Self directed IRAs allow you to hold alternative investments in a retirement account.
A self directed IRA allows investors to hold unique and varied investment options inside a retirement account. Unlike traditional IRAs or Roth IRAs, which often consist of stocks and bonds, a self-directed IRA provides a broader selection of investment options. “As we are floating at all-time highs in the stock market, some investors are beginning to remember some of the wounds they received in the financial crisis of 2007-2008 where they saw their accounts get sliced in half and still paid advisors their traditional commissions,” says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. “This has led some to look at ways to get a little more hands-on with their qualified investments.”
Using a self-directed IRA as part of a retirement savings strategy requires some research upfront. The following is a guide to self-directed IRAs, including how they work and how to decide if this investment setup is right for you.
What Is a Self-Directed IRA?
In some ways, a self-directed IRA is like a traditional IRA or a Roth IRA. The account is designed to provide tax advantages, and participants must follow the same eligibility requirements and contribution limits. The maximum contribution limit for 2019 is $6,000, or $7,000 if you’re age 50 or older. You’ll be able to start withdrawing funds when you are 59 1/2 years old.
The difference lies in the type of investments you can hold in the account. While a traditional IRA or Roth IRA might be used to invest in CDs or mutual funds, a self-directed IRA can be invested in many other alternatives. Funds in a self-directed IRA might be used for:
- Real estate.
- Undeveloped or raw land.
- Promissory notes.
- Tax lien certificates.
- Gold, silver and other precious metals.
- Water rights.
- Mineral rights, oil and gas.
- LLC membership interest.
A self-directed IRA is not a plan you manage completely on your own. You’ll need a custodian or trustee to administer the account. “A self-directed IRA is most commonly custodied with a passive custodian,” says John Bowens, a retail sales manager for Equity Trust Company in Westlake, Ohio. Passive custodians do not offer investment advice. The self-directed IRA investor has the responsibility to find and choose an asset, carry out due diligence and direct the investment.
Advantages of Self-Directed IRAs
Investing through a self-directed IRA provides built-in tax breaks on your assets’ earnings. “As with any IRA or retirement account, one benefit is the potential to grow account balances in a tax-advantaged environment for the future,” Bowens says.
This type of account also allows you to pursue an area you might be particularly passionate about. “Knowledge gained through work experience, industry involvement and even hobbies can often be translated into viable investments,” Bowen says. You might use the self-directed IRA to invest in real estate that you then maintain to provide ongoing rental income, or you could invest in a privately held company, horses or bronze.
Diversification is another possible benefit of a self-directed IRA. If you have some funds invested in the stock market, you might opt to place other funds in alternatives like undeveloped land or unsecured loans. This setup could help protect you from potential losses during a market downturn.
Disadvantages of Self-Directed IRAs
Even if you thoroughly research an asset before investing in it through a self-directed IRA, the stakes can be high. “Many of the investments that can be selected may not be regulated, and they tend to be riskier types of investments,” says Denise Nostrom, founder and owner of Diversified Financial Solutions in Medford, New York. While the investments could bring a high return, they also could generate substantial losses.
You’ll also need to be in tune with the details of the account. There are rules regarding who you can interact with using the self-directed IRA. Your family members, for instance, are considered disqualified persons. If you purchase real estate, you’ll want to make sure your parents don’t live in it. You might have to pay penalties or taxes if certain IRS guidelines aren’t followed.
Prohibited transactions through a self-directed IRA can also lead to high fees. If you own a rental property and need to make a repair, you won’t be allowed to pay for the fix out of your own pocket. If you do, the payment could be considered a contribution to the account and you could face penalties.
And while you can invest in a variety of assets through the account, there are limits. You are not allowed to hold life insurance, collectibles like jewelry and antiques or real estate that you live in.
How to Tell if a SDIRA Is Right for You
Since you’ll direct many of the decisions of the account, including managing paperwork, transactions and communicating instructions, a certain level of dedication is needed. “If you aren’t ready to make this your job, then you may regret this decision,” Polakovic says. “There is a good chance there is going to be a lot of upfront learning and will require effort to stay current.”
If you have spent a career in real estate or have been involved in equity and company funding for decades, a self-directed IRA might be a better fit. “Self-directed IRAs can be a phenomenal asset, but the people who seem to have the most amount of success with them are those that enjoy the hobby of deal finding, not those who have now decided to jump into it,” Polakovic says.
Source: U.S. & World Report
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