Self-directed IRAs (SDIRAs) are becoming more and more popular as IRA holders look to enter alternative investments. While SDIRAs can open up a world of investment options, the rules around them are complicated and compliance can be tricky. Below, we’ll look at a couple of relevant court cases that illustrate some of the potential pitfalls.
Self-Directed Equals Higher Fees
A SDIRA can own an investment in pretty much any type of asset except life insurance or collectibles. The downside to accessing investments beyond stocks, mutual funds, ETFs and bonds is that it is more expensive.
The SDIRA custodian usually charges an annual fee as well as per transaction fees. The assets also need to be valued at the end of every year for reporting purposes so there is usually a custodial appraisal or valuation fee. These fees and structures often lead to SDIRA owners taking shortcuts to save money or ease administration.
Side-Stepping Rules is Looking for Trouble
One recent case that went before the tax court involved a taxpayer whose SEP-IRA owned an LLC where he was the only owner and manager, with a national bank as the custodian. The taxpayer opened a checking account for the LLC at the same bank.
The taxpayer took distributions from his SEP-IRA and put the money into the LLC account. He then used the money to fund loans on real estate to third parties. The loans paid back over time and the repayments, including interest, were deposited back into the IRA.
The bank issued a Form 1099-R reporting the distributions as taxable events; however, the taxpayer included this income on his tax return. The IRS taxed distributions, plus the 10 percent penalty because he was under 59½. The case went to tax court with the taxpayer claiming he never actually took distributions because the money went from the IRA custodian to the LLC checking account.
The tax court found in favor if the IRS for several reasons. Most important of which is that the taxpayer held full control of the funds that were distributed. Another mistake was that he owned the LLC, which held his checking account and not the IRA. As a result, the bank as IRA custodian no longer held legal control over the money.
In the end, the taxpayer didn’t want to change custodians from the national bank, which held his SEP-IRA, because he didn’t want to pay the fees associated with setting-up a proper SDIRA. If he had, then he could have structured the investments to be made via the LLC, with the IRA as the owner of the LLC and avoided the taxable distributions completely. In the end, it cost him far more than the fees ever would have.
Collectibles Versus Property and Possession
In another case that went before the tax courts, the taxpayer opened an LLC owned by her IRA where she was the sole managing member. The IRA then purchased American Eagle gold coins, which she took physical delivery of and held in her possession.
IRAs are not allowed to own collectibles, with gold bullion and coins generally considered collectibles. There are exceptions however, with gold American Eagles being one of them – so no issue here.
The problem centered on whether the taxpayer took physical possession of the coins. The tax code says that exempt precious metals can held in physical possession by an IRA custodian. As a result, the taxpayer taking physical possession of the gold was deemed a distribution.
These two cases show that LLCs created to invest through a SDIRA must follow all the IRA rules. This is because the IRA is the entity considered to be engaged in all transactions executed by the LLC. Further, the IRA owner shouldn’t be the managing member of the LLC or take physical possession of the assets. It should always be the IRA custodian who holds the assets and maintains control.
According to the U.S. Bureau of Labor Statistics (BLS), the Producer Price Index (PPI) or the increase in prices, goods and services that producers experienced for their input costs, saw a substantial rise, according to its latest report issued on Dec. 14.
For November 2021, the PPI grew by 0.8 percent. For the past year ending in November 2021, it rose by 9.6 percent on an annualized basis. According to the BLS, this is the hottest PPI reading since this metric originated in November 2010. With costs not appearing to abate anytime soon, how can businesses combat rising costs?
Figure out Financial Priorities
Harvard Business Review (HBR) details steps that companies can take to evaluate and make adjustments to mitigate the rising cost of inflation. The first decision is to determine “high-resolution spending visibility,” which means a fully transparent documentation of how much money is spent, in what way it’s spent and how effective such spending is in the organization.
When it comes to effectively deploying capital, HBR recommends reducing expenses and/or investing capital to grow and maintain a businesses’ market edge. If there’s a unique customer experience that would suffer, that might not be the right area to cut. However, HBR cites an energy business that conducted an audit of its operations and determined a savings of $10 million was possible if it temporarily suspended 80 business operation expenses.
