Self-directed IRAs are an increasingly popular path to retirement, but there are still a lot of misconceptions about these accounts.
Self-directed IRAs maintain many of the tax advantages of standard IRAs, but come with the unique ability to invest in a wide range of alternative assets. With the right investor knowledge, you can increase your earning power while paying fewer taxes.
With an account so unique, there are also increased rules and scrutiny that intimidate many investors. However, with the right know-how, you can navigate these obstacles and build substantial wealth inside your self-directed IRA.
If you’re considering a self-directed IRA, here’s what you need to know.
What Is a Self-Directed IRA?
A self-directed IRA (SDIRA) is a uniquely structured retirement account that gives you more control over your retirement savings and can diversify your portfolio far more than a standard IRA. With a self-directed IRA, you can invest in a wider range of assets, including:
- Real estate
- Cryptocurrency
- Precious metals
- Private equity
- Peer-to-peer lending
Self-directed IRAs are administered by an IRS-approved custodian, who assists clients with certain IRS reporting requirements while safe-guarding their funds and assets. While a custodian technically holds your funds, you still get the final say on investing decisions–though it has to go through your custodian.
A Self-directed IRA can be designated as a Traditional or Roth account and maintains the same tax advantages as standard IRAs. These benefits, along with the account’s defining characteristics, make it a great choice for a primary or supplemental investment vehicle for retirement.
11 Facts to Know About Self-Directed IRAs
Self-directed IRAs can be a powerful tool on your path to retirement, but many investors are still confused about how they work. These 11 facts can help you decide if SDIRAs are right for you and what to consider as you get started.
1. You Can Invest in a Wide Range of Alternative Assets
SDIRAs offer far more investment opportunities than standard IRAs. While most retirement accounts are restricted to common assets like stocks and bonds, SDIRAs can be diversified with a wider range of alternative assets, such as real estate, mortgage notes, liens, precious metals, cryptocurrency, private equity, and commodities.
2. You Are Barred from Self-Dealing
Individuals are barred from transacting or benefiting directly from their own self-directed IRA other than via contributions or withdrawals.
While it sounds confusing, it essentially means that you can’t sell assets directly to your account or buy assets from your account using personal funds. Think of it like a business whose assets must be kept separate from yours. Only self-directed IRAs also prohibit you from benefiting directly from your account, such as using SDIRA funds to purchase a property you vacation in. You also can’t take a loan out against your SDIRA, use it as collateral, or perform any labor on property owned by the SDIRA.
3. SDIRAs Can Be Structured as a Traditional or Roth Account
Like a standard IRA, an SDIRA can be designated as a traditional or Roth account, offering tremendous tax advantages.
- Traditional SDIRAs are funded with pre-tax dollars, which grow tax-deferred while in the account. Qualified withdrawals are subject to income tax.
- Roth SDIRAs are funded with after-tax dollars, which grow tax-free in the account. Qualified withdrawals are not subject to income tax.
4. You Can’t Transact with Other Disqualified Persons
Much like you can’t engage in self-dealing, disqualified persons are also barred from similar activities. Disqualified persons include your spouse, ascendants, descendants, custodians, or account fiduciaries.
For instance, you can’t use IRA funds to invest in your spouse’s business or hire your son’s construction company to work on a real estate property in your portfolio. Likewise, you couldn’t purchase property from a disqualified person or otherwise invest in assets they own.
5. SDIRAs Must Be Opened Through a Custodian
Self-directed IRAs are required by law to be administered by an IRS-approved custodian. Your custodian holds the assets and ensures that the account complies with IRS requirements. SDIRA custodians do not provide investment advice, but but if your investment decisions meets the IRS self-directing regulations, your custodian will process the transaction.
A custodian can be a bank, credit union, or trust, but not all financial institutions offer true SDIRA accounts.
6. SDIRAs Allow You to Open an LLC Inside Your Account
If you want even more control over your SDIRA and bypass your custodian, you can open an LLC, name the SDIRA account as the owner, and designate yourself as the manager. When you choose this path, you gain what’s known as “checkbook control.”
With checkbook control via an SDIRA LLC, you can bypass your custodian to make an investment, sell an asset, or make asset-related payments, such as to pay a property manager who oversees real estate in your portfolio. Since you can bypass your custodian in many cases, an LLC can also help lower the total amount you pay in fees each year.
7. SDIRAs Come with Higher Fees
The flexibility and wide range of assets made available through an SDIRA typically lead to higher administration fees when compared to those attached to a standard IRA. Fees vary by custodian but often include sign-up annual fees, transaction fees, and fees for holding specific types of assets, such as precious metals or real estate.
