depositor's regular bank accounts. The FDIC insures depositors' IRA balances held by a bank up to $250,000 (all of a depositor's IRAs at one bank are treated as one account), in addition to coverage on other regular accounts at that bank.

Although a wide array of investments are available, the choice of assets makes a substantial difference in the IRA's end result. For example:

• Tax-exempt bonds may not be the most advantageous IRA investment — the tax-exempt feature is unnecessary because IRAs are already tax-deferred, and tax-exempt instruments typically earn less than comparable taxable instruments.
• Speculative investments may not be prudent in an IRA because taxpayers may not deduct capital losses sustained inside an IRA account.

The tax code generally bans IRAs from investing in collectibles. The term "collectible" includes works of art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, or other items of tangible personal property.

If an IRA does invest in a collectible, the IRS treats the purchase as a taxable distribution from the IRA equal to the cost, occurring on the purchase date. The distribution does not disqualify the IRA's tax status regarding other investments.

No part of an IRA's assets may be invested in life insurance. In cases where a life insurance policy is distributed as part of another qualified plan's assets, that policy may not be rolled over into an IRA. The recipient may roll over only the cash surrender value of the policy (if surrendered) into an IRA.

Per IRS regulations, IRAs cannot invest in S corporation stock. S corporations are restricted to individual shareholders — an IRA (as a trust) is not an eligible S corporation shareholder.

Although the tax code places few restrictions on the nature of acceptable IRA investments, it prohibits transactions with certain parties. Dealings between an IRA and a disqualified person — such as the IRA owner, their family members, or companies they control — may constitute a prohibited transaction. Examples include:

• Borrowing money from the IRA
• Lending IRA assets to companies the owner controls
• Using IRA assets to purchase stock in closely-held companies controlled by the owner or their family

Institutional trustees and custodians generally will not allow prohibited transactions to take place — but they may not always be aware of all the circumstances. The IRA holder is responsible for any violation, not the trustee.

The penalty for engaging in a prohibited transaction is disqualification of the entire IRA. The entire value of the account as of January 1 of the taxable year (plus any earnings for the year) is taxed as ordinary income to the holder. The account's tax-deferred status is disqualified as of January 1, so any contributions made to the account that year are also disallowed. Unless the individual is age 59½ or older or is disabled, the constructive distribution is also subject to the 10% premature distribution penalty.

The rule is somewhat less stringent when IRA assets are pledged as collateral for a personal loan (rather than borrowed from directly). In that case, only the pledged amount — not the entire account — is treated as a taxable distribution.

Most IRA participants self-direct the investment of their IRA assets even though those assets are under the nominal control of a trustee or custodian. With the exceptions noted above, IRAs may be invested in a wide array of conventional and non-conventional investments.

Self-directed IRAs let investors make their own investment decisions — ordering purchases or sales in much the same way as through a regular brokerage account. From an employee's perspective, freedom of investment choice may be the clearest advantage of an IRA over coverage by another type of qualified plan. Even where an IRA is not self-directed, the owner retains the right to choose a trustee or custodian.

Mutual funds offer IRA owners a wide choice of investment options through their IRA programs. Some funds offer the flexibility to switch IRA balances between different fund types with a simple phone call. Many funds charge only a small annual maintenance fee, while others impose sales charges (loads) that reduce the amount of the IRA investment, or redemption charges upon sale of shares.

A self-directed brokerage account is an IRA established through a sponsoring brokerage firm or financial institution. Depending on the sponsor, investment choices may extend beyond stocks to include corporate and government bonds, certain option strategies, and real estate partnerships.

While offering maximum flexibility, many brokerage account investment decisions call for the expertise of a knowledgeable investor. Self-directed brokerage accounts can also be expensive for active traders, since a commission is charged by the brokerage firm on every completed transaction.

Two issues arise with respect to IRA fees and commissions: (1) are they deductible, and (2) do they count toward the annual IRA contribution limit? The answers depend on whether the fees are trustee/administrative fees or brokerage commissions.