Analyze Past Spending for Future Efficiency
After a business understands spending patterns and how they impact profitability, this can be analyzed to see how to work around inflation. HBR gives the example of how “external groups” beyond the decision makers on new build projects cost certain companies more than $400 million and six months of time. By using “cross-functional collaboration,” costs that could be cut or work that could be done differently gave the company a way to realize greater efficiency.
Reduce Choices for Consumers
As the competition among employers to find and retain workers is tough, including the pressure to raise wages, simplifying what a company offers can help reduce costs.
Mondelez International, a global producer of comestibles, reduced the number of products it offered to customers by 25 percent when the COVID-19 pandemic started. Similarly, hotels began reducing the need for housekeeping by asking guests, especially during the pandemic, if they needed their rooms freshened up during stays.
Selectively Digitize Tasks
When it comes to businesses fighting for their survival, one silver lining of the pandemic is automation. Many companies discovered the benefits of automation, including higher profits, gains in output, etc.
HBR explains that processes on data for products, such as weight, size, images, etc., can be automated, freeing up human workers for higher level tasks, such as analysis and projections. Citing the example of David’s Bridal, through its Zoey messaging concierge service during the beginning of 2020, appointment and communication center expenses fell by 30 percent. This helped shift human workers to devote more time to in-person assistance.
While there’s no magic recipe to combat inflation, by analyzing a company’s books and keeping up with trends, there are many ways to affect cost savings.
According to a Dec. 15 Federal Open Market Committee (FOMC) statement from the Federal Reserve, the federal funds target range will remain at 0 percent to 0.25 percent. Beginning in January, the FOMC will reduce its monthly purchase of assets to $40 billion in Treasury securities and $20 billion in mortgage-backed securities, with tapering expected to finish well before mid-2022. The FOMC also projects three rate hikes in 2022. These monetary policy adjustments are all subject to change based on the economic developments going forward, signifying uncertainty for markets in 2022.
What History Says
Looking back to the last “taper tantrum” in 2013 when Ben Bernanke was in charge of the Federal Reserve, equities lost 5.8 percent during June 2013 (similar to the decline in markets during September 2021). While many considered this a “market pullback,” the S&P 500 saw gains of 17.5 percent for the rest of 2013. Looking from WWII onward, there’s been 60 instances of the stock market falling initially by 5 percent to 6 percent, but the next month it was up 3.3 percent on average, and 92 percent being higher by year-end.
From the second half of December 2013 through October 2014, the S&P 500 advanced 11.5 percent, primarily because Wall Street was confident in the economy’s health in growing with the Fed’s bond-buying.
After the rallying months, markets have gained an average of 8.4 percent 100 days later. For the 2021-2022 cycle, the rally is expected to go through January 2022. However, historical S&P 500 trends suggest volatility and a drop of 5 percent or greater in February 2022. February is generally the second worst month of the year for market performance.
What’s Happening this Cycle
Fed Chair Powell clearly indicated that rates are to be raised soon and inflation is expected to stabilize. Inflation is expected to hit 6 percent in Q4 of 2021, and trading on Wall Street is expected to see bearish trends to start 2022.
Since the Fed has been crystal clear about tapering, such communication has likely resulted in a relatively smoother transition for the markets. According to the Board of Governors of the Federal Reserve System, quantitative easing (QE) began in 2008 due to the financial crisis, was rolled back at the end of 2018, but the Fed became more accommodative again during the COVID-19 crisis. As of October 2021, the Fed’s balance sheet was $8.5 trillion. This was double what the Fed’s balance sheet was in early 2020 and 10 times as large from mid-2007 levels of $870 billion.
With Powell yet to be reconfirmed for a second term, there is uncertainty, along with the 2022 mid-term elections and pressure from progressive politicians looking for a dovish Fed chair.
Powell’s comments at the recent FOMC meeting explained that once COVID-caused jams to the supply chain are resolved, inflation will subside. This perspective, paired with his continual observation of the economy and flexibility on raising rates, has become a tug-of-war between the Fed and Wall Street investors on market performance. The Fed also indicated that once the bond-buying is complete, it’s not an automatic trigger for interest rate hikes. However, depending on how inflation plays out, the market will have its own interpretation of how the Fed will react to unfolding inflation.
