Self-Directed IRA: Know the Risks Before Investing

For investors who like a hands-on, do-it-yourself approach, a self-directed individual retirement account may sound like a perfect investment vehicle.

But in February 2023, the Financial Industry Regulatory Authority, or FINRA, which oversees broker-dealers in the U.S., issued an alert about self-directed IRAs.

“Investments in these kinds of assets have unique risks that investors should consider,” FINRA wrote in its February alert. “Those risks can include a lack of information and liquidity — and the risk of fraud.”

In addition to those risks, FINRA also cautioned about complex tax rules and high fees.

To understand FINRA’s concerns, it’s important to understand that a self-directed IRA is a very specific type of investment. It’s not just an account that an investor holds at a brokerage, without using an advisor. That’s simply a traditional or Roth IRA.

A self-directed IRA is a very specific structure that allows investors to hold assets they can’t put in traditional or Roth accounts. Assets held in a self-directed IRA can grow tax-free. Alternative assets, such as real estate, precious metals, cryptocurrencies, tax lien certificates, promissory notes and private-placement securities, are allowed in a self-directed IRA.

Here’s what investors need to know about the potential benefits and drawbacks of self-directed IRAs before deciding to invest their money this way:

— When a self-directed IRA may be a viable option.

— Potential pitfalls of self-directed IRAs.

— How financial advisors can help with self-directed IRAs.

— Common self-directed IRA blunders.

[READ How to Determine Your Investment Risk Tolerance]

When a Self-Directed IRA May Be a Viable Option

While there are clear drawbacks that can make traditional and Roth IRAs seem relatively simple in comparison, there are cases where a self-directed IRA may be appropriate.

“Self-directed IRAs can make sense for investors with specialized knowledge or interests in alternative assets,” says Sean K. August, CEO of The August Wealth Management Group in New York. “For example, if you have experience in real estate and believe that it offers higher potential returns than traditional investments, a self-directed IRA can be a way to diversify your retirement portfolio.”

However, he adds, “It’s important to weigh the benefits of investing in alternative assets against the added complexity and potential risks.”

Jason Escamilla, CEO of Impact Labs in San Francisco, says using a self-directed IRA to hold certain assets makes the most sense under specific conditions.

“It’s important to weigh the benefits of investing in alternative assets against the added complexity and potential risks.” – Sean K. August, CEO of The August Wealth Management Group in New York

He cites a situation in which an investment faces unfavorable tax treatment outside of an IRA but is not allowed in a traditional IRA. Certain real estate and crypto transactions may fall under that category.

Some investments kept in self-directed IRAs may also have higher potential for appreciation. But you won’t be able to invest in real estate you live in, life insurance or collectibles.

A self-directed IRA could also make sense if an account is large enough to spread out any extra fees over the asset base. “Examples include paying the annual and transaction fees of the self-directed IRA custodian,” Escamilla says.

An investor cannot use debt or margin borrowing in an IRA without taking an additional tax hit. Real estate and other cash-flowing investments often involve debt financing, frequently backed by a personal guarantee. But if the asset is owned by an IRA account, debt financing with a personal guarantee triggers what’s called unrelated business taxable income, or UBTI.

A self-directed qualified account can avoid UBTI triggered by debt financing if there is no personal guarantee from the IRA account owner. This is called non-recourse debt.

In addition, Escamilla notes, there should be no personal benefit from an investment held in a self-directed IRA. “No joy rides on the rental yacht,” he quips.

[SEE: 10 Long-Term Investing Strategies Advisors Love.]

Potential Pitfalls of Self-Directed IRAs

Even if an investor is aware of potential risks, such as those pointed out by FINRA, there are still more potential pitfalls to avoid.

There are several possible mistakes that investors can make with self-directed IRAs, says Krisstin Petersmarck, an investment advisor representative at Bridgeriver Advisors in Bloomfield Hills, Michigan. Those include “not fully understanding either the fee structure of self-directed IRAs or the associated market risks, term and/or liquidity of alternative investments. Perhaps most notably, not fully understanding applicable IRS code, particularly as it relates to taxation and access or distribution of the underlying assets,” she says.

She adds that self-directed IRAs should be used with caution and only by savvy investors who understand the applicable tax code as well as other associated risks.

August cites several other pitfalls, including the potential for fraudulent investments, which can lead to substantial losses.

How Financial Advisors Can Help With Self-Directed IRAs

“Some investors may underestimate the amount of time and effort required to manage alternative assets, which can lead to poor investment decisions,” August says. “It’s important to thoroughly research each investment opportunity and consult with a qualified financial advisor before making any decisions.”

He notes that financial advisors should also be aware of the potential tax implications of self-directed IRA investments, as well as any potential penalties for violating IRS rules.

Jaime Raskulinecz, CEO of Next Generation Trust Company in Roseland, New Jersey, says self-directed IRAs only make sense for sophisticated investors who are willing to take the time to understand regulations on these investments, or are working with an experienced financial advisor who can steer them in the right direction.

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Common Self-Directed IRA Blunders

“The biggest mistakes we’ve seen are allowing a disqualified person to use a property owned by the IRA, using personal funds to add to an investment or do improvements, lending funds from an IRA to a friend or associate in order to personally take those funds and later claim it’s a bad loan, and jumping into an investment with little or no due diligence,” Raskulinecz says.

Raskulinecz also notes the potential for fraud. “Investors should be wary of anyone selling assets that promise unrealistic or outsized returns, saying there is a limited time to get into the investment or lose out, and who is unable to explain all the details on the investment,” she says.

Nonetheless, she believes self-directed IRAs should be utilized more, even if an investor needs an advisor to assist with the investments.

“In a perfect world, more advisors would be familiar with this strategy and the rules of self-directed IRAs in order to add to their practice and help investors who might be less sophisticated but could still benefit from the diversification,” Raskulinecz says.

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