If the term “self-directed custodian” doesn’t inspire a particular vision, don’t worry, you are not alone. You may be a seasoned investor and very familiar with retirement plans like 401(k)s, individual retirement plans like IRAs, and traditional brokerage accounts. Conversely, you may be at the beginning of your investing journey, sorting through acronyms and investment possibilities. Regardless of where you fall, “custodian” selection is not likely a top consideration.
Most custodians look very similar, and for those seeking large publicly traded investments, it often doesn’t matter who you choose. But if you want to access to a wider variety of typically private, "off the beaten path" investments, then it is critical to understand the importance of your choice of custodian. Indeed, selecting a “self-directed” custodian empowers you with a broad array of investment choices that could help you reach your investment goals with your tax-sheltered retirement and health savings dollars. However, by the virtue of self-direction, such custodians are unable to direct your specific actions or provide investment, financial, or tax advice.
Most of us learned to invest in the same way you would select from a pre-set menu. Like the famous quip from Henry Ford, “customers can select any color they wish, as long as it is black,” your investments largely follow a familiar set of public stocks, bonds, mutual funds, and, more recently, ETFs. These can work well but are far from your only investment options available. In this post, we will introduce the basics of custodians for tax-sheltered plans, answering questions like:
For the pre-set menu investments, the custodian was likely only in the background, hired by the brokerage or mutual fund company to provide custodial functions and reporting. Since the menu was already printed, you didn’t need to worry about the background functions. The custodian only supported that particular menu of investments, nothing customized for you.
Hiring a self-directed custodian gives you freedom to venture off script and make your own choices. As a self-directed custodian, New Direction Trust Company plays a vital role in supporting your “off-menu” investment selections while retaining the tax advantages of your tax-sheltered plans.
Think of us as a bank of sorts. Similar to a checking account at a bank, IRAs, 401(k)s, Health Savings Accounts (HSAs), etc., are all held at a company like ours. The IRS stipulates that retirement and HSAs must remain in the custody of an organization like NDTCO, maintaining a buffer between you and this special tax-advantaged account.
The main responsibility of a financial custodian is to hold the plan’s assets and cash. As previously mentioned, maintaining a buffer between individual account owners and accounts is important. By holding the cash for you, the custodian ensures that you cannot simply hand over money to a seller and receive the asset yourself — your account, not you, must remain the “investor.” You instruct NDTCO to execute the investment on behalf of your account. NDTCO will then send the money from your account to the investment seller, and the seller will fulfill their end of the transaction by releasing the asset to your account. At the completion of the process, the asset will be “owned” by your account and not by you. NDTCO’s custody will specifically and legally define this distinction.
Once the asset is acquired, ongoing cash movement related to the asset is key to successful management. The custodian provides access to tools and systems to facilitate things like payment of utility bills, property taxes, and HOA dues, as well as processing for receipt of rents, interest, and dividends into the account. NDTCO’s online portal provides tools to easily initiate payments as well as monitor incoming cash receipts.
When you file your income taxes every year, you must gather the applicable documents, prepare your return, and send it off to the IRS. Similar to individual income tax filings, your IRA also has to tell the IRS what’s going on each year for the plan. Although the return is informational only, it doesn’t include a tax due! NDTCO handles this process on behalf of account holders.
In addition to a few other forms that may only be needed for particular investments, NDTCO automatically generates an IRS Form 5498 for your account each year. We send a copy to you and another copy to the IRS, leaving nothing for you to do in relation to this process. Form 5498 describes the fair market value of your account as of December 31, the prior year, and also reports any contributions you made during the previous year.
Another common tax form is Form 1099, which is only generated for distributions taken from your account in the previous year. As with Form 5498, NDTCO will send a copy of Form 1099 to the IRS and a copy to you. If you owe income taxes as a result of a distribution, you’ll simply include payment with your regular income tax filing.
A big part of maintaining the tax benefits of your self-directed account lies in following the IRS rules. Prohibited transactions, be they intentional or unintentional, may result in the forcible distribution of an asset and possibly the entire account. But don’t worry, NDTCO can help you prevent that from happening!
As the conduit between you and your self-directed account, we may be able to identify a prospective prohibited transaction and assist in preventing the violation, and, in some cases, rectifying the issue. In doing so NDTCO can lend a hand in maintaining the IRS compliance of your account and your investments, thus helping retain the tax advantages of your account. We also offer numerous courses and webinars aimed at providing education to help you understand the rules.
Most financial custodians offer a suite of account options, but most only offer their accounts via a connection with an investment provider. Very few are available for hire directly to individuals, and even fewer offer true self-direction to their clients. As a result, most custodians effectively limit their accounts to invest in stocks, mutual funds, and other publicly traded instruments. Some don’t even allow their clients to choose which of those their accounts can hold.
At NDTCO, we proudly enable our clients to invest in a much wider variety of assets. In fact, the Federal tax code only prohibits a few very specific investments, which is generally interpreted as permission to hold all other alternative investment types provided the IRS rules are followed. NDTCO clients invest in real estate, private lending, private equity, precious metals, and many other alternative investment options, all available to you as a self-directed investor!