What is a Self-Directed IRA?
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How Does a Self-Directed IRA Work?
Traditional IRAs often consist of bonds, mutual funds, stocks, and other typical investment assets. In self-directed IRAs, one can hold assets from a privately owned company, a real estate property, a cryptocurrency startup, a tax lien certificate, and other assets that are not commonly found in a regular retirement portfolio.
With a self-directed IRA, it’s up to the individual investor to choose the assets they will buy, however, they need to use a trustee or custodian to ensure that their self-directed individual investment account does not lose its tax-advantaged status. The custodian’s task is to issue all necessary tax statements and ensure that the account adheres to Internal Revenue Service tax guidelines.
It is wise to seek a custodian before opening a self-directed IRA account. In different types of IRAs, brokerage firms serve as custodians. However, many big brokerage firms do not accommodate self-directed IRAs; instead, some trust companies or banks specialize in handling such accounts.
That said, not all self-directed IRA custodians offer relevant services to the types of assets in a certain account. A good custodian provides services to manage the specific asset/s that can be invested in. In addition, they should have years of experience handling self-directed IRAs and be able to understand the IRS rules that govern self-directed individual retirement accounts.
Advantages of Self-Directed IRAs
Many people prefer self-directed IRAs over other types of individual retirement accounts due to their benefits. Here are some of the pros of opening a self-directed individual retirement account.
Unlike regular IRAs that only allow common types of assets, self-directed IRAs allow for more unique and diverse investment options, and a more diverse portfolio can be one effective way to reduce risk. If one of the assets decreases its value due to market volatility or other external factors, the investor may still have other, unrelated investments in their account that can counterbalance the negative effect of losing value in that asset.
A self-directed IRA allows investors to hold an array of assets, such as real estate investments, tax lien certificates, commodities, limited partnerships, private placements, and other less common types of investments.
Another advantage of investing in SDIRAs is the tax-advantaged growth of assets in a retirement account. The gains that SDIRA assets generate can be either tax-deferred or tax-free.
The account will initially receive a tax break, which allows investments to grow faster. They can only be taxed as income when withdrawn later
Better Control of the Investment
As its name suggests (“self-directed”), the investor will direct access and control of the funds in their retirement account. They can choose which assets to purchase, where they are allotted, and how they want to diversify their investments.
The custodian cannot force the account holder to choose or disregard an investment because the custodian’s main job is only restricted to tax-related matters of the account. The person who owns the SDIRA has relatively full control on the investments, and they can provide specific instructions to the custodian if need be.
It is also relatively easy to make an investment through a self-directed IRA. For example, if an investor thinks an asset may benefit them, they can simply wire the funds from theirSDIRA or write a check to purchase it. The speed of making investments is one of the attractive qualities of SDIRAs.
Self-directed IRAs are exempt from state and federal bankruptcy up to certain limits. It is advisable, however, to spread assets to grow the funds in the account.
Apart from asset protection, a self-directed individual retirement account can also be transferred to family members. Many people can arrange beforehand to pass this investment account to their partner, children, or grandchildren.
Greater Investment Returns
With its tax advantages and fast-growing assets, the investor has a greater chance to secure higher returns to their individual retirement account. This, of course, can only happen if the investor chooses profitable assets and have diversified their portfolio.
Disadvantages of Self-Directed IRAs
There are many advantages to setting up a self-directed IRA. That said, investors should be aware of the drawbacks associated with this type of individual retirement account.
Some transactions are strictly prohibited in self-directed IRAs, and one of these prohibitions is using an asset for personal benefit. For example, the owner of a plumbing company cannot hire their plumbers to fix the damaged faucet in a rental property owned by their SDIRA.
Penalties include suspension of tax benefits.
Self-Directed IRAs are a Double-Edged Sword
It is an advantage to have full control of an SDIRA, but this also presents some problems, chief of which is leaving the investor on their own.. An SDIRA custodian cannot furnish investment advice. A financial advisor may help, but even this is on the investor to perform due diligence and research.
Lack of Liquidity
Some assets in an SDIRA are not as liquid as common assets, such as bonds, stocks, and mutual funds. For instance, when real estate is owned in an SDIRA, the investor will likely have to wait for a longer time to find a buyer and liquidate the asset. Some SDIRAs also have a minimum liquidation requirement at age 70.
This can be problematic for those who need money but cannot yet distribute the assets in their self-directed IRAs.
While there is protection against bankruptcy, some SDIRA assets are not entirely secure. Some investment options are held privately. For example, investing in a fledgling tech company may incur significant losses if the company does not succeed.
SDIRAs Have Fees
Self-directed individual retirement accounts come with several fees. Typical fees in owning an SDIRA include a one-time establishment fee, first-year yearly fee, custodian fee, and charges for paying investment bills.
One example of fraud in self-directed IRAs is when custodians make an evaluation of a specific investment. SDIRA custodians are prohibited from evaluating the legitimacy or quality of any investment in self-directed individual retirement accounts.
A self-directed IRA is one of the go-to options for retirees. Some of the pros of a self-directed IRA are its tax-advantaged status and the account holder’s ability to control their investments. However, like many investments, it has its pros and cons, so it is a good idea to research it thoroughly before committing to this investment option.
- Hartman, R. (2020). A Guide to Self-Directed IRAs. US News.
- Bergman, A. (2019). The Case For The Self-Directed IRA. Forbes. Retrieved from
- U.S. Securities and Exchange Commission. (2018). Investor Alert: Self-Directed IRAs and the Risk of Fraud. Retrieved from https://www.sec.gov/investor/alerts/sdira.html