Putting the Fed’s Moves Into Perspective
QE and lowering the Fed funds rate both can be effective monetary policy. QE helps when the Fed increases its balance sheet by buying long-maturity bonds and mortgage-back securities to drive lower yields. Lower interest rates enable cheaper borrowing, which can help the economy grow employment and increase growth. If QE is rolled back, there will be uncertainty over whether the economy can stand on its own two feet.
The true question of the potential impact on markets is whether the Fed will taper only or also reduce its balance sheet holdings. Other ways the Fed can tighten monetary policy is by adjusting short-term interest rates via the discount window/federal funds rate. The Fed similarly can sell assets from its balance sheet via open market operations (OMO).
In November, President Biden signed legislative funding that represents the largest transportation spending package in U.S. history. The $1.2 trillion Infrastructure Investment and Jobs Act authorized funding for roads, highways, bridges, public transit systems, utility systems, electrical grids, energy projects and broadband infrastructure.
Because the funding extends over a five-year period, it should not have a major effect on the fiscal deficit. This is not only good news for taxpayers, but also investors. Those long-term investments offer the potential for shareholders to get in on the ground floor of reliable and well-capitalized government projects by hundreds of American companies poised to get the business. The new bill is expected to enhance productivity, innovation, improve labor force participation and have a positive impact on inflation. Overall, the bipartisan bill is expected to help drive economic growth for the foreseeable future.
Because this funding has been long-awaited and is badly needed, infrastructure projects that have been in the planning stages for years can finally take off. Furthermore, the federal funds will be allocated to local public-private partnerships, which enable community job development and enhance local economies.
More than $110 billion is directed to repair and rebuild 45,000 bridges, highways and major roads across the country. The funding also focuses on climate change resilience, as well as safety (reduce traffic fatalities) and parity across geographic areas and demographic populations. Industries poised to benefit include:
- U.S. steel companies
- Companies that produce aggregate materials (e.g., gravel, crushed stone, sand)
- Manufacturers of construction, roadbuilding, earthmoving and mining equipment
- Companies that lease heavy equipment
Presently, more than 30 million U.S. residents live in areas with either poor or no broadband access. Particularly during the pandemic, we have learned how important internet access is to keep Americans connected – in jobs, through online education, with community news and resources – not to mention social networks and personal relationships. The new legislation provides $65 billion in funding for broadband infrastructure, particularly in rural communities throughout the country, in an effort to provide universal access to reliable high-speed internet. Investment sectors that should benefit include:
- Manufacturers of wireless towers
- Power management companies that supply the electrical components and systems for wind and solar farms to integrate them into the national grid
Water Utility Infrastructure
The bill allocates a $55 billion investment into water infrastructure and the elimination of lead pipes for the 10 million American households and 400,000 schools and childcare centers that currently lack safe drinking water. Investment opportunities include utilities and companies that specialize in:
- Water distribution
- Water filtration
- Flow technology
- Water treatment/purification
- Manufacturing pumps, valves and desalination units
Currently, the United States has a repair/replacement backlog of more than 24,000 buses, 5,000 rail cars, 200 stations and thousands of miles of tracks, signals and power systems. To update and expand the nation’s public transit system, $66 billion will go toward passenger rail, $25 billion to upgrade U.S. airports and $17 billion for ports throughout the country. In addition to bolstering the nation’s supply chains and transportation systems, upgrades will focus on reducing emissions and deploying more electrification and other low-carbon technologies. Industry sectors that should benefit include:
- Marine transportation
- Delivery services
- Logistics companies
Sustainable Energy Sources
The infrastructure bill allocates $65 billion toward upgrading the nationwide power infrastructure with new lines for the transmission of renewable, clean energy. Another $7.5 billion is earmarked to install 500,000 electric vehicle (EV) chargers along highway corridors to accommodate the fleet of electric consumer and commercial cars currently in production. Opportunities in sustainable energy investments include:
- Electric vehicle industry, including government fleets of electric vehicles, such as U.S. mail trucks
- Companies that build EV charging stations
- Commodities used in green materials, such as copper (electric vehicles and renewable energy sources use four times more copper than internal combustion vehicles)
Given the breadth of infrastructure opportunities on tap, one way for investors to get exposure across the wide range of industries is to invest in a diversified infrastructure or utility funds (mutual fund or ETF). Through a single, professionally managed investment, investors can spread their capital across a wide spectrum of engineering and construction firms, rail travel companies, electricity providers, water and sewage services, and more.
