Investing for retirement can be confusing with the sheer number of options available these days. If you’re thinking of opening an IRA, here’s everything you need to know about self-directed IRAs and conventional IRAs.
In this article:
- Defining Conventional IRA and Self-Directed IRA
- Asset Allocation, Control, and Risks
- Income and Expenses
The Great Debate in Investing for Retirement: Self-Directed or Conventional IRA?
IRA Definition: An IRA (Individual Retirement Account) is an investment vehicle with tax benefits. Investors chose this retirement account primarily to have money on hand and a recurring income upon reaching one’s retirement age.
Defining Conventional IRA and Self-Directed IRA
When it comes to investing for retirement through an IRA, there are two options available for investors — conventional and self-directed. The main difference between these two is the level of control they give to the account holder.
A conventional IRA is an IRA that allows investors to invest passively. In this IRA, financial institutions, such as a bank or brokerage firm, make investment decisions regarding an investor’s account. Investment options are also limited to more traditional forms of investments.
Contributions in a conventional IRA are made by the investor, and depending on the arrangement, the investor’s employer as well. These investors treat their IRA as an annuity, or as a nest egg, when they become retirees.
Investors who prefer to manage their nest egg while enjoying the tax benefits of an IRA can choose a self-directed IRA. With this, the investor takes the driver’s seat in making the investment decisions.
A self-directed IRA can invest in any asset that a conventional IRA can, while providing more investment options that most brokerage accounts won’t allow, including cryptocurrencies and real estate.
To make it simple, think of a self-directed IRA as a very flexible investment basket that can hold different kinds of assets. There are several types of self-directed IRA, but these are the two most popular:
- Traditional IRA — Self-directed IRA where investors defer the tax
- Roth IRA — Self-directed IRA where the investment is post-tax, meaning the investors pay the taxes when contributing rather than withdrawing
Asset Allocation, Control, and Risks
Conventional IRA Control, Asset Allocation, and Risks
In a conventional IRA, the account holder doesn’t make the investment decisions—this honor belongs to the financial institution who oversees the account. Asset allocation is limited to stocks, bonds, money market assets, mutual funds, and other investment assets.
One downside to this is it limits investment options. This type of IRA can have capital allocated to various stocks, but the investment vehicle is still the same—corporate securities. Some brokers and custodians may apply higher transaction fees as well.
Self-Directed IRA Allocation, Control, and Risks
Perhaps the most critical reason why an investor may choose a self-directed IRA over a conventional IRA is control. The investor can personally control which investments and transactions to make.
A self-directed IRA, whether a Roth IRA or a Traditional IRA, can accept real estate, tax liens, and even precious metals. This flexibility means higher diversity, which can minimize the risks bought by market cycles.
Self-directed IRAs also may have lower overall expenses, as there is usually little to no fees for fund managers and financial advisors.
However, higher control also means higher accountability. It’s essential that account holders of a self-directed IRA are aware of certain restrictions for this IRA to avoid being penalized by the Internal Revenue Service (IRS).
Income and Expenses
A self-directed IRA provides more investment options than a conventional IRA. Note though that having more options does not necessarily mean better investment returns, but it often can offer more growth potential.
As for expenses, a self-directed IRA may have lower costs as there’s a lesser need for external services because of the amount of control given to the account holder.
Social Security may not provide enough income for retirees, so investors can consider getting additional income by investing for retirement. Annuities and individual retirement accounts can help investors reach their retirement goals and supplement their Social Security income.
Choosing between a conventional or a self-directed IRA ultimately depends on what kind of investor someone intends to be. Rather than thinking that a self-directed IRA is contrary to a standard account, investors should consider a self-directed IRA as a mode where investors take the reins of their investments.
Investors who wish to take on a more active role in their investment and enjoy the freedom of having more variety in investment options may be better suited to a self-directed IRA. Those who would prefer taking a backseat and letting someone else handle their investment for them might prefer a conventional IRA.
What kind of IRA do you currently have or which are you thinking of getting? Why did you choose one over the other? Let us know in the comments section below.