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September 29, 2021

The Courage to Diversify - A Brief History of the Self Directed IRA

The history of anything having to do with the government and finances is usually complicated, and – dare we say it – a little bit boring. The same is true for the Self Directed IRA. However, there is a benefit to being informed. When you learn about the history of the Self Directed IRA (and retirement accounts in general), it will get you grounded in the facts. That way you’ll be able to parse a lot of what’s written about Self Directed IRAs and know what is true, what is empty marketing language, and whether there is validity in the critiques from the financial community.

Who Offered the First Retirement Account?

The first retirement account in recorded history appears to have been in the form of a pension. In 13 BCE, the Roman Emperor Caesar Augustus offered his soldiers a pension package. Upon completion of 20 years of service, each soldier would receive a payment that was 13 times their salary. Historians believe that this payment was instituted in order to generate soldier loyalty. If so, this would be very similar to modern day companies that offer generous 401(k) plans as an employee incentive. In 1775 the Continental Congress followed suit with a pension program for America’s naval forces. The first commercial retirement account was offered by the American Express Company in 1875. Obviously this was still a far cry from the Self Directed IRA as these plans did not have voluntary investments. Rather, the income from these accounts came straight from the government or corporation’s coffers.

Income Tax Enters the Picture

The U.S. government tried implementing an income-based tax a number of times in the 1800’s but none of them lasted. That changed in 1909. In that year Congress passed the 16th Amendment allowing for such taxation. This in turn enabled Congress to then pass the Revenue Act of 1913, the nation’s first robust income tax. It was only a short while later that retirement accounts and income tax were inextricably linked. The Revenue Act of 1926 declared that income from pension plans was not to be considered part of an employee’s current taxable income.

ERISA – Retirement Law Becomes Canon

In 1974 the Employee Retirement Income Security Act (ERISA) was enacted. This laid the groundwork for all future retirement accounts. Even today when we speak about the laws regulating retirement accounts and Self Directed IRAs, most of the talking points start with ERISA. Some of the essential elements of this legislation include:

  • Set fiduciary standards for plan sponsors
  • Proper retirement plan disclosures both to the government and to employees
  • Limitations on annual contributions

ERISA led to the creation of IRA accounts. Part of the rationale behind the legislation was to make Americans more self-sufficient. Social Security can only go so far and not everybody has a job that offers a pension. With that in mind, ERISA and the establishment of IRAs allowed all workers to access a retirement account that could help them save.

The Emergence of the Self Directed IRA

The legislation that allowed the IRA to spring into existence didn’t dictate what kind of assets the IRA could invest in. Of course, there were rules to maintain the integrity of the retirement investing. These included Prohibited Transactions which prevented people from taking advantage of their retirement accounts in the here and now. In short, this just meant that neither the account holder nor a close family member could benefit from the plan before retirement. However, choice of assets was never delineated. Aside from a few specific assets (like collectibles), almost anything else was considered a legitimate IRA investment.

The reason IRAs tended to stay invested in the stock market is because of a different aspect of the legislation. An IRA has to be held by a bank or qualified custodian. The companies that fit that description tended to work mostly with stock market products. Hence, an IRA that was being held by these companies was automatically slotted into their investment model. This really only started changing in the 1980’s when independent companies began to apply for non-bank trustee status. This allowed them to hold IRA accounts but within a framework that would permit alternative assets. Finally, the Self Directed IRA was born. Account holders could now open an IRA account and choose to invest in virtually any asset.

Self Directed IRAs Achieve Independence

The next historical step for Self Directed IRAs was gaining the ability to perform transactions without going through the custodian. One of the few drawbacks with the original model of the Self Directed IRA was the time and expense involved in performing transactions. The custodian holding the Self Directed IRA had to be instructed to perform every transaction and then they had to actually do it. This obviously put a delay on transaction execution.  Even more annoying was the fact that because the custodian was dedicating manpower to the transaction, they were rightfully charging a fee for the service.

A Florida resident, James Swanson, decided to challenge this setup. In 1985 he did two things. The first was to establish an S corporation called Swansons’ Worldwide Inc. The second was to open an IRA account at Florida National Bank. Then he put the two together. Much in the same way that your IRA can invest in the stock of a major company, Mr. Swanson had his IRA invest in Swansons’ Worldwide Inc. In this case the IRA actually purchased all the shares of the company. This allowed Mr. Swanson to effectively self-direct his IRA funds by managing the company and deciding what it should invest in. It was a legal maneuver which allowed him to perform transactions without having to go through the custodian.

This setup was challenged by the IRS and in 1996 the court handed down a decision in the case of Swanson v. Commissioner. The court ruled in favor of Swanson and declared that this kind of Self Directed IRA setup was legal and did not run afoul of any Prohibited Transactions. Subsequently the IRS issued a Field Service Advisory informing their agents as to the legality of the arrangement.

This led to the development of the Self Directed IRA product that is now known as a Checkbook IRA or IRA LLC. Working with a custodian, the IRA facilitator will open an LLC or Trust that can in turn open a checking account at any bank. The IRA will then fund the LLC. This gives the account holder full checkbook control of the Self Directed IRA funds. It costs more to setup due to the procedures involved, but in the end it can save thousands of dollars in transaction fees by avoiding the custodian.

Are you ready for a Checkbook IRA?

Speak with a Broad Financial specialist and find out if this kind of Self Directed IRA would work for you.


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