As the President of a Self-Directed IRA custodian, I am frequently asked what a Self-Directed IRA custodian is and how it varies from a regular bank or financial institution by clients, friends, and coworkers.
An IRA can only be established and administered by a bank, financial institution, or approved trust business in accordance with state law, according to IRC Section 408. The entity that manages your retirement account is known as an IRA trustee, sometimes known as a custodian. Every individual retirement account is required by law to have a custodian or trustee.
Approximately 50 million IRAs are currently invested in traditional asset investments. This covers equities, mutual funds, and exchange-traded funds (ETFs). Since the financial crisis of 2008, however, retirement account investors have grown more aware of the benefits of alternative investments. They’re starting to realize that it can help diversify their retirement account investment portfolio and operate as an inflation hedge.
Alternative assets are acceptable for an IRA, with the exception of life insurance, collectibles, and certain self-dealing and conflict-of-interest transactions as defined by Internal Revenue Code Section 4975.
For one simple reason, most banks and financial organizations that offer IRAs only allow their IRA clients to invest in traditional assets such as stocks and exchange traded funds since this is how they make money. The IRA custodian has the discretion to pick which IRS-approved investments are available to their clients.
What is the IRA trustee?
A trusteed IRA is a type of Individual Retirement Account in which the Financial Institution that maintains the IRA manages it as a trust (for which it serves as trustee), rather than just as a custodial account. In fact, an IRA is designed to be structured as a trust account by default under IRC Section 408(a), while a custodial account may be treated as a trust account (and so meet the IRA requirements) under IRC Section 408(b) (h).
In reality, this implies that a trusteed IRA is governed by a trust document, which the IRA owner signs and agrees to upon opening the account (and may assist create and structure up front), and for which the Financial Institution will function as trustee, subject to the IRA owner’s instructions. A custodial IRA, on the other hand, is one in which the Financial Institution just holds the assets on behalf of the IRA owner, who retains complete legal control over the account. This distinction whether the IRA is literally controlled by the IRA owner (with the Financial Institution serving as custodian) or whether the IRA is controlled by a trust document (with the Financial Institution serving as trustee and taking direction from the IRA owner) may appear to be minor, but it has significant implications.
However, regardless of whether the account is set up as a custodial IRA or a trusteed IRA (or as an Individual Retirement Annuity, or “IRA Annuity,” under IRC Section 408(b)), the laws regulating IRAs are the same. The standard IRA tax rules apply in all cases, including the ability to deduct IRA contributions if the requirements are met, the taxability of distributions when received, the risk of early withdrawal penalties prior to age 59 1/2, and the requirement to take Required Minimum Distributions after age 70 1/2.
However, both during the life of the IRA owner and especially after death, the functioning of a trusteed IRA and the role of the trust document that regulates it differ significantly from that of a custodial IRA.
What does it mean to be a custodian of an IRA?
An IRA custodian is a financial institution that safeguards your account’s investments and ensures that all IRS and government rules are followed at all times.
Can I be the trustee of my own IRA account?
While you’re alive, you can’t put your individual retirement account (IRA) in a trust. You can, however, name a trust as the IRA’s beneficiary and direct how the assets are handled after your death. This is true for all IRAs, including regular, Roth, SEP, and SIMPLE IRAs. If you wish to place your IRA assets in a trust as part of your estate plan, you need think about the characteristics of an IRA and the tax implications of particular activities.
What is the difference between a custodial IRA and a Traditional IRA?
A custodial IRA permits the account holder (in this case, your child) to put money aside for retirement after taxes. A custodial Roth IRA functions similarly to a standard Roth IRA in most ways.
The fundamental distinction between these two sorts of accounts is: Because custodial Roth IRAs involve minors, they must be supervised by a parent (or another adult).
Is Fidelity an IRA custodian?
Although the Custodian of my IRA, Fidelity Management Trust Company (FMTC), is (and its successor custodian may be) a bank, I understand that neither Fidelity Distributors Company LLC nor any mutual fund in which this IRA may be invested is a bank, and that mutual fund shares are NOT I deposits or obligations of, or (ii) securities of, any bank.
Why do I need a custodian for my IRA?
An IRA is a custodial account, which means it requires the services of a custodian to keep its tax-favored status. The custodian guarantees that all investments are approved by the Internal Revenue Service and that the taxing authority receives all relevant reporting and paperwork. The custodian acts as the account’s primary overseer and performs tasks such as providing investment performance statements and purchasing and selling IRA investments.
Who regulates IRA custodians?
We occasionally come across the perplexing myth that individual retirement accounts (IRAs) are unregulated, like in this recent Wall Street Journal article.
