If you want to invest in non-traditional assets with your retirement savings, you might find it challenging to do so with IRAs held at brokerages, banks, and other financial firms.
You're likely to be limited to just stocks, bonds, and mutual funds when you have your IRA (individual retirement account) with these institutions.
A self-directed IRA solves this issue by allowing you to take advantage of certain alternative assets.
With self-directed IRAs, you are in charge of your funds and can invest them how you see fit.
This post will reveal everything you need to know about self-directed IRAs and cover some pros and cons of using them.
What Are Self-Directed IRAs?
A self-directed IRA is simply a kind of retirement account that allows you to invest in a broader selection of asset classes.
A trustee or custodian still administers the IRA, but it is managed directly by the account holder, hence why it is called “self-directed.” You can either open up a self-directed traditional IRA, in which you make tax-deductible contributions or a self-directed Roth IRA, in which you make tax-free contributions.
Like an IRA that you'd get from a bank or brokerage, you need to follow the eligibility requirements and contribution limits to participate. For example, in 2022, the maximum contribution limit is $6,000 (or $7,000 if you're 50 years old or older), and you can only withdraw funds once you reach 59 and a half years old.
Most people choose to open a self-directed IRA to invest in alternative asset classes. Holders of simple IRAs are typically limited to just stocks, bonds, mutual funds, ETFs, and CDs. With a self-directed IRA, you can invest in:
- Precious metals (gold, silver, platinum)
- Real estate (rental properties, crowdfunding)
- Tax lien certificates
- Limited partnerships
- Promissory notes
And much more. Self-directed IRAs afford you much more freedom in the investments available, but that also means that you are responsible for doing your due diligence and picking intelligent investments.
How to Open a Self-Directed IRA
Typically you can go to a brokerage firm to open up any, but many mainstream brokerages don't offer the option of opening a self-directed IRA.
The most common place you'll find self-directed IRAs offered is through providers that specialize in them. Some banks and trust companies provide these services. Different providers will have other offerings when it comes to investments available, so be sure to shop around if you're interested in a specific asset class. As a side note: the IRS still doesn't allow certain types of investments inside self-directed IRAs (like insurance or collectibles).
The steps for opening a self-directed IRA are as follows:
- Find a provider to open the account for you.
- Do due diligence on the investments you'd like to make.
- Decide on your investments.
- Contact the investment sponsor or holder to invest.
- Direct your provider to carry out the transaction for you.
Keep in mind that these accounts are “self-directed” and that your provider cannot give you any financial advice. Also, for the most part, investments made in self-directed IRAs are less liquid than investments made in regular IRA accounts.
It would be best to do lots of research before making any investments for these reasons.
If you're not up for the task alone, working with an experienced financial advisor or fiduciary can help you to minimize your risk throughout the investing process. Keep in mind that your SDIRA provider will not carry out any due diligence for you.
Advantages and Risks of Self-Directed IRAs
Before setting up your own self-directed IRA, it's wise to understand the pros and cons of doing so.
There are certain benefits and risks to self-directed IRAs, as with any financial decision. Here is an overview of them.
Advantages of Self-Directed IRAs
Here are some of the most significant advantages associated with self-directed IRAs.
- Diversification – The main advantage to owning a self-directed IRA is that it allows you to diversify your investments away from traditional asset classes like stocks and bonds. A self-directed IRA lets you invest in wealth-building vehicles like real estate and even gives you the ability to make purchases in shares of non-publicly traded companies.
- Specialization – You can leverage your intellectual capital through self-directed IRAs if you have unique expertise or experience in a particular field. By making investments that align with your passions, you provide yourself with a sharper edge over the rest of the market.
- Higher Returns – By investing in unique asset classes, there is the potential for greater returns. With an SDIRA, you can invest in a broader range of assets than with a regular IRA, which also opens up the possibilities of you selecting a big winner. If you're creative and use self-directed IRAs the right way, you can earn some sizable returns.
Risks of Self-Directed IRAs
Here are some of the most significant risks to consider when opening a self-directed IRA.
- Prohibited transactions – There is a strict set of rules that you must follow when investing with self-directed IRAs, and if you break one, you could be liable for a lot of owed money and penalties. If not, you may find your earnings taxable and be on the hook for penalties. For each asset class you own, you should know all the rules that govern it and follow them to a tee.
