The desire of every investor — including investors in retirement accounts — is to maximize return on investment. As a result, investors with greater risk tolerance are always on the lookout for opportunities to earn higher returns.
Self-directed individual retirement accounts (IRAs) exist as a way for relatively more risk-tolerant investors to seek higher returns on their retirement accounts. Similarly, they appeal to some investors as a way to further diversify their investment portfolio at the asset class level.
However, the pursuit of higher returns and broader diversification comes with its own risks. Consequently, smart retirement planning must include weighing the benefits and the risks before making a choice.
What Is a Self-Directed IRA?
A self-directed IRA (SDIRA) is a type of IRA that allows holders, also called investors, to hold a variety of alternative investments that are not available for regular IRA (traditional IRA, Roth IRA) holders.
The investment assets available to regular IRA holders include stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs) and certificates of deposit (CDs). In addition to these regular assets, an SDIRA allows you to invest in a number of alternative investments.
Investment options for self-directed IRAs include:
- Real estate (with exceptions, like the property that you live in)
- Commodities like gold, silver, oil and gas
- Private placement
- Tax lien certificates
- Water and mineral rights
Like regular IRAs, a self-directed IRA requires the appointment of a custodian that will administer the IRA and hold its invested assets for safekeeping. However, searching for a custodian that can administer self-directed IRAs can be a daunting process.
First, many custodians who administer regular IRAs will avoid SDIRAs, limiting the pool of possible custodians. Second, apart from finding a custodian who administers SDIRAs, you must be specific and find one that supports investment in the particular assets you are interested in.
Types of Self-Directed IRAs
A self-directed IRA can either be a traditional SDIRA or a Roth SDIRA.
- Traditional SDIRA:
- A traditional SDIRA works like a traditional IRA in that contributions to this account type are tax-deductible while distributions are taxed at the point of withdrawal. Similarly, withdrawals at age 59 1/2 years and above are penalty-free.
Also, like a traditional IRA, required minimum distributions (RMD) begin at age 72.
- Roth SDIRA:
- Like a traditional Roth IRA, contributions to a Roth SDIRA are not tax-deductible but withdrawals from the account are tax-free. An income ceiling applies to contributions.
Unlike a traditional SDIRA, there are no required minimum distributions for a Roth SDIRA. Withdrawals after age 59 1/2 years are penalty-free only when the account is at least five years old.
Types of Self-Directed IRAs
How Are Self-Directed IRAs Different From Regular IRAs?
A self-directed IRA has the same contribution limits as a regular IRA: $6,000 (or $7,000 if you are 50 or above.) Also, as seen above, a traditional SDIRA and a Roth SDIRA are like a regular traditional IRA and a Roth IRA. However, there are some notable differences.
The first major difference between self-directed IRAs and regular IRAs lies in the expanded range and variety of investment assets that the former permits.
Another difference is that self-directed IRAs usually have a smaller pool of custodians.
Third, unlike regular IRAs, you choose and manage the investments you want in your account. Custodians don’t give you any financial advice or conduct extensive due diligence on your behalf. Since it’s self-directed, you take responsibility for your own choices.
As the U.S. Securities and Exchange Commission puts it, “Custodians for self-directed IRAs disclaim most duties to investors.” As a result, they won’t typically evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”
Benefits of Self-Directed IRAs
Self-directed IRAs provide investors with more flexibility by increasing the number of asset classes that investors can explore. When they refuse to limit themselves to the world of stocks, bonds, mutual funds, ETFs, REITs and CDs, investors can explore other options that might even have more potential than the classes they have grown used to.
The possibility of obtaining better returns than with traditional assets is a major benefit of self-directed IRAs. The primary motivation of investors who prefer self-directed IRAs is the potential for higher returns from these alternative investments. Therefore, they are often the provenance of skilled and risk-seeking investors who are confident about their ability to earn higher-than-average returns.
Another benefit is the opportunity for broader diversification. The modern portfolio theory has shown that the more negatively correlated assets a portfolio has, the less its risk.
Gold, for example, has been used as a diversification tool over the years because of its low correlation with stocks and bonds over time, making it a good diversification tool. According to data from Morning Star as reported by ETF Trends, bitcoin, now dubbed the “digital gold,” has also shown the same relationship to bonds — posting even less correlation than gold.
Risks of Self-Directed IRAs
Self-directed IRAs also come with their own risks.
- There are many fees involved in a self-directed IRA. When added together, they can become very expensive to maintain. Common fees include a lump sum establishment fee, a first-year annual fee, an annual renewal fee and fees for settling investment bills.
- Prohibited Transactions
- There are certain transactions that are prohibited for self-directed IRAs by the Internal Revenue Service (IRS). For example, you cannot borrow money from your SDIRA, sell property to it, live in a property purchased from your SDIRA or use personal money to repair or renovate an SDIRA-acquired property.
Failure to comply will result in penalties, interests and a forfeiture of tax benefits.
- Due Diligence
- As the name implies, you choose the investments in your self-directed IRA. Your custodian won’t give you financial advice or typically conduct due diligence on your investment choices.
- Selling some alternative investments can be very hard because they are not as liquid as traditional investments. Take real estate as a typical example. This can be a significant problem if you have a traditional SDIRA where you are required to make RMD at 72.
- Limits on Possible Investment
- While self-directed IRAs widen the range of investments, the IRS exempts assets such as life insurance, S corporation stocks and collectibles.
- In 2018, after stating that custodians have no duty to help you select investments, the SEC warned about the tendency of fraudsters to allure SDIRA holders with fraudulent investments. Much of this warning centered on certain self-directed IRAs allowing investment in digital assets like cryptocurrencies. The SEC warned of fraudsters using the allure associated with digital asset classes to entice investors with a promise of high returns.
Again, they warned, SDIRAs allow investors to hold alternative investments that, unlike publicly traded securities, may have limited financial information available. Even when financial information is available, a public accounting firm may not audit it as is normal practice.
- Higher Risk
- Alternative investments, though potentially more profitable, are also potentially riskier because of high volatility. The same assets that can move wildly to the upside can also fall drastically to the downside.
Some risks of self-directed IRAs include:
How Can You Open a Self-Directed IRA?
If, after evaluating the benefits and risks, you are interested in self-directed IRAs, you can open your own account by following the process outlined below.
Steps To Open a Self-Directed IRA
- Decide on the alternative investments you are considering. It’s better to identify the broad asset classes you want to include in your self-directed IRA before researching custodians. This is because not all custodians allow all alternative investments permitted by the IRS.
- Find a custodian that allows investment in those asset classes. Once you have decided on the broad asset classes, you can start searching for custodians that fit the bill. Apart from selecting one that allows the asset class you are considering, you should also evaluate custodians based on fees, integrity and customer support. It’s better to find the right one at the start, because there is a fee involved in changing custodians later on.
- Open an account with your chosen custodian. Once you have selected a custodian, request to open a SDIRA and complete all paperwork.
- Research your proposed investment opportunities. Since the custodian won’t do it for you, take responsibility for conducting due diligence for every investment opportunity. Ensure you consult your financial advisor (if you have one) about any investment.
- Choose a broker that will facilitate the transaction. The broker helps you purchase whichever alternative investment you are interested in. This could be a bitcoin exchange or a real estate agent, for example.
- Give investment orders to your custodian. Once you have decided on a broker, you can then order your custodian to fund and complete the transaction. When this is done, your custodian holds the investment for safekeeping.
Opening a self-directed IRA is simple. What is more difficult is deciding whether to own one in the first place. Therefore, ensure you spend time thoroughly evaluating this option — and speak with your financial advisor — before making a decision.