What You Need to Know About Self-Directed IRAs

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Updated on Wednesday, February 13, 2019

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It has a fancier name, but a self-directed IRA is just another kind of IRA, or individual retirement account. Like its cousins, a self-directed IRA allows money to grow in a tax-advantaged way so savers can roll up a portfolio for retirement more efficiently.

Here’s what you need to know about self-directed IRAs, their risks and whether it might make sense for you.

What is a self-directed IRA?

A self-directed IRA is an account that allows you to make investments in nontraditional assets. Standard IRAs — traditional IRAs and Roth IRAs — allow you to purchase common investments such as stocks, bonds, certificates of deposit (CDs), mutual funds and exchange-traded funds (ETFs). But a self-directed IRA allows you to invest in numerous other assets — private businesses, real estate, mortgages and even limited partnerships. It provides nearly limitless flexibility to invest.

The catch? You’ll have to find a custodian who’s willing to undertake the extra work of holding these unusual investments. Many of the well-known brokers don’t want the hassle of dealing with these offbeat assets, and you won’t receive investment advice from any brokerage. So if you’re opening a self-directed IRA, you’ll need to understand the investments yourself or hire an advisor who does.

The beauty of this is that it can hold many kinds of assets, including the following:

  • Rental properties and real estate
  • Private companies
  • Private mortgages
  • Stock in private companies
  • Some precious metals
  • Horses
  • Intellectual property

These are only some of the many kinds of alternative assets that might fit within a self-directed IRA. However, while this kind of IRA is more inclusive, it doesn’t accept all kinds of investments. For example, the IRS expressly forbids an IRA from holding life insurance and collectibles. But outside of those express prohibitions, there’s almost no limit.

The risks of a self-directed IRA

Investors have numerous potential pitfalls when managing a self-directed IRA. Here are some of the most relevant:

  • Investment risk: If you’re directing your own IRA, you won’t receive any financial advice unless you specifically hire someone to provide it to you. That means you’ll need to conduct your own due diligence on any investment to determine whether it’s suitable for investment. If you’re buying alternative assets, they may not have the strong track record that traditional investments such as stocks have. When you go with a self-directed IRA, you’re assuming all the risk in making smart investment decisions.
  • Penalties for prohibited transactions: The IRS prohibits all kinds of transactions with the assets in your IRA and is ready to penalize you heavily for what may seem like a small infraction. One of the biggest prohibitions is on receiving any personal benefit from assets owned in your IRA. For example, if you spend a night in a rental property owned by your IRA, you’ve just run afoul of the rules and will owe a penalty. You’ll need to be fully aware of all the prohibited transactions to stay out of trouble.
  • Lack of liquidity: Alternative assets tend to be much less liquid than traditional assets such as stock and bonds. They don’t always have a ready market, meaning that if you need to sell immediately, you probably won’t receive the value you otherwise could. In fact, if the market is really illiquid, you might not ever be able to realize your asset’s value. There’s simply no guarantee that anyone will want to buy what you own.
  • Fees: While standard IRAs usually can be established for fee at well-known brokers, custodians for self-directed IRAs may charge quite a bit more to hold your self-directed IRA. They may charge a fee to set up the account and then an ongoing annual fee. For example, one company charges a steep $1,250 to create the account and $180 each year to be the custodian. That’s a steady drain on your returns.
  • Fraud: Since you’ll be managing your investments yourself, you’ll need to watch out for things such as fraud, especially if you own a business. Alternative investments don’t have the kinds of protections for investors offered by regulated publicly traded companies, including regular financial audits.

Who can open a self-directed IRA?

Self-directed IRAs are available to anyone who is otherwise eligible to open a traditional or Roth IRA. (Here’s how to decide which kind is right for you.)

If you want to contribute to a traditional IRA, there are two qualifications:

  • Did you (or your spouse) have earned income for the year in which you want to make the contribution?
  • Are you under age 70 and a half?

If you want to contribute to a Roth IRA, there are a two qualifications:

  • Did you (or your spouse) have earned income for the year in which you want to make the contribution?
  • Did you earn less than $122,000 (for single or head of household in 2019) or $193,000 (for married filing jointly in 2019)?

If you meet the qualifications for either of these IRAs, you can set up a self-directed IRA as well.

When a self-directed IRA makes sense

The self-directed IRA can make sense for an investor in several situations, especially if you need its main benefits — the potential for higher investment returns and diversification. Here are some of those situations:

  • Potential for higher returns: By investing in nonstandard or alternative assets, you may be able to earn higher returns than you would from traditional assets. For example, you might have an attractive investment opportunity in real estate or in a private business — both of which would be unavailable in assets such as stock and bonds. In alternative assets, there generally will be fewer rivals bidding, meaning you might be able to find a great deal. The flip side is that the assets have lower liquidity.But the potential for higher returns does not mean that alternative assets will always — or even frequently — provide a better return than traditional assets. It only means that they might return more. In a self-directed IRA, the investor must understand and select the investment or hire an advisor who does. In any case, you must know what you’re doing.
  • Diversification: More investment options also mean that you may be able to create a more diversified portfolio beyond assets that are available in the public markets. Ideally, this added level of diversification leads to a less volatile portfolio and better risk-adjusted returns. But you’ll need to own assets that are noncorrelated, meaning they perform well even when the public markets are doing poorly and vice versa.You also may want diversification because you have a huge portfolio that’s otherwise all in traditional assets, and a self-directed IRA is a retirement option offering that.
  • Flexibility: If you need nearly unfettered flexibility to invest, then the self-directed IRA is for you. But be warned: Most investors don’t need this level of flexibility, and you’ll want to fully understand the kinds of transactions that the IRS prohibits in order to avoid a penalty.

Bottom line

For those investors looking to invest in nearly anything and still get a tax break, the self-directed IRA can be a great vehicle. But it does have numerous downsides, especially in the risks presented by the kinds of investments that can be owned in the IRA. While it does present a lot of flexibility, most investors would be best served by sticking with standard IRAs and the range of time-tested investment options they offer.

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