The truth is that IRA participants benefit from a thorough regulatory structure that regulates the IRA, IRA providers, and, in most circumstances, the investments kept within the account.
Let’s go over the basics of the IRA regulatory structure to clear up any misunderstandings.
An IRA is often a trust arrangement in legal terms, with the account being kept in trust for the owner by a trustee or custodian. The custodian will most likely be a bank or a nonbank financial services organization. Each of these categories of caretakers is bound by a set of strict rules:
- Banks are regulated by the Federal Deposit Insurance Corporation, which sees them as fiduciary trustees.
- Nonbank IRA custodians are regulated by the Internal Revenue Service (IRS). Any nonbank trustee or custodian must demonstrate to the Internal Revenue Service (IRS) that it can meet a set of regulatory standards. One of these needs is the ability to act in accordance with accepted fiduciary standards by proving business continuity and having a fixed location, as well as fiduciary expertise, fiduciary procedures, and financial accountability. Nonbank trustees and custodians must also show that they have procedures in place to help them manage their fiduciary powers, such as annual audits of their books and records.
Individual retirement annuities are also possible, but the annuity contract must be provided by an insurance business that is regulated by the state.
IRA owners profit from the laws around those assets when they choose an investment that meets their needs. Consider mutual funds, which accounted for 47 percent of IRA holdings as of the first quarter of this year. Mutual funds are subject to a rigorous, comprehensive regulatory regime, as discussed in more detail here. Mutual fund assets are held in rigorous custody to avoid Ponzi schemes, and their value is marked-to-market every day using strict pricing methods. To avoid the pitfalls that tripped up certain other financial products during the previous financial crisis, funds must operate with a simple capital structure and extremely little usage of leverage. These safeguards are backed up by strict disclosure rules and monitored by independent directors who act as watchdogs for investors’ interests.
Deposits (which are controlled by state or federal banking authorities) and annuities are two other IRA investments (regulated by state insurance commissions). The remaining assets are invested in a variety of securities and commodities-related instruments, including ETFs, closed-end funds, stocks, bonds, and commodities, all of which are regulated by securities and commodities regulators. It’s also feasible to own real estate, private businesses, or other non-traditional assets that aren’t regulated by state or federal governments. While no full data on non-traditional investments held in IRAs is available, they appear to make up a modest percentage of total IRA holdings.
When an IRA owner consults a financial planner, adviser, or broker about investing the assets of an IRA, the planner, adviser, or broker may be bound by fiduciary requirements or be bound by other professional standards.
- Investment advisors are governed by the Investment Advisers Act of 1940, state adviser legislation, or both, and are bound by fiduciary commitments to their clients. These guidelines, which are intended to prevent advisers from overstepping their bounds or exploiting clients, require them to operate in the client’s best interests. The Advisers Act also imposes fees and advertising obligations on advisers.
- Under the Financial Industry Regulatory Authority’s jurisdiction, brokers are bound by standards of fair practice and advertising. Brokers must make adequate and relevant securities recommendations to customers, and brokers must disclose conflicts of interest on a transactional basis.
Washington regulators are still looking into methods to protect retirees. The implementation of fiduciary duties is one prominent endeavor. The Department of Labor suggested a dramatic modification of the Employee Retirement Income Security Act’s definition of fiduciary last October (ERISA). Separately, the SEC is considering the findings of a Dodd-Frank Act-mandated study on the standard of care for broker-dealers providing retail investment advice. The SEC staff proposed that all broker-dealers and investment advisers be held to a universal fiduciary obligation in that research. ICI has made comments on both the Department of Labor’s fiduciary proposal and the Securities and Exchange Commission’s standard of care research.
- ICI’s Testimony at the Department of Labor’s Fiduciary Definition Proposal Hearing
- ICI Testimony to the ERISA Advisory Council Working Group on Retirement Security Approaches in the United States
Who owns an IRA?
Custodians manage all IRA accounts for investors. Banks, trust corporations, and any other business permitted by the Internal Revenue Service (IRS) to function as an IRA custodian are examples of custodians. The majority of IRA custodians limit IRA account assets to firm-approved equities, bonds, mutual funds, and CDs.
What happens if a trust is the beneficiary of an IRA?
When a trust is specified as the beneficiary of an IRA, when the IRA owner dies, the trust receives the IRA. The IRA is then kept as a separate account and treated as a trust asset. The following are some compelling reasons to name a trust as an IRA beneficiary rather than an individual:
- Getting around the beneficiary’s ownership restrictions. Perhaps the intended beneficiary is a minor who is unable to own the IRA due to legal restrictions. Perhaps the IRA owner wishes to help a special needs individual who will lose government benefits if he or she owns assets in his or her own name. In both circumstances, naming a trust as the IRA beneficiary, which will then become the legal owner in place of the minor or special needs individual, could be a viable solution.
