A self-directed individual retirement account is a very specific tax-advantaged vehicle that gives investors the ability to choose investments beyond traditional options such as stocks, bonds and exchange-traded funds, or ETFs.
A self-directed IRA can hold alternative assets such as real estate, private equity, precious metals and other commodities, and cryptocurrencies. They can’t hold investments in collectibles, life insurance or real estate you live in.
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While self-directed IRAs offer the potential for greater returns, they also require thorough research and understanding of the investment options, as well as compliance with IRS regulations to maintain tax-advantaged status. Here’s what you need to know about self-directed IRAs:
— Know the rules and risks of a self-directed IRA.
— Pros of a self-directed IRA.
— Cons of a self-directed IRA.
— Does a self-directed IRA have higher returns?
— Potential pitfalls of self-directed IRAs.
— Best practices when investing in a self-directed IRA.
Know the Rules and Risks of a Self-Directed IRA
“A self-directed IRA is a sharp object, meaning the user should read the safety manual before proceeding,” says Christopher Shepler, a chartered financial analyst who serves as vice president and investment officer at Fiduciary Trust Co. in Boston.
For example, he says, many people are familiar with TV commercials featuring an actor who touts the benefits of buying gold in a self-directed IRA. “There may or may not be a good thesis for buying gold, but the celebrity is not considering the questions of asset location and tax efficiency,” Shepler says. “Gold doesn’t pay interest or dividends, so depending on advice from a tax professional, not an actor, it could be better to hold an asset like gold outright rather than in a tax-deferred vehicle.”
Pros of a Self-Directed IRA
Beyond investment flexibility, a self-directed IRA offers several benefits. For example, investors can take more control over their retirement savings, potentially leading to higher returns. In addition, self-directed IRAs provide the opportunity to invest in alternative assets that may not be available through traditional retirement accounts, such as real estate or private equity.
Like other IRAs, they also offer tax advantages.
“Investing through a self-directed IRA provides unique perks that can help bolster your retirement savings,” says Ines Zemelman, founder and president of TFX, a New York company that offers tax preparation and other services for U.S. expats. “Built-in tax breaks on the earnings from your investments are one of the key advantages,” she says.
She cites the example of an investor who purchases a rental property within a self-directed IRA. Any rental income generated from that property is typically tax-deferred or tax-free within the IRA, depending on whether it’s a Roth or a traditional IRA. The property is owned by the IRA and is an investment only, and it cannot be used for personal purposes.
“This means you won’t owe taxes on the rental income as long as it remains within the IRA,” Zemelman says. “If you sell the rental property for a profit within the IRA, any capital gains from the sale would also be tax-deferred or tax-free, again depending on the type of IRA.”
That can result in significant tax savings compared to investing in the same assets outside of a retirement account, where an investor would be subject to immediate taxation on rental income and capital gains.
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Cons of a Self-Directed IRA
While self-directed IRAs offer flexibility, they also come with risks and drawbacks.
Investors may face complexity and regulatory compliance issues when managing alternative assets. That’s something you don’t typically face with a standard IRA holding stocks, bonds or funds.
Additionally, there’s a higher potential for fraud or misuse of funds without proper due diligence, and the lack of professional guidance could lead to risky investment decisions.
“The risk is high with non-standard, potentially unregulated investments,” says Sean Lovison, a certified financial planner and accountant at Purpose Built in Moorestown, New Jersey. “Payoffs can be enormous, but they should primarily be considered lottery tickets and not make up the bulk of your retirement plan.”
For example, holding shares of a pre-initial public offering company may not result in the payday an investor is hoping for. “You need to be realistic about the likelihood of any private company going public and becoming the next Google,” Lovison says.
Does a Self-Directed IRA Have Higher Returns?
Because self-directed IRAs offer the opportunity to invest in a wider range of assets, investors may get better returns from alternative investments such as real estate, private equity or precious metals.
Also, the ability to make investment decisions independently allows investors to take advantage of specific market opportunities, potentially leading to greater profitability over the long haul.
Lovison offers an analogy for investors considering a self-directed IRA, which he says can feel like planting an exotic garden.
“While it’s riskier and requires more care, the blooms can be extraordinary,” he says. “Yes, there’s potential for higher returns, especially if you’re investing in areas where you have expertise. However, like any garden, it’s all about the right conditions: knowledge, timing and a bit of luck.”
Potential Pitfalls of Self-Directed IRAs
Investors should be aware that fees may be higher in self-directed IRAs, due to the complexity and administrative burden associated with managing alternative investments.
“The fees are higher as most of these investments must be made manually; think real estate closings,” says Jaime Raskulinecz, founder and CEO at Next Generation Trust Co. in Roseland, New Jersey.
Raskulinecz says investors should do their due diligence not only when it comes to self-directed IRAs, but in other areas of financial services.
“If it sounds too good to be true, it usually is. This applies to alternative investments as well,” she says.
Raskulinecz adds that some traditional, big-name custodians say they offer self-directed IRAs, but those amount to being able to invest in products that the brokerage sells. “This is much different than true self-direction,” she says.
Best Practices When Investing in a Self-Directed IRA
Best practices for investing in a self-directed IRA include thorough research, diversification and understanding investment risks.
Avoiding prohibited transactions and maintaining accurate records are also crucial for compliance and avoiding penalties.
“Choose a specialized custodian that can guide you to ensure that the tax-advantaged status of the account remains intact,” Raskulinecz says.
She suggests talking to that custodian often to avoid inadvertently creating a prohibited transaction. “There are rules that are easy to understand and follow,” she says.
She also advises against trying to game the system. “There are plenty of things that are allowed that will give potentially greater gains without deliberately doing something not allowable,” she says.
Finally, Raskulinecz says, “Make sure you understand the investments you’d like to make and that you are well versed enough that you can perform due diligence.”
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What Is a Self-Directed IRA? Pros and Cons of This Unique Investment Account originally appeared on usnews.com
Update 04/17/24: This story was previously published at an earlier date and has been updated with new information.
