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What Is a Self-Directed IRA?
A self-directed individual retirement account (IRA) is a type of retirement account that offers investors more flexibility and control over their investment strategies. Sophisticated investors who are interested in or passionate about alternative investments may use a self-directed IRA as part of their retirement planning to diversify their portfolio.
All IRAs have a custodian—a bank or trust company—who holds the account and ensures IRS rules are followed. With traditional IRAs, custodians generally only allow you to invest in approved asset types, such as stocks, bonds, CDs, index funds, ETFs, and mutual funds.
With a self-directed IRA, investors have the option to invest in a range of alternative investments, including:
- Real estate
- Precious metals and other commodities
- Crypto assets
- Private placement securities
- Promissory notes
- Tax lien certificates
Investing in these assets carries a greater amount of risk due to lack of information, low liquidity, and potential for fraud.
Types of Self-Directed IRAs
Similar to other IRAs, you can choose between two main types of self-directed IRAs:
Traditional IRA
With a traditional IRA, you can avoid paying taxes on contributions by investing cash on a pretax basis. Your investments grow tax-deferred and are taxed at your ordinary tax rate when you withdraw money at retirement.
Roth IRA
A Roth IRA allows you to invest cash after-tax. Your investments grow tax-free and you won’t be subject to taxes when you withdraw money at retirement.
Contribution limits also apply to self-directed IRAs. The maximum contribution limit for 2023 is $6,500, or $7,500 if you’re age 50 or older. For 2024, the limit increases to $7,000 and $8,000, respectively.
Pros and Cons of Self-Directed IRAs
There are strong advantages and disadvantages of self-directed IRAs that investors must consider before opening an account.
Pros
- More control over investments: Self-directed IRAs provide a wide range of investment options, including alternative assets. You have more control over your investment choices, allowing you to customize your portfolio based on your preferences.
- High potential for return: Because you’re allowed to invest in alternative assets, there’s potential for greater returns compared to traditional assets. Naturally, the higher potential for returns also comes with increased risk.
- Ability to invest in real estate: You can directly purchase and own real estate within a self-directed IRA. However, you can’t sell or rent the property to certain family members, including your spouse, parents, grandparents, children, children-in-law, or grandchildren.
Cons
- Increased investment and tax complexity: You need to have a good understanding of alternative investments to successfully invest in a self-directed IRA. You’ll also have to follow complex tax rules—for instance, you can’t invest in collectibles and life insurance—so understanding IRS rules is also essential. Mistakes or failure to follow the rules could lead to additional taxes, penalties, and loss of deferred tax status.
- Fees: Self-directed IRAs may have higher costs because of the need for a custodian or trustee as well as the costs related to the individual investment choices. Increased fees could affect the performance of your investments.
- Potential for fraud: Investors must be wary of fraud and scams with the investment options and even from account custodians. It’s important to ask questions, verify all information, and consider getting a second opinion from a professional before taking advantage of investment opportunities.
Self-Directed IRA vs. Traditional IRA
A self-directed IRA and traditional IRA have similar tax advantages, contribution limits, and early withdrawal penalties. There are, however, some key differences between the two IRAs.
| Self-Directed IRA | Traditional IRA |
|---|---|
| Range of alternative assets including real estate, cryptocurrency, private equity, precious metals, and more | Traditional investment options including stocks, bonds, ETFs, index funds, and mutual funds |
| High investment risk | Relatively low investment risk |
| Managed by a self-directed IRA custodian or trustee | Managed directly through a bank or trust company |
| High cost; fees may be charged for account opening, record keeping, purchase and sale of assets, transactions, and money transfers | Lower cost; fees may be charged for account administration, advisory services, transactions, and mutual fund management |
| Low liquidity | Low liquidity |
You might benefit from opening a self-directed IRA if you have a strong understanding of and passion for alternative investments, want more control over your investment choices, have a higher risk tolerance, and are looking to diversify your retirement portfolio.
On the other hand, a traditional IRA might be the better option if you have a lower risk tolerance, want to focus on traditional assets like stocks and bonds, and don’t want to deal with the complexity of managing your own investments.
How to Open a Self-Directed IRA
While a self-directed IRA grants you more control over your investments, you’ll still need a custodian or trustee to manage the account and perform investments on your behalf. Here are the steps to open a self-directed IRA:
- Find a custodian: Look for a financial institution or investment firm that specializes in self-directed IRAs. Narrow your options by considering fees, services, and experience with your preferred investments.
- Apply for an account: Many firms offer an online application to streamline the process. You’ll provide some personal and financial information, review and sign disclosures, and pay any setup fees.
- Fund the account: Add funds to your IRA with a new contribution or transfer or rollover from another qualified retirement account.
The Bottom Line
A traditional IRA is usually sufficient for the average investor. It offers tax benefits and investment growth opportunities. If you’re considering a self-directed IRA for its flexibility and potential gains, it’s important to consider both the risks and rewards. Consulting an unbiased financial professional can help you explore your options and make a solid decision for your financial future.
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