Several decades ago, when American union membership began to decline and private companies started rolling back employee pension programs, the government needed to create a way to allow workers to become investors and independently save for their retirements. One of the solutions they came up with was the individual retirement account, or IRA. There are three basic types of IRAs:
- Traditional IRA
- Roth IRA
- Self-directed IRA
In a traditional IRA, a worker can elect to have a certain percentage of their salary deducted on a tax-deferred basis and put into the IRA. When the worker reaches retirement age, they can begin withdrawing from their IRA, at which point the withdrawals are subject to taxation. A Roth IRA works in much the same way, except that the contributions are taxed, meaning the investor draws on the proceeds without taxes once they reach retirement.
Both traditional IRA and Roth IRA contributions are controlled by a private manager who grows the fund’s value by investing in a variety of traditional investments. The individual investor has no control over the what investments are made, and fund managers can only use fund contributions to buy into traditional investment offerings like stocks and bonds.
However, in a self-directed IRA, or SDIRA, accounts are managed by the investors themselves. The SDIRA offers investors a much higher level of control and input over their retirement savings. SDIRA holders are also given more autonomy to put investor contributions into alternative investments, such as real estate or precious metals.
What Can You Invest in with a Self-Directed IRA?
In contrast to a traditional or Roth IRA, where all the decisions are made by the fund manager, and they are limited to traditional investments, a self-directed IRA gives investors the ability to put their money into alternative investments. Examples of the kinds of investments you can make with SDIRA contributions include:
Benefits of a Self-Directed IRA
Self-directed IRAs offer investors tangible benefits over traditional or Roth IRAs. Chief among them is direct control. With a traditional IRA or Roth IRA, an investor puts their money into a box and trusts the fund manager to grow their wealth. Investors have little input as to what the IRA’s manager does with their money or where they put it.
Sure, they get statements as to how well their fund is doing, but the early withdrawal fees and lack of liquidity means investors are pretty much stuck with whatever choices the account manager makes. A self-directed IRA investor, by contrast, is allowed to pick and choose what happens with their IRA contributions. So, for a savvy investor, this higher level of control can translate to rapid growth.
Another significant benefit of the SDIRA is the increased freedom that allows investors to use their IRA contributions to make alternative investments. Many of the alternative investments available to SDIRA holders offer higher potential returns than securities, stocks and bonds. Additionally, the ability to invest in real estate allows IRA investors to grow a portfolio of properties that can generate passive income for them in a way that traditional investments don’t.
Lastly, the SDIRA offers the investor a greater ability to diversify their portfolio. Theoretically, a SDIRA investor could use half their contributions to make the kind of slow and steady investments of a traditional IRA, while using the other half of their contributions to diversify into higher-yield alternative offerings.
Risks of a Self-Directed IRA
The independence and flexibility that comes with a self-directed IRA is a potential benefit for investors, but that doesn’t mean self-directed IRAs are not without risk. First of all, as an investor, if you’re going to decide what to do with your IRA contributions, it’s critical for you to understand investing fundamentals and how they relate to your investment goals.
Think of it this way: If you’re not an experienced driver, driving your car is probably a lot riskier than buying a bus ticket and leaving the driving to a professional. This risk level is elevated by the fact that you can make alternative investments with your self-directed IRA contributions.
Alternative investments certainly offer more upside than traditional investments but that upside also comes with more risk. This is after all a retirement account, so if you manage it poorly or make investments that don’t pay off, you’ll only have yourself to blame when there isn’t enough money in the fund to sustain you in retirement.
Liquidity also is an issue. Even though you have more control over what investments are made with your self-directed IRA contributions, the other penalties for early withdrawal still apply. In most cases, early withdrawals will eliminate all the tax-deferment benefits that come with having an IRA. So, the money you put into your self-directed IRA is pretty much untouchable for you.
Even your self-directed IRA will not be completely self-directed. Yes, traditional and Roth IRAs have a fund manager who handles all the transactions. However, your self-directed IRA will still have a “custodian.” This custodian is basically a referee who regulates what self-directed IRA investments you can and can’t make. That’s important because making prohibited transactions is just as serious as early withdrawals.
