An IRA is an individual retirement account that allows individuals to set aside money for retirement. IRA plans are usually paid for by money that is directly given by the person, or from money that is rolled over from a 401(k) plan. In 2022, the maximum contribution you can make to your retirement savings is $6,000. If you are age 50 or older, you can contribute an additional $1,000. You can move as much money as you want from one IRA to another when you roll over.
The traditional IRA is a retirement savings plan that allows you to set aside money for retirement and defer taxes on the earnings until you withdraw the money at retirement. There are two main types of IRA: the traditional IRA, where you can defer tax on your earnings until you retire, and the Roth IRA. Additionally, if you own your own business, you may opt for the SEP or SIMPLE IRA.
How Does a Self-Directed IRA Work?
A self-directed IRA has many of the same features as a standard IRA. The contribution limit for the 2023 tax year is $6,500 ($7,500 for those 50 and over). You can choose to open a self-directed IRA as a traditional IRA or a Roth IRA, with the same pre-tax and post-tax contribution rules.
A self-directed IRA custodian allows you to buy a variety of alternative investments, which is different from traditional IRA custodians.
The regular IRA custodian usually limits investment options to approved securities, such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds.
Different companies that hold and manage IRAs for clients offer the option of investing in gold bars, silver ingots, or cryptocurrency like Bitcoin. Some investors want the tax benefits that come with an IRA for investments in non-traditional asset classes. This could potentially lead to more profitable returns.
Custodians of self-directed IRAs generally only hold assets after they have been purchased from another broker, meaning that you typically cannot buy non-traditional assets directly from the custodian. Additionally, self-directed IRAs come with more complexity and the potential for fraud if you purchase alternative assets fromDealers you can’t trust.
There are two types of Self-Directed IRA’s: those that are full-service/custodian controlled, and those that are Checkbook Control/IRA LLC.
Full Service/Custodian Controlled
An IRA opened at a “regular” financial institution offers fewer investment options than a custodian controlled Self-Directed IRA. You will need a custodian that allows for the investments you wish to make.
Most IRA custodians generate fees by simply opening and maintaining IRA accounts, without offering any financial investment products or platforms. The custodian of a self-directed IRA controls the fund and invests according to the IRA holder’s direction.
Checkbook Control/IRA LLC
The investor has complete control over their investment when using a Self-Directed IRA LLC with “checkbook control”. This is the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate, that require a high frequency of transactions. An IRA that owns a limited liability company is called a “Checkbook IRA.” In this arrangement, the limited liability company is funded and owned by the IRA. You, the plan’s owner, serve as its manager.
This means that you won’t have to pay certain fees and you won’t have to wait as long for things to happen that are often associated with using a full-service IRA custodian. The Checkbook IRA LLC allows investors to act quickly and efficiently when they come across a good investment opportunity, without incurring extra costs.
What Assets Can You Own in a Self-Directed IRA?
You can own the following non-traditional assets in a self-directed IRA:
- Cryptocurrency, like Bitcoin or Ethereum.
- Precious metals, including gold, silver and palladium at or above certain standards of purity standards.
- Real estate properties, although there are a variety of special rules that govern investing in real estate via a self-directed IRA.
- Startups, via crowdfunding platforms like Wefunder, SeedInvest or StartEngine.
- Tax liens and deeds on foreclosed properties.
- Foreign currency, via so-called forex IRAs.
You cannot invest in life insurance or collectibles that don’t meet IRS purity standards. If you proceed with the withdrawal, the amount you spend will be counted as such, and you will be responsible for any taxes or penalties for early withdrawal.
Self-Directed IRA Benefits
Many people choose to have a self-directed IRA because they either want to make more money or they want to have a more diverse retirement fund that includes assets other than the typical stocks and bonds.
Potential for Higher Returns
Investors can choose to hold a variety of non-traditional assets in their retirement accounts, including real estate, gold and cryptocurrency. The main advantage of self-directed IRAs is that investors can choose to hold a variety of non-traditional assets in their retirement accounts, including real estate, gold and cryptocurrency, says Syet Nishat, partner with the Wall Street Alliance Group.
As opposed to a traditional IRA held by a brokerage company, a self-directed IRA allows you to invest in alternative investments such as commercial property or LLC membership interest. You can also put your retirement money into assets that have a higher risk but also have the potential for a higher reward, such as investing in Bitcoin or early-stage private companies.
Investing in assets like this comes with higher potential returns than just investing in the stock market, but it’s also a lot riskier.
Many retirees are concerned about market volatility and inflation reducing their life savings. To them, being able to invest in different types of investments means they could possibly protects themselves from future economic decline or the value of their money gradually decreasing over time.
Self-Directed IRA Disadvantages and Risks
Self-directed IRAs can be a good choice for some experienced investors, but they come with more risks and disadvantages than regular IRAs.
When you invest in assets such as real estate and physical gold, it can take much longer to sell your holdings and access the money. Even though you might be able to sell your belongings quickly, you may have to accept much less money for them than what they are worth or what you paid for them in the first place.
Compare and contrast stocks, exchange-traded funds (ETFs), and mutual funds. Securities that are highly liquid are easier to sell quickly when you need money.
An IRA account usually does not require account management or trading fees. The fees you owe for your self-directed IRA depend on the institution you use as well as the assets you invest in. With gold, for example, you can be charged for things like storage, insurance, and maintenance. Be sure to know any fees you might have to pay for investing in a self-directed IRA.
