1974: The IRA is born! A boost for working Americans’ retirement dreams. And a tax break!
The law was called “ERISA” (the Employee Retirement Income Security Act) and with it the IRA (Individual Retirement Account) came into being. The rules were simple. If you were a working American – in any field at any income level – you could have your very own IRA and contribute up to $1,500 a year, from your wages, tax-deferred. Your IRA’s funds were held for you by a custodian – typically a large bank or brokerage house – and were yours’ to invest. With a few exceptions, your IRA could diversify into stocks, real estate, mutual funds, bonds, private businesses, commodities, intellectual property, etc. At the age of 72, Uncle Sam required your IRA to start paying him – and you – back. Which meant you had to begin withdrawing funds to pay the original deferred tax and the tax on the profits you had made on your investments.
In practice however, your ability to diversify was limited by your IRA’s custodian.
Since the banks and brokerage houses which acted as custodians focused solely on selling stocks, bonds and mutual funds, their accounting systems and administrative policies were only geared to those areas. They were neither willing nor able to handle their IRA account-holders’ wishes to purchase or invest in real estate, private businesses, commodities, intellectual property, etc. The result? Many Americans had to settle for less diversification in their IRA portfolios than they might have wished and which Congress had originally intended.
By the early 1990’s IRAs were growing in size, and needed to be upgraded.
People began to look for ways to invest their IRA funds into the other asset classes: real estate, private placements, private loans, etc. (i.e. non-traditional or “alternative” investments). Because their custodians – banks and brokerage houses – were unable to accommodate them, several trust companies with the administrative flexibility to hold alternative assets entered the IRA arena. As a result, a new level of diversification became possible for IRA investors, one that truly permitted an IRA accountholder to “self-direct” their retirement assets.
With diversification solved, timing became the issue.
Now that an IRA accountholder could invest in many different asset classes, timing became an important factor. Good opportunities might arise quickly – and with small windows of opportunity. The administrative procedures at most custodians and trust companies could actually impair a person’s ability to move in a timely fashion. The issue found resolution thanks to Swanson, a landmark legal case in 1996, and ultimately resulted in what today we call “The Checkbook IRA.”
Thank You, Mr. Swanson.
James Swanson, a U.S. taxpayer, had his IRA form a new special-purpose company, which was wholly owned by his IRA. At the same time, Mr. Swanson was appointed as the non-compensated manager of the company, authorizing him to make all decisions. Whatever profits the company made, flowed back into Mr. Swanson’s IRA. Simple, easy and effective. The Internal Revenue Service challenged Mr. Swanson on the grounds that he was engaged in a prohibited transaction. But as he was not benefiting in any way from this activity – all the profits the company made went back into his IRA to be withdrawn (beginning when he turned 72), the courts ruled rightly in Mr. Swanson’s favor. Furthermore, the courts required the IRS to reimburse Mr. Swanson for his legal fees.
In 2001, the IRS published a Field Service Advisory (FSA) to its field agents.
It confirmed the court’s ruling and stated that “in light of Swanson”, retirement accounts like self-directed, checkbook-controlled IRAs are an established, legal upgrade of the traditional IRA.
The Checkbook IRA is born.
As a result of Swanson and the Field Service Advisory, the Checkbook IRA became formalized, and allowed self-direction to go one huge step further by giving the IRA account-holder a checkbook. It is this checkbook that allows the IRA accountholder to invest his/her retirement money directly into real estate, tax liens, private placements, foreclosures, small businesses, etc. The following is a synopsis of this process. The IRA account-holder causes a new, single-member LLC to be formed and wholly owned by his/ her IRA. The IRA account-holder then directs their self-directed IRA custodian to purchase 100% ownership of the newly formed LLC with all or a portion of the IRA account-holder’s IRA funds – thus enabling the transfer of the IRA funds to the LLC. The IRA account-holder is then legally appointed by the custodian as the non-compensated manager of the LLC. In capacity of manager, the IRA account-holder is then able to open a checking account at a local bank and use its checkbook to place all investments for the LLC (on behalf of their IRA). The profits of the LLC then flow back to the IRA, either tax-deferred or tax-free (in the case of a Roth IRA). Accordingly, by transacting at the LLC level, there is no need to involve the custodian for each and every transaction. This method saves time and money. It saves time, by eliminating the need to have the custodian review and sign all contracts, issue checks, etc. And it saves money, by avoiding the transaction-based fees from the custodian. Find out more about Broad’s Checkbook IRA.
The Ultimate Solo 401(k) can trace its history back to 1875 when the American Express Company established America’s first corporate pension plan.