How to Open a Self-Directed IRA
There are some brokerages that act as custodians for self-directed IRAs. With that said, most of the larger, more-recognized brokerages don’t offer this service because their business model doesn’t dovetail well with investor-controlled funds. Remember, the brokerages generally earn their commissions on investment offerings they make available to clients. Supervision of clients that make their own investment decisions isn’t something with a lot of financial upside for most brokerages.
In most cases, you will have to find a company that specializes in supervising self-directed IRAs. The best place to look for these is among banks and trust companies. The catch here is that each company may have its own rules on what the custodian considers an “allowable” investment, so make sure you pick a custodian whose self-directed IRA rules are flexible enough to allow the kind of investments you prefer to be added to your self-directed IRA portfolio.
With all of this in mind, if you’re not a very experienced investor with a long track record of making successful investments, it’s advisable to hire a financial adviser to help you make investments with your self-directed IRA. They will not only be able to help you develop a coherent investment strategy, their early input should help you avoid making prohibited transactions that your custodian wouldn’t approve.
Self-Directed IRA Rules
If you want to have a self-directed IRA, you also need to follow all the rules and regulations related to your IRA. One of the most important rules is regarding “prohibited transactions.” Examples of prohibited self-directed IRA transactions include:
- Self-dealing. An IRA transaction involving the sale, exchange or rental of self-directed IRA assets with a disqualified person — basically anyone who is an immediate relative of the self-directed IRA holder. For example, you couldn’t use your self-directed IRA to buy stock in a company run by you, your child or your spouse
- Using self-directed IRA funds to extend credit, lend money to or otherwise make financial arrangements with a disqualified person
- The exchange of goods and services for financial consideration between the self-directed IRA and any disqualified person. An example of this is the self-directed IRA holder who had a plumbing company doing a copper repipe on a piece of real estate owned by the IRA holder (or the IRA holder hiring an immediate relative to perform these services).
- Using self-directed IRA assets to financially benefit or enrich a disqualified person. An example of this would be selling a rental property in your IRA but diverting the funds into your personal bank account instead of back into the IRA.
Any distributions or withdrawals you make from your self-directed IRA must be reported to the federal government. In a traditional IRA, the manager of your fund is responsible for making these reports and making them accurately. In a self-directed IRA, you are responsible for reporting on all distributions and withdrawals.
Seeing as how the penalties for making prohibited transactions or working with disqualified persons can eliminate the tax breaks that make your self-directed IRA a good investment vehicle, it’s mission-critical that you have a good custodian and follow their instructions. Failure to do so could create a financial mess that takes years to clean up.
If you make an incorrect withdrawal or early distribution, the penalties can be severe. You must also be mindful of the maximum contribution limits you can make to your IRA. For investors older than 50, the maximum annual amount you can contribute to any IRA (traditional, Roth or self-directed) is $7,000. For investors younger than 50, the maximum contribution is $6,000.
Should I Open a Self-Directed IRA?
Both traditional and self-directed IRAs offer several potential benefits to investors. Chief among them is the ability to make investments and build wealth on a tax-deferred basis, which allows you to make larger contributions and grow your wealth more quickly. The question of whether you should open a self-directed IRA depends on several variables.
If you prefer alternative investments like real estate to traditional investments like mutual funds or stocks, there may be a benefit to you opening a self-directed IRA. Many of the alternative investments have more upside and a better potential payoff, but that also comes with elevated risk. If you feel comfortable managing this risk and/or have specific knowledge about certain alternative investments, a self-directed IRA could be a great investment vehicle for you.
It’s important to understand your self-directed IRA is not necessarily a bread-making machine that you just set and forget. Even if you hire a financial adviser to help you, running a self-directed IRA will require a lot of effort and attention on your part.
You have to be honest with yourself about how much risk you can bear and how much time you have to dedicate to your self-directed IRA. Ultimately, you are the only person who can answer the question about whether a self-directed IRA is right for you. The good news is, there is nothing stopping you from having a traditional IRA and a self-directed IRA at the same time.
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