- Concentrated portfolios – Though self-directed IRAs let you invest in various asset classes, the flip side of the coin is that it's also easy to become too heavily concentrated in these alternative investments. Often, if you're only seeking diversification, one of the best options is to go with an ETF or index fund.
- Due diligence – The due diligence of each investment is entirely up to you, and the firm you set up the IRA with can not help you with it. When thinking about setting up an SDIRA, make sure to factor in the value of your time (or if you are hiring a financial advisor, factor in the additional fees you will be paying them.)
- Fees – Self-directed IRAs have a different fee structure than regular IRAs, and the payments can differ depending on which custodian you are with and what investments you choose.
- Fraud – Since SDIRA providers can not evaluate an investment for account holders, scams are more common. Many fraudsters lure people into their schemes by saying that the custodian has approved and vetted their investment. Be wary about what you're investing in with your self-directed IRA.
- Liquidity – If you run into an emergency and need funds, it will be hard to withdraw them from your self-directed IRA. Selling stocks, bonds, and mutual funds are pretty simple and only requires a button click. Unfortunately, this is not the case for many investments available for self-directed IRAs. Self-directed IRAs do allow you to invest in a broader range of asset classes, but that also means you will sometimes be giving up your liquidity for it.
FAQs About Self-Directed IRAs
Here are some frequently asked questions about these self-directed retirement accounts answered:
What is the difference between a self-directed traditional IRA account and a self-directed Roth IRA account?
The difference between traditional and Roth IRA accounts is when the account owners realize tax benefits. For example, in a traditional IRA, you can take a tax deduction on the contributions made to your account. When you make withdrawals in the future, the IRS taxes the money withdrawn as regular taxable income. With Roth IRA accounts, you won't be able to make a deduction on the contributions to the account, but your retirement funds will be tax-free.
Is there a minimum amount required to open a self-directed IRA account?
There is no minimum contribution requirement for self-directed IRAs, but the recommended amount you put in depends on what investment options you are considering. For example, suppose you invest in real estate with your self-directed IRA account. In that case, you'll want to make sure you have enough money to cover the down payment plus any additional repairs, improvements, and expenses made on the property.
What assets cant I buy with a self-directed IRA?
There are certain assets that the IRS does not allow in IRAs. These include artwork, antiques, gems, stamps, certain coins, metals (aside from gold, silver, and platinum), life insurance, and alcoholic beverages.
If I have a 401k from an old employer, can I roll over the money into a self-directed IRA?
If you are no longer an active employee, you are allowed to roll over the money from your previous employer's plan to a new self-directed IRA. The IRA rollover process is quite simple and requires transferring your funds from your last custodian to your new SDIRA provider. Just be sure to check and make that all rollover activity is compliant with the IRS, so you don't suffer any unnecessary penalties.
Can I partner with others to make investments using my self-directed IRA?
You may partner your self-directed IRA with another funding source. This action is known as partnering and is available for your non-IRA funds, spouse's IRA, or even another person's IRA.
Everything to Know About Self-Directed IRAs
Self-directed IRAs can be an excellent option for people seeking investments in alternative asset classes and looking to diversify their returns.
However, there are plenty of risks involved, and a certain level of dedication is needed if you want to manage a self-directed IRA successfully. If you have specific expertise in a field or happen to specialize in an industry, opening a self-directed IRA might be a wise move.
Before opening a self-directed IRA, be sure to weigh all the pros and cons and ask yourself if you need a self-directed IRA or if you can realize your goals using an IRA from a brokerage. If you find that the answer is resoundingly positive, it may be time to start looking into self-directed IRAs as a viable investment vehicle.
Want more information on the benefits of an SDIRA and how you can get started? Download your free copy of the Self-Directed IRA Basics guide today.
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This article was produced and syndicated by Wealth of Geeks.
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Jeff is a current Harvard student and author of the blog Financial Pupil who is passionate about learning, living, and sharing all things personal finance-related. He has experience working in the financial industry and enjoys the pursuit of financial freedom. Outside of blogging, he loves to cook, read, and golf in his spare time.