More Limited Protections
Self-directed IRA custodians are typically responsible only for administering and holding assets. The quality and legitimacy of the investment options in the IRAs they offer are not investigated by them and they are not liable for it. For example, you might buy gold from a third party that does not meet purity standards for your IRA, which can cost you money from the fraudulent purchase and from tax penalties.
Scott Klauenberg, a financial planner at Klauenberg Retirement Solutions, emphasizes the importance of researching anything you want to purchase for a self-directed IRA. It is more important than usual to ask questions and verify information when dealing with self-directed IRAs, he says.
Greater Risk for IRS Rule Violations
If you do something that the IRS does not approve of, it can be costly. Investing in a self-directed IRA can be risky because if you don’t follow the IRS’s rules about investment and use, your whole account could be penalized.
You broadly cannot do the following things with an IRA: hold unapproved assets, borrow money from it, sell property to it, use it as security for a loan, or use it to buy property for personal use. There are some simple rules to follow when investing with a traditional IRA. The waters become muddied when discussing alternative asset classes.
The example given is if you use a self-directed IRA to invest in rental properties. If you spend one night in an IRA-funded rental property, your IRA is considered null and void as of the beginning of that year. For tax purposes, you are considered to have withdrawn all the assets in your account at their fair market value on the first day of the year.
Self-Directed IRA Choices
Traditional Self-Directed IRA
The traditional IRA was established by the Employee Retirement Income Security Act of 1974. The IRS sets an annual limit for how much you can deduct from your taxes for contributions made to the plan.
You can withdraw money from your distribution at any time, and the amount you withdraw will be subject to taxes. If you are younger than 59 1/2, you will have to pay an extra 10% if you withdraw money from this account. Once you reach that age, you will only have to pay taxes on the distribution.
At age 72, you are required to take withdrawals from your account, called required minimum distributions (RMD). The approximate value of an RMD is 3% of the combined value of all traditional IRAs. Every year that you take money out of this account, it will be considered taxable income.
Individuals who wish to receive an income tax deduction. Pretax money can be put into a traditional IRA, which means that you would not have to pay taxes on the money that is contributed to the plan.
If you or your spouse earn more than $129,000 ($214,000 married filing jointly), you will not be able to take the tax deduction for your 401(k) plan. If you do not have access to a workplace plan, there are no income limitations for deductions.
This means that you don’t have to pay taxes on the money in your IRA until you withdraw it.
Self-Directed Roth IRA
The Taxpayer Relief Act of 1997 created the Roth IRA. The Roth IRA is funded with money that has already been taxed, as opposed to a traditional IRA which is funded with money that has not yet been taxed. There is no upfront tax deduction. However, all qualified distributions will be tax-free during retirement. You must be at least age 59 1/2 and have had your Roth IRA open for at least five years to qualify for this. Additionally, you can withdrawal your Roth contributions at anytime without being taxed or penalized.
You can contribute to a Roth IRA as long as you have earned income, unless your income is above the limit set by the IRS. In 2022, people with incomes of $144,000 or less, and married couples with incomes of $214,000 or less, will be able to contribute directly to a Roth IRA. The annual contribution limits for a Roth IRA are the same as the limits for a traditional IRA.
After you turn 72, you are not required to take distributions from your account. This allows your Roth to grow untouched. If you don’t need the money, you can give it to your beneficiaries.
Those who don’t need the money right away can get a tax break from a traditional plan. This investment option may be most beneficial for younger individuals who have not yet reached their maximum earnings potential. However, anyone can benefit from tax-free money during retirement!
High earners cannot contribute money to a Roth account, but they can still get money into the account indirectly. Since 2010, anyone has been able to convert their traditional IRA to a Roth IRA, regardless of income. The Backdoor Roth strategy allows you to increase the amount of money you have in your retirement account that is not subject to taxes.
While contributions to an IRA are not tax deductible, the opportunity to shelter all future Roth IRA gains from taxes is very beneficial.
Self-Directed SEP IRA
The 1978 Revenue Act implemented the Simplified Employee Pension IRA (SEP IRA), which provided for a retirement account that employees could contribute to, primarily for small businesses. A SEP IRA can only be adopted by a US-based business. It is essentially a profit-sharing plan. The maximum contribution you can make to a SEP IRA in 2022 is $61,000 and this must be made using pretax funds. You can contribute a percentage of your income/salary (20% or 25% if W-2) to employees who are eligible for the contribution.
A small business or sole proprietor. The SEP IRA was the most popular plan for small business owners and the self-employed before 2001. EGTRRA was passed in 2001 and helped make the Solo 401(k) more popular. If you are self-employed or own a business with only one owner, you should generally choose a SEP IRA. This kind of IRA allows you to make higher contributions, and has a loan option and Roth feature.
This means that if you have any employees who work more than 30 hours per week, you are not eligible to set up a Solo 401(k). A SEP IRA is still the best option for most people.
Self-Directed SIMPLE IRA
The Savings Incentive Match Plan for Employees (SIMPLE IRA) was implemented in 1996 with the Small Business Job Protection Act. Any business in the U.S. with fewer than 100 employees can set up a SIMPLE IRA.
Although the SIMPLE IRA has a lower deferral limit than a 401(k) plan, it uses an IRA-style trust to hold contributions for each employee, which is unlike a 401(k). In 2022, employees can defer up to $14,000 annually, with a $3,000 catch-up contribution for those at least age 50.
TheEmployersponsored retirement plan is the most common and easiest way for business owners to set up a retirement plan. This type of plan is also very affordable for employers. The SIMPLE IRA is not as popular as other IRAs because it is not as strong as a 401(k) plan. If you’re happy with making small annual contributions as a business owner, this might be a good option for you. All other retirement plans should be considered first.