We like to have options, whether it’s a closet full of different wardrobes or dozens of flavors to choose from at our favorite ice cream shop.
Self-directed IRAs allow investors to have more control over their investment choices. An IRA, or Individual Retirement Account, is a personal savings plan that offers tax advantages. Self-directed IRAs offer the same tax advantages as regular IRAs, but with more investment options.
Sounds great, right? But hold up! Since we’re dealing with less mainstream investments, self-directed IRAs can also be more complicated. We are discussing a long list of rules and guidelines to follow, high-risk investments, complicated fees, and the burden of more responsibility for your investment choices.
We need to take a close look at self-directed IRAs to understand how they work and decide if they are a good option for retirement savings.
What Is a Self-Directed IRA?
A self-directed IRA is a retirement account with tax advantages that is similar to a traditional or Roth IRA. The main difference is that a self-directed IRA allows you to invest in a wider range of “alternative” investments.
How Does a Self-Directed IRA Work?
Self-directed IRAs are very similar to traditional and Roth IRAs. Traditional and Roth accounts are both designed to offer tax benefits. Traditional accounts offer tax-deferred growth, while Roth accounts offer tax-free growth and withdrawals in retirements.
In a traditional IRA, you’re generally only limited to investing in stocks, bonds, and mutual funds. The biggest difference between a self-directed IRA and a traditional IRA is that with a self-directed IRA, you can invest in a wider range of things, not just stocks, bonds, and mutual funds. Most brokerage firms offer regular IRAs that only allow you to invest in traditional investments such as stocks, bonds, and mutual funds. If you have a self-directed IRA, you may be able to invest in things like real estate, small businesses, and cryptocurrencies.
Self-directed IRAs are most commonly used for long-term investments that are not as easy to buy and sell as stocks, bonds, or mutual funds.
Here’s a list of some things you can invest in with the funds inside your self-directed IRA:
- Real estate
- Undeveloped land and livestock
- Precious metals (gold, silver, etc.)
- Private businesses
- Energy and natural resources (water or mineral rights, oil and gas, etc.)
- Tax lien certificates
- Promissory notes
Advantages of a Self-Directed IRA
Invest in What You Understand
After the 2008 financial crisis, Americans became frustrated with the equity markets. Since the financial markets rebounded, we are thankfully able to see it. Many investors still have not recovered from the large market swings. They are not sure what goes on in Wall Street and how it all works.
Many people in the lower and middle classes are more familiar with real estate, making it a more comfortable investment for them. The upper class is more familiar with Wall Street and other securities than the lower class.
We often hear people discuss the benefits of owning a home, and how much money can be made by owning real estate. The popularity of Donald Trump and reality TV has caused real estate to become a more trusted asset class for Americans.
Real estate investing, although risky, is seen as more favorable by many investors in comparison to stock market investing. You can make investments in real estate and other alternative assets with a Self-Directed IRA LLC without paying taxes on them. Inflation Protection
Many Americans are financially invested in the stock market. Most of us have our savings connected to the stock market, whether it’s through retirement investments like IRAs or 401(k) plans, or through personal savings.
Roughly 90% of retirement assets are invested in the financial markets. If you’re looking to mix things up a bit and invest in something other than stocks, real estate is a great option. It provides diversification away from the equity markets and can be a very lucrative investment. If you have a more diversified Self-Directed IRA, your assets are less likely to move in the same direction. Diversification will not always guarantee a profit, or keep you from experiencing a loss. Despite this, by incorporating non-traditional asset classes into your portfolio, you can safeguard your finances during times when the market is struggling, and limit your losses in comparison to the wider market. Invest in What You Understand. Learn more about Self-Directed IRA Myths here.
Economic conditions have recently caused new fears of inflation. Rising food and energy prices, along with high federal debt levels and low interest rates have contributed to this. Some investors may look for ways to protect their portfolios from losing value because of inflation.
There is no way to know for sure if these inflation risks are real. Many retirement investors are worried about their assets losing value due to inflation. Inflation can negatively affect a retirement portfolio because it causes the value of money to decrease over time.
Inflationary pressure raises the prices of essential goods and services, making it more difficult for people to maintain a decent standard of living. Some examples are gas, shelter, clothing and medical services. When inflation decreases the value of money, it causes the prices of goods and services to go up.
If someone has an IRA worth $250,000 during a time of high inflation, the value of their IRA will be worth less in terms of purchasing power. Working hard now can mean being able to retire later.
Many investors have long recognized that commercial real estate can provide a way to offset the effects of inflation. Rents typically increase when prices do, providing a buffer against inflation.
Many non-traditional assets, such as real estate and precious metals are assets that can be seen and touched. If you own a piece of real estate, you can point to it and say to your family, “That’s ours.”
Some people find it psychologically important to have gold, especially during times of financial instability, inflation, or political or global upheaval.
If you want to use your retirement funds for investments in unconventional assets and expect to do a lot of trading (for example, with rental properties), worry about liability (for example, with real estate), want more control over your IRA, or value privacy, then you should choose a self-directed IRA LLC.