- Solving problems involving a second marriage or various types of family configurations. During the lifetime of his second husband, an IRA owner may desire to have RMDs benefit his second spouse, with the remainder of the IRA passing to his own children. If an IRA owner leaves his IRA to his spouse outright, he can be sure that his spouse would profit, but he can’t be sure that his children will. His objective to help both sets of beneficiaries can be realized if he instead leaves the IRA to a properly formed trust.
- Putting a stop to a beneficiary’s access. We commonly think of IRA beneficiaries taking only the necessary minimum distributions, but an individual who inherits an IRA has the option of taking bigger distributions or even withdrawing the whole account balance. The access of a beneficiary of an inherited IRA owned by a trust, on the other hand, will be limited by the trust’s conditions.
- The process of naming subsequent beneficiaries. When an individual inherits an IRA, she has the option of naming her own initial successor beneficiaries. If the IRA owner wants to have more control over the successor beneficiary than the initial beneficiary, the succession provisions must be written in a trust and the trust must be named as the IRA beneficiary.
- Creditor protection is provided. A person’s personal IRA is protected from creditors to some extent, but this does not always apply to an inherited IRA. In Clark v. Rameker (2014), the United States Supreme Court held that inherited IRAs are not immune from creditors’ claims as “retirement funds” under the Federal Bankruptcy Code. An inherited IRA held in a properly constituted trust will not be a beneficiary’s asset and will have some creditor protection.
- Providing funding for estate plans that are geared to avoid estate taxes. The majority of rich persons’ estate plans incorporate trusts designed to reduce and defer the payment of federal and state estate taxes. The component of these trusts that shelters an individual’s federal or state estate tax exemption levels must be financed at the individual’s death for such estate plans to work as intended. An IRA is frequently the sole asset accessible for this purpose.
Should I put my house in a trust?
The opportunity to avoid probate is the principal advantage of putting your house into a trust. The probate process is public information, but the transfer of a trust from a grantor to a beneficiary is not. You can also bypass the multistate probate process by putting your house in a trust.
Does an IRA go through probate?
Traditional IRAs are governed by a complex set of rules. Six key differences exist between IRAs and other financial assets:
Regardless of what you specify in your will or living trust, your IRA account has a beneficiary who will receive your IRA upon your death.
In states where probate is difficult, this can save a lot of time and money.
Any IRA distributions are taxed as ordinary income, not at the lower capital gains rates.
When a person dies, most of their other assets incur a step-up in cost basis, wiping out all capital gains on those assets up to that point in time. IRAs, on the other hand, are a different story. The beneficiary of your IRA will pay regular income tax at his or her rate on any distributions.
You must first take a distribution, pay the income tax and any relevant penalties, and then make the gift if you want to contribute portion of your IRA to an individual or organization. For persons over the age of 701/2 who give $100,000 or less to a qualifying charity, there is an exception called the Qualified Charitable Distribution (QCD). If all of the QCD’s criteria are met, the distribution is deducted from your taxable income.
- The only asset in your estate subject to Required Minimum Distributions is a traditional IRA (RMDs).
When you die away, RMDs apply to both you and your beneficiary. The requirements for RMDs are particularly complicated, and they rely on whether the beneficiary is your spouse, the age difference between you and the beneficiary (if the beneficiary is your spouse), and whether you had begun taking your RMD prior to your death. While the IRS is fine with you having deferred growth in your IRA for many years, you must withdraw a portion of your IRA and pay ordinary income tax on it in the year you turn 72 (70 1/2 if you turned 72 before January 1, 2020). These RMDs will be renewed every year after that.
What does it mean if you are a custodian on a bank account?
The Uniform Transfers to Minors Act (UTMA) accounts and the older Uniform Gift to Minors Act (UGMA) accounts are the two types of custodial accounts. The key difference between them is the type of assets you can provide.
Real estate, intellectual property, and pieces of art are all examples of assets that can be held in UTMA accounts. Cash, securities (stocks, bonds, or mutual funds), annuities, and insurance policies are the only financial assets allowed in UGMA accounts. UGMA accounts are permitted in every state in the United States. South Carolina, on the other hand, does not accept UTMA accounts.
Custodial accounts are set up in the minor’s name in both UTMA and the previous version UGMA, with a designated custodianusually the child’s father or guardian. The company that houses the account sets the initial investments, minimum account balances, and interest rates.