A recent Tax Policy Center estimate reports that over 60 million Americans own an IRA, totaling over $9.4 billion in assets. The overwhelming majority of these IRA accounts are comprised of well-known options: including Roth, traditional, SEP, and SIMPLE IRAs.

A closer look at these assets reveals that 3%-5%, per the Retirement Industry Trust Association, reflect a lesser-known type: the self-directed IRA (SDIRA).

What is an IRA?

Before we dive into SDIRAs, let’s ensure we have a firm grasp on IRA basics.

Simply defined, an IRA is a savings account designed specifically to help fund your retirement.

In enjoying the ability to choose the type of instruments you want to invest in (and change) within your IRA, you can (for example) select from a variety of options including stocks, bonds, and mutual funds. 

Two primary types of IRAs for individuals include Roth and traditional IRAs, both of which offer considerable tax breaks. The difference, however, is just a matter of when you receive the same.

A traditional IRA is a tax-deferred account, meaning you’ll pay taxes on a future date. Thus, your contributions are typically funded with pre-tax dollars and earnings grow tax-deferred until you make a withdrawal during retirement. 

Alternatively, your tax break comes later with a Roth IRA because your contributions are funded with after-tax dollars. However, your money grows tax-free and you can make tax-free withdrawals on  qualified distributions in retirement.  

What is a self-directed IRA?

You can set up a self-directed IRA as either a Roth or traditional IRA, with the type of assets you own within the account representing the largest difference between the two options. An SDIRA is more flexible in that it can hold more than just stocks, bonds, and mutual funds—also potentially containing a variety of investments typically prohibited from traditional and Roth IRAs. Examples of this include commodities, real estate, cryptocurrency such as bitcoin and dogecoin, and precious metals.

Another difference between SDIRAs and other IRAs is that the former type of account is directly managed by the account holder: meaning that each investment you make no longer requires approval by the account custodian (the entity holding your assets).

Self-directed IRA advantages

The primary reasons why most people open a self-directed IRA account are to seek higher investment returns and have the option for greater diversification. A self-directed IRA feeds your ability to accomplish these goals as you are in complete control of the investments within your account. For example, if you are knowledgeable about investing in various categories—such as a private company, livestock, tax lien certificates, or undeveloped land—you have the flexibility to determine which investments to dive into and how you want to allocate your funds.

Risks of owning a self-directed IRA account

While owning an SDIRA comes with many benefits, you should also familiarize yourself with potential risks before opening an account.

For starters, you need to understand associated rules: because if you break one, the entire account could become distributed to you early and you’ll thus need to pay taxes and perhaps a penalty as well. For example, let’s say you have a rental property investment through your SDIRA. Rules dictate that you’re not allowed to withdraw money from the account to fix any issues that arise within that property (e.g., a broken window) because doing so would violate the “self-dealing” rule. Visit the IRS website for a complete list of prohibited transactions.

You’ll also need to conduct your due diligence for every investment, especially since SDIRA custodians aren’t responsible for verifying investment legitimacy or claim accuracy. Custodians also aren’t allowed to offer financial advice for such investments. Consequently, SDIRAs summon a higher risk of fraud. In fact, the Securities and Exchange Commission (SEC) recently issued an investor alert concerning potential fraud risk in self-directed IRAs.

SDIRAs also reflect lower levels of liquidity. For example, it’s much easier to pull out of stocks, bonds, and mutual funds than it is for real estate or livestock investments. This is sometimes a concern, particularly with respect to required minimum distributions (RMDs) for SDIRAs established as traditional IRAs. That’s because if there’s no liquidity to distribute the funds, you can get hit with a 50% penalty from the IRS on the amount set for distribution. A Roth SDIRA doesn’t have the same restrictions; however, this can eventually present an issue when a beneficiary inherits the IRA and needs to liquidate it within a 10-year period.

While fees vary, fee structures are also often more complicated and steeper with SDIRAs than Roth and traditional IRAs.

How to open a self-directed IRA account

Opening a self-directed IRA is as easy as setting up any other type of IRA once you find a custodian for the account.

Most household-name brokerage firms don’t offer self-directed IRAs, as SDIRA custodians are often trust companies and some banks. While these companies are approved by the IRS (click here to view a list of approved non-bank trustees and custodians), they provide fewer protections and little to no oversight compared to traditional and Roth IRA custodians. Therefore, your best resource in this respect is a financial advisor who can direct you to a trustworthy custodian for your SDIRA.

Upon identifying a custodian, you can then fund the SDIRA—just as you would any other IRA.

In sum: what you should know about self-directed IRAs

Self-directed IRAs aren’t for everyone, as they are best suited for sophisticated investors who are confident they can better diversify their funds and ultimately earn higher returns. That’s why for most investors, a regular IRA is just fine.

Still have questions about self-directed IRAs? Schedule a FREE Discovery call with one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.