Believe it or not, the New Year is here. If you’re trying to wrap your head around everything that’s ahead, one of the best things you can do is prepare yourself financially. Here are a few tasks you can get started on right away.
Look Back at 2021
Depending on how in-depth you want to go, this could take a couple hours or more. That said, ask yourself these questions: Did you spend as planned? Where do you want to adjust, increase or decrease spending thresholds? What kind of unexpected expenses came up? How did you handle it? Think about what you’ll do for the upcoming year. When it comes to money, the cliché “hindsight is always 20/20” will often ring true.
Tackle Your Debt
If you want 2022 to be the year you become debt free, it can happen. We’re talking about consumer debt, not your mortgage, rent, car payments or any other necessities. A good strategy is to make a list of your credit cards, balances and interest rates. Start with the account balances that are the highest and create a payment plan, then move down the list until you’re finished. Balance transfers to cards with zero interest (for a limited time) are a smart idea, too. Then freeze your spending for 30 days, or however long you need. It might take some time, but these days, financial freedom is well worth it.
Increase Your Retirement Funds
Good news: the maximum contribution limit for your 401(k)s increases by $1,000 in 2022 compared to 2021, for a total of $20,500. If you’re 50 or older, the limit is $27,000, which is great for those closer to retirement. If you can’t max out your contribution, just increasing it by one percent can have an incredible effect. According to calculations from Fidelity Investments, if you’re 35 and earning $60,000, this tiny bump could yield an additional $85,000 to your retirement fund over a 32-year period. That’s equal to putting aside $12 per week (how easy is that?), assuming a 5.5 percent return and consistent salary growth.
Create a Back-Up Plan
This probably isn’t something you want to think about, but it’s necessary should something happen to you. Take few minutes to update your beneficiaries on all your financial accounts, including retirement, investment and benefits accounts. Next, make sure you have a durable power of attorney, someone you trust to take care of all your monetary affairs. After this, designate a health-care proxy or power of attorney, who can speak for you if you become incapacitated. Finally, update your will. Decide who will inherit your assets. If you have children, you can even assign guardians for them. In the long run, if the worst-case scenario unfolds, you’ll save your loved ones a lot of time and trouble.
Carve Out Time for a Life Audit
This task might sound big, but it’s necessary if you want to achieve your dreams – financial or otherwise. Start with a pen or pencil, about 100 sticky notes, a journal and a large space, perhaps a door, board or wall. Turn your phone off, then get started. Look back at your life. Assess where you’ve been, where you are and where you’d like to go, then brainstorm. Do you want to save a certain amount of money this year? Put away some cash for a dream trip? Learn a language? When you think you’ve finished, then organize your goals into three categories: personal, work/career and money. After that, further divide them short-term and long-term goals. Take a photo of your notes and keep it near to remind yourself of what you’re trying to accomplish. More often than not, your dreams involve money, which is directly related to your priorities and how you budget.
Budget for 2022
Now that 2021 is in your rearview mirror (and perhaps you’ve even done a life audit), take what you’ve decided upon and create a budget you can live with. Then, download a budget app to keep you on track. If last year’s budget worked well and you’re already on your way to living your dreams, just hit “repeat.” If not, make necessary changes. That said, no matter the status of your finances, it might be a good idea to increase your emergency fund, given all the uncertainty we’re facing in our world.
If you think about it, taking time in January to look closely at your finances is kind of like going to the doctor for your yearly checkup: You want to make sure there are no red flags you need to address. After all, your fiscal health might be as important as your physical health.
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