There’s no denying the importance of diversification in your portfolio. A well-balanced mix of investments is critical for managing risk and riding waves of market volatility.
While the typical investor may turn to a mix of stocks, mutual funds and bonds for diversification, others may seek to broaden their horizons. For those investors, alternative investments such as real estate, private equity or cryptocurrencies may be more alluring.
Those types of investments can add a new layer of diversification, as well as yielding tax advantages if you’re holding them in a self-directed individual retirement account. According to the U.S. General Accounting Office, nearly a half a million investors own self-directed IRAs, with collective assets valued at $50 billion.
“The primary advantage of a self-directed IRA is to invest in items that may not be allowed by a traditional IRA custodian,” says Bob Phillips, managing principal at Spectrum Management Group in Indianapolis.
[See: 10 Long-Term Investing Strategies That Work.]
With a regular IRA, investment options are limited to publicly traded securities, such as mutual funds. A self-directed IRA gives investors greater control over their investment options and how they access those assets.
“IRAs offer higher flexibility for withdrawals than ERISA-sponsored plans by allowing flexible tax withholding,” says Gage Kemsley, vice president of Oxford Wealth Advisors in Rio Rancho, New Mexico. “ERISA forces 20 percent of the withdrawal to be held back for federal taxes, which for most individuals is too much.”
Self-directed IRAs don’t, however, allow investors to sidestep early withdrawal penalties for distributions taken before age 59½. But they can yield tax benefits if you’re planning to pass your account on when you pass away.
“One major benefit of a self-directed IRA is to leave money to someone other than a spouse,” says Robert Baltzell, president of RLB Financial in Valencia, California. “The beneficiary inheriting the IRA isn’t subject to an early distribution penalty.”
Withdrawals would still be subject to regular income tax, but the account would continue growing tax-deferred in the meantime.
Those benefits make a strong case for investing in a self-directed IRA. The bigger question is, which investments are right for you?
Start with the exclusions. If you’re narrowing down your investment choices for a self-directed IRA, get familiar with what you can’t invest in first.
The Internal Revenue Code makes those distinctions in Sections 409 and 4975, which prohibit “disqualified persons” from engaging in certain types of transactions, says Adam Bergman, president at IRA Financial Trust and IRA Financial Group.
“In general, as long as the self-directed IRA does not purchase life insurance, collectibles or engage in a prohibited transaction, then the investment can be made,” he says.
In addition to life insurance and collectibles, such as antiques, jewelry, stamps or fine wines, you can’t use a self-directed IRA to invest in most coins, real estate that’s designated for personal use or derivatives, which are considered speculative investments. That still leaves plenty of other choices, however.
[See: 10 Reasons Warren Buffett Is a Better Investor Than You.]
“The beauty of the self-directed IRA is that so long as the investment does not violate the IRS rules and the IRA holder feels comfortable with the investment, it can be made,” Bergman says.
In addition to prohibited investments, take care to avoid prohibited transactions, as well, Phillips says. That includes owning real estate you plan to live in or rent to your children or investing in shares of a business you own.
“Investors should research the prohibited transaction rules for self-directed IRAs before making any investment,” Phillips says.
Match investments to your investing style. Your time horizon and preferred strategy can strongly influence where you park investment dollars in a self-directed IRA.
Bergman says residential real estate and private equity are the most popular choices for buy-and-hold investors. Real estate, in particular “because of the potential tax-deferred or tax-free, in the case of a Roth IRA, cash flow.”
Real estate could also make sense as a short-term investment if you’re looking for a passive investment, says Jonathan Faccone, managing member and founder of Halo Homebuyers, a New Jersey and Eastern Pennsylvania-based real estate development and investing company.
“Actively managing rental portfolios using retirement funds can be very risky because of the amount of knowledge and work that goes into successfully managing a buy-and-hold real estate portfolio,” Faccone says. “It’s essentially running a business which consequently comes with a learning curve, your own personal involvement and a lot of undue risk for your hard-earned retirement funds.”
Focusing instead on short-term equity deals may be a safer way to earn a solid return on your investment, Faccone says. You will, however, need a reputable real estate expert on board as “tax rules don’t allow you to manage these kinds of investments yourself because it needs to be an ‘arms-length’ qualified transaction.”
Also consider how your age impacts your self-directed IRA choices.
“A younger person isn’t going to be concerned about income; they want the money to grow,” Baltzell says. “Someone thinking long-term might choose to invest in stocks that pay out dividends instead.”
Ultimately, you have to decide which is more important: growth now or income later.
Kemsley says investors should be cautious of investing in individual stocks within their self-directed IRA, especially if you’ve chosen a traditional IRA. Any tax savings you enjoyed by deducting contributions may be dramatically outweighed by the amount of taxes owed in retirement if your investments have performed well. In that scenario, investors may benefit more by placing stocks with high growth potential in a non-IRA account and paying long-term capital gains tax rates instead.
Keep taxation in perspective. Investing in a self-directed IRA can increase diversification but there are some potential tax pitfalls to avoid.
Chris Jackson, CEO and founder of Lionshare Partners in Los Angeles says the list of investments you may want to avoid includes ones that drive a loss that you want to flow through to your tax return or real estate investments that result in heavy paper losses. You also need to be mindful of the rules for required minimum distributions if you’re investing in real estate.
[See: 8 Foreign Picks to Diversify Your Portfolio.]
“At the age of 70½, you have to take out a required minimum distributed from your self-directed IRA but what if your real estate doesn’t have the cash flow?” Jackson points out. “This can be a problem because you can’t make any more IRA contributions and there’s a 50 percent tax on the amount that was supposed to be distributed.”
A higher tax bite can diminish your investment earnings. When choosing any investment for your self-directed IRA, real estate or otherwise, remember this simple rule:
“Just because you can, doesn’t mean you should,” Baltzell says.
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How to Choose the Best Investments for a Self-Directed IRA originally appeared on usnews.com
