How are investments made through an IRA account?

Before learning the IRA investment process, it’s helpful to first understand exactly what an IRA account is (legally), how it invests, who is involved in the process, what it may invest in, and the types of eligible retirement accounts.

Legal Entity

In the eyes of the law, an IRA account is nothing more than a special type of trust. This trust is established when an account owner adopts a Retirement Plan Trust Agreement with a qualified IRA custodian whom is required to serve as the trustee of IRA account. Qualified IRA custodians are typically a bank, brokerage, or other financial institution, but it can be any other entity approved by the IRS to custody these account types. The standard trust agreement is a template form provided by the IRS and used by all custodians for the adoption of IRA accounts. For a standard individual IRA, IRS Form 5305 is used to adopt the IRA account; however there are many versions of this form corresponding to the different IRA account types, e.g. pre-tax, post-tax, employer, or individual. The Plan Trust Agreement will name the grantor beneficiary (account owner) and the trustee (IRA custodian), as well as detail the rules of the trust and the responsibilities of all parties.

While the IRA account owner is the grantor beneficiary of the trust (owner), the IRA custodian serves as trustee and holds exclusive signing authority for the IRA account. Upon establishment of the trust there are essentially three standalone legal entities involved, these are, 1) the account owner (you), 2)  the trust (your IRA account), and 3) the IRA custodian (the company you engaged to oversee that you are investing within the guidelines of the IRS rules). An analogy relating to the film industry may be used to portray this relationship; you (the owner) are the director of the film, the IRA custodian serves as your actors, and the trust is your film. You tell the actors how you want your film to look and they make it happen.

Making Investments

When making investments with an IRA, the account holder is responsible for performing all due diligence on the investment as well as to prepare any investment related documents as needed. The account owner will then direct the IRA custodian to make the investment which, in some cases may be accomplished through a simple click of a mouse button, such as trading stock using a brokerage IRA account, or may be much more complex such as the submission and execution of a real estate closing packet and loan application, as may be needed for a real estate purchase.

The investment purchase process is streamlined in the case of buying and selling stocks with your IRA account on a typical brokerage platform (e.g. Fidelity, Schwab, Vanguard…), where the custodian has very little interaction in the investment; they merely facilitate the transaction through the use of their online interface. However, the custodial role becomes much more apparent in the case of buying alternative investments, real estate for example, as the custodian will be reviewing and signing all agreements entered into by the IRA account.

After the investment has been made by the IRA account, the account holder would then oversee the investment; initiating transactions (buy/sell/exchange) at their discretion. The custodian would house any IRA proof of ownership documentation as well as report the IRA activities on an annual basis to the IRS.

The investment process for an IRA account will vary greatly based on your custodian’s process and the investment of your choice. In any case its important to remember that it is always the IRA account that is making the purchase and not you personally. With that said, the investment will always be bought in the legal name of the IRA account, and all cash required for the initial investment and ongoing maintenance (if needed) will be paid by the IRA account.

Roles and Responsibilities

As you can see there are a few hands in the pot, so to speak, in the establishment, funding of investments, and ongoing activities of an IRA account. Below you will find the various parties involved as well as their responsibilities in the process.

IRA Custodian

In its role as a passive custodian, the IRA custodian will not provide financial or investment advice, nor will it solicit or endorse any particular investment or asset sponsor. The IRA custodian has no authority to initiate investments on behalf of the IRA accounts without the account holder’s express permission. They do not perform due diligence on the prospective investment and will not determine whether a transaction would be deemed a prohibited transaction as outlined in the Internal Revenue Code section 4975; the “rule book” as we will cover later. It’s worth noting however, that your IRA custodian will not make the investment on behalf of your IRA account if the transaction is obviously prohibited.

  • The IRA custodians primary responsibilities include:
  • Processes applications to establish IRAs
  • Accept, document, and record personal contributions, as well as IRA transfers and rollovers to and from other IRAs/retirement plans
  • Execution of the account holders investment instructions to buy, sell, exchange, or liquidate investments held by the IRA account (investment purchases and sales)
  • Safekeeping of all IRA investment documentation such as subscription agreements, promissory notes, stock certificates, and/or any other proof of ownership of the investments made by the IRA account
  • Accounts for all income from the investments held by the IRA account
  • Facilitates account distributions (withdrawals) from the IRA account to the IRA account owner
  • Performs tax reporting of IRS Forms 1099-R and 5498 as required by the IRS
  • Provides IRA account statements
  • Complies with State and/or Federal Regulations governing IRA Custodians

IRA Administrator

IRA administrators are not IRS approved IRA custodial entities; meaning they are not a bank, trust company, or other entity approved by the IRS to hold retirement accounts. Rather, IRA administrators will partner with an approved IRA custodian who will fulfill the custodial role. However, the services provided by IRA administrators are virtually indistinguishable from that of an IRA custodian. Administrators simply serve as the front office for the custodian, which in some cases can result in better client support, technology, education, etc., as the IRA administrator is not bogged down by the day to day custodial duties.

IRA administrators are generally empowered to facilitate transactions, to provide bookkeeping and reporting services, as well as to process and report contributions and distributions. The custodial bank will house any investment ownership documentation as well as oversee and audit the administrator for compliance to the same regulations upheld by the custodial bank regulators.

IRA Account Owner

As the IRA owner your primary role/responsibilities include:

  • Establish the IRA account with the IRA Custodian of your choice
  • Oversee and initiate the movement of funds from your current retirement account provider to your new IRA Custodian via rollover or transfer; ensuring adherence to rollover rules
  • Sending in personal contributions as desired, ensuring compliance with IRS limits and proper tax reporting
  • Seek appropriate tax or legal counsel to determine whether a proposed transaction would be deemed a Prohibited Transaction as outlined in Internal Revenue Code section 4975
  • Perform proper due-diligence on prospective investments
  • Organize the documentation needed by your IRA provider to make the investment of your choice
  • Direct your IRA provider to make the investment and subsequent investment activities (buy/sell/exchange)
  • Monitor your IRA account and any investments held within making sure to notify the custodian of any unusual or unexplained activities
  • Adhere to your IRA providers requirements pertaining to annual valuations (if required)
  • Request distributions as desired, ensuring adherence to proper personal tax reporting
  • Understanding that certain investments made with an IRA account may generate Unrelated Business Taxable Income or Unrelated Debt Financed Income. This tax is triggered when investing in operating companies and/or whenever debt is used by the IRA to generate revenue. The account owner should consult with their tax professional to determine if tax is due, and if so prepare Form 990-T, instructing their custodian to send the tax payment. This is an IRA tax liability and not a personal tax liability