Investing in an individual retirement account is an effective way to supplement savings in a 401(k) or another employer-sponsored plan. According to a 2015 TIAA-CREF IRA survey, 18 percent of Americans save in an IRA and 56 percent of those who don’t have one said they would consider including an IRA in their retirement plans.
While traditional and Roth IRAs are relatively well-known, there’s a third option that retirement savers should be aware of: the self-directed IRA.
Self-directed IRAs, in a nutshell, put you in control of your investment choices. In addition to stocks, mutual funds and bonds, you can invest in real estate, precious metals, energy and other alternative investments.
“The primary advantage of saving for retirement in a self-directed IRA is that you’re able to invest in the kinds of investments you have specific knowledge of or expertise in,” says Mark Goldstein, president of SAFE-Money Alliance in Las Cruces, New Mexico.
That freedom, paired with the potential for tax-deductible contributions and tax-deferred earnings makes self-directed IRAs an appealing choice for investors whose focus lies on creating lasting wealth. That doesn’t mean, however, that a self-directed IRA is right for everyone.
[See: 7 Reasons to Invest in an IRA.]
Before adding one of these accounts to your portfolio, it’s important to understand what makes a self-directed IRA different and how it can impact your retirement outlook.
Your investing style matters. Every investor has a distinct personality when it comes to how they manage their investments and that can’t be ignored when the question of a self-directed IRA is on the table.
Kirk Chisholm, a wealth manager and principal at Innovative Advisory Group in Lexington, Massachusetts, says self-directed IRAs are best suited to investors who are meticulous about managing their accounts and prefer a do-it-yourself approach.
“Investing in traditional assets can be as easy as pushing a button on your computer, while alternative assets can be much more paperwork intensive,” Chisholm says.
Beyond that, investors must be aware of the specific rules that go along with investing in a self-directed IRA. For example, you can’t use a self-directed IRA to invest in things like collectibles, antiques or rare coins.
David Hryck, a tax attorney and partner at New York-based Reed Smith, recommends that investors educate themselves on how self-directed IRAs operate before diving in.
“A self-directed IRA gives you far more responsibility and forces you to really understand how to invest properly,” Hryck says.
Your investment goals and risk tolerance also come into play. Even if you have no trepidation about guiding your own investment choices, a self-directed IRA may still miss the mark if it doesn’t align with what you hope to accomplish or requires you to assume more risk than you’d like.
“Self-directed IRAs are ideal for people looking for portfolio diversification in areas they’re familiar with, outside of the typical choices,” Goldstein says.
[See: 8 Ways to Profit From Donald Trump’s Infrastructure Plans.]
He points out that experienced investors may feel that the risk involved in investing in assets they understand may be considerably less than the risk of investing exclusively in a conventional IRA. The opposite may be true for someone with a shorter history of investing.
Your choice of investments can also influence your perspective on including a self-directed IRA in your portfolio.
For example, let’s say you’re interested in generating steady cash flow through a rental property. If you were to purchase a property directly, any rental income received each month would go right back into your pocket. When you invest in a rental home using a self-directed IRA, on the other hand, the rental income must be funneled back into the IRA.
If your long-term goal is increasing your nest egg in a tax-advantaged way, then the self-directed IRA might make more sense. On the other hand, if you need an additional income stream right now, you’d likely be better off investing in real estate outside of your retirement accounts.
Look at the bigger tax picture. Self-directed IRAs can offer some tax benefits but there are some potential pitfalls investors need to be aware of.
“The primary advantage (of a self-directed IRA) is deferred taxation on growth,” says Colby Winslow, a certified financial planner with WaterOak Advisors in Orlando, Florida.
Another advantage of using a self-directed IRA is the ability to hold investments that would typically be held as taxable assets. When taxes can be deferred, the tax that would have been paid can be reinvested to earn growth on those savings.
At the same time, investors need to be aware of how investing in a traditional self-directed IRA can affect their tax situation.
“The money coming out of the self-directed IRA will be taxable upon withdrawal,” says Jimmy Lee, CEO of Las Vegas-based Wealth Consulting Group.
For an investor who ends up in a higher tax bracket at retirement, distributions from a traditional IRA can lead to a higher tax bill. Another host of issues can crop up once you reach age 70.5.
“If someone purchases fairly illiquid assets and they’re expected to take required minimum distributions, they may be forced to sell assets within the IRA to free up enough cash to transfer out,” Winslow says.
Failing to take required minimum distributions can trigger a substantial tax penalty, equal to 50 percent of the amount you’re required to withdraw. That could add significantly to your tax burden so you need to have a plan for managing illiquid assets before RMDs kick in.
Choose your custodian carefully. The custodian holds the assets in your self-directed IRA for you and it’s important to carefully vet your options. If you need a starting point, Lee encourages investors to consider the size of the custodian, since that can be an indication of the firm’s stability.
Jaime Raskulinecz, founder and CEO of Next Generation Trust Services in Roseland, New Jersey, says it’s also important to look at the services a prospective custodian provides.
While a custodian for a self-directed IRA won’t offer direct investment advice, Raskulinecz says they should be able to answer questions about your plan, efficiently manage the paperwork and reporting and regularly review your account to ensure that you’re not engaging in prohibited transactions that fall outside of IRS guidelines.
Chisholm reminds investors to consider whether a self-directed IRA custodian accepts the type of assets you’re considering investing in. Lastly, he cautions against choosing a custodian without thoroughly reviewing the fees.
[See: 13 Ways to Take the Emotions Out of Investing.]
“Each company’s fee schedule caters to a certain type of investor,” Chisholm says, and ultimately, you should be looking for one that best fits your investment strategy.
More from U.S. News
What 8 CEOs Are Saying About Donald Trump’s Victory
8 Ways President Donald Trump Will Affect Wall Street
9 Stocks to Buy for the Aging Baby Boomer Market
4 Things to Know About Self-Directed IRAs originally appeared on usnews.com