This means that you don’t pay tax on certain types of income until a later date. The most common types of tax-deferred investments are IRAs and Qualified Retirement Plans. This means that you can delay paying taxes on your income, gains, and earnings until you withdraw the funds and take possession of them.
The money in your retirement account will grow without being taxed as long as it stays in the account. This means that your retirement funds will grow faster if they are held in the fund than if you held them yourself. This means that you will be able to save money for retirement at a quicker pace.
When you retire and withdraw your IRA funds, you will probably be in a lower tax bracket and thus be able to keep more of what you have saved up.
So, with using an traditional IRA retirement savings vehicle:
- You don’t pay taxes on the money you invested
- You may pay taxes at a lower rate when you finally do “take home” your money
If you don’t spend the money in your account, it will continue to grow without being taxed. This allows assets to grow more quickly, giving you an advantage when saving for the long term.
Disadvantages of a Self-Directed IRA
They Come with Higher Fees and Complicated Recordkeeping
self-directed IRA’s are more complex than traditional investments, most companies that offer them charge higher fees, which could reduce your earnings. This would require a lot of work to keep track of records and to meet all the tax reporting requirements.
There are many rules and guidelines that must be followed.
You also have to be aware of prohibited transactions set by the IRS. They are like landmines that could destroy any tax benefits that come with a self-directed IRA. If you do not follow the guidelines, you may have to pay fees and penalties to the government during tax season.
They Often Deal with High-Risk Investments
The biggest downside to self-directed IRAs is that the investments they allow tend to be riskier. Do you want to risk your retirement on something as unpredictable as cryptocurrency or as complicated as a tax lien certificate?
Self-Directed IRA Rules and Guidelines
The IRS has specific rules and guidelines about what you can and cannot do with a self-directed IRA. If you make a prohibited transaction or break any other rules relating to your self-directed IRA, your entire account could be considered distributed to you, which would result in taxes on all the assets in your account.
If you break any of these rules, you could end up owing a lot of money in taxes, penalties, and other consequences. So that you are clear on what the rules are for the type of investments you have in your account.
Although self-directed IRAs offer more investment freedom than traditional IRAs, there are still some restrictions on what types of investments are allowed. The IRS states that it is not permissible to invest in collectibles, life insurance, or real estate that one resides in. These would all be considered prohibited transactions.
We don’t want to be the ones to tell you this, but you can’t use your retirement money to buy that collection of rare first edition comic books that you’ve been wanting for a while (that probably wasn’t a great idea anyway).
The IRS typically does not approve of people who try to buy and sell investments in a self-directed IRA with certain people where there is a potential conflict of interest. These people are called disqualified persons.
Here’s a list of people you can’t make transactions with:
- Family members (your spouse, your kids, your parents and others)
- The investment company that provided your IRA
- Any entity (like a company or trust) where a disqualified person owns more than 50% of that entity
- Any entity where the IRA owner (most likely you) is an important employee or is a 10%-or-more shareholder of that entity
Some people try to be smart and do business with themselves through their self-directed IRA. That is called self-dealing and it is not allowed by the IRS. This is what you need to know: You cannot buy or sell property to yourself, you cannot lend money to yourself from your IRA, and you cannot pay any expenses or take any money from the IRA home with you. So don’t even think about it!
Types of Self-Directed IRAs
You can expand your investment opportunities by establishing a Self-Directed IRA. There are two types of Self-Directed IRAs.
- Custodian-Controlled IRA- A traditional Self-Directed IRA
- Checkbook Control IRA – Self-Directed IRA LLC
What’s the difference between the two? Some financial institutions offer a custodian-controlled IRA. Although they often allow you to make different types of investments, you will need to have someone agree to all investment decisions.
A checkbook control IRA is the best way to self-direct your individual retirement account. With checkbook control, there’s no need for custodian consent. You control what investments you make- when to buy and when to sell. This is the perfect retirement investment for IRA investors who want to have control and to invest in alternative assets.
Should I Invest in a Self-Directed IRA?
We’re going to be honest with you–you probably don’t need a self-directed IRA to invest for retirement.
Almost always, it is wiser for people to save for retirement using a regular IRA account (with Roth being the best option) and their employer’s retirement plan. Here’s what we recommend:
- Invest 15% of your gross income in good growth stock mutual funds in regular tax-advantaged retirement accounts.
- Have a 401(k) with an employer match? Start there and invest up to the match.
- After that, open up a Roth IRA and invest up to the max. That way, you can take advantage of tax-free growth and tax-free withdrawals in retirement!
- And if you still haven’t hit 15%, then go back to your 401(k) and invest the rest there.
While self-directed IRAs do allow for investing in a wider range of assets, most of those options are either too risky or too complex to pursue. You shouldn’t invest in something just because you can. Precious metals? Pass. The emotional rollercoaster that is cryptocurrency? The tilt-a-whirl at the state fair is probably a better option than what you’re currently doing.