The recently finalized Department of Labor (DOL) fiduciary rule will undoubtedly usher in substantial changes in the financial advisory community—and one result of these changes will likely be a considerable increase in the number of clients who choose to use self-directed IRAs in retirement planning. Changes in the cost structure associated with providing retirement advice is widely expected to push more middle-market clients into the self-directed IRA market because the new fiduciary standards generally do not apply to these accounts. Instead, the client acts as his or her own fiduciary. 

Despite this, the role of the advisor does not end once a client chooses a self-directed IRA—the client still needs to understand the rules applicable to self-directed IRAs, but the advisor himself must also learn where to draw the line in providing advice so as to avoid fiduciary liability with respect to these accounts.

Self-Directed IRAs and the Fiduciary Standard

A self-directed IRA is a retirement account that clients often use as a way to invest in nontraditional retirement account assets, such as real estate, precious metals or a business. As the name suggests, a client determines which assets to hold within the IRA, typically without the advice of a financial advisor.  Although third-party custodians provide the self-directed IRA, they should not become subject to the new DOL fiduciary standard because they are not providing the client with “investment advice” or recommending certain investments or financial products.

However, owners of self-directed IRAs may still rely upon their advisors for answers to questions about the investment performance of their accounts—and advisors will need to gain an understanding of when to draw the line in providing advice so as to avoid inadvertently becoming subject to the fiduciary standard.

While future guidance from the DOL is expected, as it currently stands the rule does provide some basic guidance for advisors to rely upon.

The DOL rule allows advisors to continue to provide general retirement education to clients without triggering the fiduciary standard. DOL guidance gives the example of an advisor who provides general information about the mix of assets that an average person should have based on age, income and circumstances, but makes clear that discussing specific investments would trigger the fiduciary standard. 

An advisor may also generally provide a client with historical information about assets, such as historical rates of return for different asset classes. The advisor must exercise caution in providing this advice, as providing information about specific investment options can cause the advisor to make an investment recommendation and become a fiduciary with respect to that advice.

Advisors are permitted to review the performance of the specific client’s self-directed IRA, as well—but such advice should be limited to historical performance of the account, rather than forward-looking predictions. If an advisor does become subject to the new DOL rule, he or she will likely be required to comply with the best interest contract exemption and execute a formal agreement with the client that commits the advisor to act in that client’s best interests.

Prohibited Transactions: The Basics

The client who chooses a self-directed IRA must also understand what he or she can and cannot do with that account—i.e., the client must know the prohibited transaction rules. First, the client (who is a disqualified person with respect to the self-directed IRA) is not permitted to personally purchase the assets held within the IRA. Instead, it is the IRA that must actually purchase the assets. This means that the IRA must be established first—the client is not permitted to sell his or her own assets to the IRA.

Relatedly, the client’s personal assets cannot be used for the benefit of the IRA. This prohibition extends to the client’s lending money or otherwise extending credit to the IRA, as well as to providing personal guarantees with respect to the IRA’s debt.

The client also cannot provide goods, services or facilities to the self-directed IRA. This might occur, for example, if the IRA holds a piece of real estate that the client intends to use a rental property. The client is not permitted to furnish the rental property with his or her own furniture, or otherwise provide services with respect to the property.

When a prohibited transaction has occurred, the client will be required to correct the transaction and also pay an excise tax equal to 15% of the amount involved in the transaction for each year in the taxable period.  However, if the transaction is not corrected (i.e., undone to the extent possible) within the taxable period, the excise tax increases to 100%.

This is simply a basic overview of some of the more common mistakes that clients might make—the prohibited transaction rules can be complicated, and the client should always seek competent advice before entering into a transaction. Further, the IRS has provided specific exemptions to exclude certain transactions that might otherwise be treated as prohibited from the prohibited transaction rules.

Conclusion

While self-directed IRAs may provide opportunities for clients to continue to save for retirement without subjecting their advisors to the DOL fiduciary standard, it is now more important than ever that clients and advisors alike understand the diverse array of requirements applicable to these accounts in order to avoid running afoul of both the DOL and IRS rules.

See these additional DOL Fiduciary Rule articles:

‘Rolling’ DOL Fiduciary Guidance Begins in Fall: DOL’s Hauser

Sen. Wyden Proposes Capping Contributions to ‘Mega’ IRAs

Half of IRA Rollovers to Stay in Plan After DOL Fiduciary Rule: Cerulli

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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