A self-directed IRA offers a wider range of investment opportunities than a conventional IRA. To find out what it is, how it works, and how to avoid penalties from the IRS, read on.
In this article:
- What Is a Self-Directed IRA?
- What Are the Different Types of Self-Directed IRAs?
- Who Is an IRA Custodian?
- Where Do I Get a Self-Directed IRA?
- When Can I Use a Self-Directed IRA?
- Why Should I Choose Self-Directed IRAs Over Regular IRAs?
- What Are the Risks With a Self-Directed IRA?
- How Can I Make a Self-Directed IRA Investment Work for Me?
Important Facts About Self-Directed IRAs
What Is a Self-Directed IRA?
A self-directed IRA is an IRA that allows the investor to make all investment decisions. While regular IRAs generally allow for a variety of mutual funds, stocks, and bonds, a self-directed IRA has broader investment opportunities.
These opportunities include real estate properties, private companies, and even more unconventional ventures such as precious metals and digital currencies. Most ventures are fair game as long as the custodian approves the deal.
What Are the Different Types of Self-Directed IRAs?
1. Custodian Controlled SDIRA
A special IRA custodian watches over and maintains this kind of account. The custodian holds the funds and invests them at the direction of the IRA holder.
IRA custodians are unlike a typical financial institution, by way of generating fees as they open and maintain IRA accounts. They don’t offer financial investment platforms or products at all.
This type of self-directed IRA may be a good fit for those looking to invest in alternative assets with low-frequency transactions.
2. Financial Institution Offered SDIRA
Most banks and financial institutions offer this type of account, making it the most popular out there. This type of self-directed IRA offers only investment options from the bank or the financial institution itself.
Such investment offerings include exchange-traded funds, stocks, and mutual funds. This is extremely popular with investors seeking to invest in more traditional assets.
3. Checkbook Control SDIRA
This type of account is growing in popularity among retirement investors. It allows investors to invest in more alternative assets with a high transaction frequency.
It also creates a limited liability company (LLC), which the IRA holds and funds, and the IRA holder manages. This lets the holder bypass delays and costs that usually come with hiring an IRA custodian.
Limited Liability Company (LLC) Definition: A type of corporate entity where members are not held liable for the company’s debt or liabilities. They combine qualities of corporations and sole proprietorships, where there are flow-through taxations available to members.
The structure of this type of account allows the investor to act quickly on any opportunity, with little cost and delay.
A checkbook control self-directed IRA is ideal for investors who want to invest in alternative assets that require high-frequency transactions. These assets include tax liens or rental properties.
Who Is an IRA Custodian?
An IRA custodian is an asset holder for IRA funds placed in an account. They track contributions, transfers, distributions, and investments.
A custodian can be a financial institution or non-financial institution, as long as the IRS approves them. Either way, the IRS requires an IRA custodian to report all transactions.
Where Do I Get a Self-Directed IRA?
Several brokerage firms and financial institutions stand as custodians for all kinds of IRAs. However, common brokers don’t usually offer self-directed IRAs.
Companies that serve as custodians to self-directed IRAs usually have their own investment specialties. Each one handles different kinds of investments, so some thorough research is necessary.
A self-directed IRA is complex in nature, so it may be best to speak to a financial advisor before opening anything. There are advisors who have experience managing deals with self-directed IRAs, who may be helpful to newer investors.
When Can I Use a Self-Directed IRA?
Anybody seeking more diverse investment options will have more to gain with a self-directed IRA. Furthermore, anyone can start at any time, but the only difference is the type of investment that investors decide to take up.
Investors will have a maximum contribution limit of $6000, or $7000 if they’re over 50. While many experts recommend that older investors stick to more traditional, low-risk investments, they can still reap the benefits of tax-deferred distribution and growth.
Why Should I Choose Self-Directed IRAs Over Regular IRAs?
The goal of IRAs is to provide investors with future financial security. Social Security and most other government programs can prove to be unreliable upon retiring age, and the ever-volatile stock market can cripple life savings if they take a big dip.
Most retirement savers are happy enough with the types of assets that regular IRAs offer. Bonds, stocks, ETFs, and mutual funds, among others, are considered diverse enough as investments.
Self-directed IRA accounts allow its holders more agency and freedom over what investments they should make. They also offer more varied investment options that have greater returns.
Investors with a good grasp of investment markets and those who know how to make them work are a good fit with self-directed IRAs.
What Are Some Risks with a Self-Directed IRA?
While investors may enjoy the freedom that comes with a self-directed IRA, it also allows little room for error. IRA custodians aren’t allowed to give financial advice, which means investors have to do their due diligence or opt to hire financial advisors who specialize in investing in self-directed IRAs.
Also, the call of diverse investment options may be tempting with self-directed IRAs, but they can be as lacking in diversity as most retirement investment accounts. Investors who want to diversify may opt to buy exchange-traded funds or ETFs, which lets investors buy various assets from different sources in a safer way.
Exchange-Traded Funds (ETFs) Definition: A type of fund that owns third-party assets like stocks and bonds. They differ from a mutual fund in that the shares trade on common stock on an exchange.
Large ETFs have a high daily volume on average, and much lower fees than mutual funds This makes them an attractive venture for investors.
How Can I Make a Self-Directed IRA Investment Work for Me?
A self-directed IRA allows investors the freedom to access various investment options. However, it is crucial that investors do their own research and enact due diligence with every identified investment opportunity.
To be on the safe side, be sure to consult with a financial advisor or tax attorney before making big investment decisions.
For all its benefits, freedom of movement, and variety of options, having a self-directed IRA also carries great complexities. But that’s no reason to fret, as this can teach beginners to be more responsible, and forces them to understand how to properly invest solo.
Do you have experience with handling a self-directed IRA? Let us know what it’s like in the comments section below?