InvestingBytes.com

Individual retirement accounts (IRAs) are, more often than not, made up of paper investments like stocks and bonds. However, it doesn’t need to stop there. An IRA can also be made of precious metals, real estate, or sometimes even oil and gas royalties. The income from these investments comes from the production of oil and gas wells. While the rules of the IRS provide you with a wide variety of options to choose from for your IRA, most regular options can be seen to be limited to easy-to-administer paper investments.

In such cases, a self-directed IRA needs to be opened for nontraditional investments like oil and gas royalties. Such an IRA account can be set up by investment companies that only make sure that your holdings abide by the rules of IRS but don’t give you a direction for the investment of your funds. Once the account is set up, you can deposit the funds that will then be invested by the company as per your direction.

You can invest in oil and gas with a self-directed IRA through various options like investing in a land that is being explored for minerals, investing in mineral rights of a land that is being explored, purchasing interests in oil and gas refineries, and drilling companies, acquiring commodities, and futures contracts.

However, putting oil and gas loyalties in an IRA account leads to the loss of one of the biggest advantages of the account. People usually prefer to buy royalty investments in their taxable accounts as there is a possibility of protecting a part of your income from taxes using what is known as depletion allowance. Depletion is an accounting tool that considers the chances that the oil or gas well might run dry. For instance, say your royalty is based on $30,000 of gross income, then the first $4,500 of royalty payments would be free of tax. However, when one invests in a tax-free or tax-deferred account, they lose the advantage of depletion tax shelter.