The earning potential and freedom an SDIRA provides can far outweigh the increased fee, but it’s important to compare fee schedules when shopping for a custodian.
8. There Are Additional Reporting Requirements
While your custodian is responsible for reporting certain tax forms associated with your SDIRA (EX: Form 5498), you may be required to submit other forms.
Depending on the type of assets you hold inside an SDIRA, there may be additional reporting requirements you are personally responsible for providing to your custodian. These requirements can include annual valuations for property held in the account (FMV of account), partnership tax return forms (if leveraging an SDIRA LLC), and unrelated business income tax forms (typically if using a non-recourse loan to invest in property).
Please consult a tax professional or CPA in order to determine which required tax forms you will need to file regarding your specific situation.
9. Contribution and Income Limits Are the Same as Standard IRA Accounts
Both standard IRAs and SDIRAs are subject to the same contribution limits and income limits (Roth IRA exclusive). These limits specify the amount of money you can contribute to your account, not including account rollovers, interest, or earnings from a transaction.
Limits can change annually to account for cost of living adjustments (COLA). The 2024 limit is $7,000, with an additional $1,000 catch-up contribution available to individuals 50 years of age and older. Roth SDIRAs are subject to additional limits based on your income and tax filing status.
10. Early Withdrawal Penalties Still Apply
SDIRAs are also subject to the same withdrawal rules and regulations as standard IRAs. Withdrawals made when you are 59 ½ or older are not subject to penalty, but if you withdraw from your account before that age, you’ll likely face a 10% penalty.
However, there are a few circumstances that won’t result in a penalty. These include:
- Making a withdrawal that qualifies for an early-withdrawal exclusion: The list of IRS-approved early-withdrawal exclusions includes exceptions for buying your first home, having a baby or adopting a child, sustaining a medically diagnosed complete or partial disability, or using funds for qualifying educational expenses.
- Rolling over funds from one retirement account to another qualifying account. If using an indirect rollover, you must deposit the funds in the new account within 60 days.
- Withdrawing from contributions held in a Roth IRA account that is 5 years or older. Withdrawals from earnings will be taxed.
11. SDIRAs Are Less Liquid and Require a Longer-Term Focus
Assets traded on the open market, like stocks and bonds, are liquid assets that can be sold off in a day, but that’s not always the case for assets held in SDIRAs. Real estate investments, mortgage notes, and private equity investments can take years to realize their true earnings and aren’t as easy to liquidate in the short run.
That’s not necessarily a drawback of an SDIRA; the goal, of course, is to build wealth for the future. It is, however, something you should keep in mind as you plan your investment strategy.
Is a Self-Directed IRA Right for Me?
To recap, self-directed IRAs allow far wider investment opportunities than standard IRAs, but come with stricter rules.
If you want more control over your retirement savings and the opportunity to diversify your portfolio with alternative assets, then an SDIRA is worth considering. These accounts allow you to leverage high-yield assets, like real estate, to grow your account faster than is generally possible with a standard IRA.
Further, an SDIRA is also a great option if you’re well-versed in a particular industry or asset collection and want to use that knowledge to invest. For instance, if you have a deep understanding of the real estate market or are savvy when it comes to precious metals and commodities, an SDIRA can give you the freedom you need to make educated investment decisions.
FAQs
What types of assets can be invested in through an SDIRA?
An SDIRA can hold a wide range of assets, including:
- Real estate
- Foreign currencies (Forex)
- Mortgage notes
- Tax liens
- Precious metals
- Private Equity
- Cryptocurrency
- Commodities
- LLCs
Who can act as a custodian for an SDIRA, and what is their role?
SDIRA custodians must be approved by the IRS and can include banks, trusts, brokerage firms, and other approved financial entities. Custodians hold assets, and ensure that your account remains compliant with the most recent IRS rules and regulations.
What are the benefits and risks associated with investing in an SDIRA?
SDIRAs give you more flexibility and control over your retirement account. When you open an SDIRA, you gain access to alternative assets that can’t be held in a standard IRA. These include real estate, cryptocurrency, private equity, and precious metals.
With an SDIRA, you can also establish checkbook control, which lets you execute transactions, pay asset-related bills, and receive asset-related income, such as rent, instead of going through a custodian.
Despite the benefits, an SDIRA does come with risks. Because your custodian does not provide investment advice, you must complete due diligence before every transaction. Failure to do so can leave you vulnerable to significant losses and your account vulnerable to penalty. SDIRAs also come with higher fees than standard IRAs.
What are prohibited transactions in an SDIRA, and how can they affect the account holder?
Prohibited transactions include any transaction that is considered self-dealing or carried out with a disqualified person, such as a spouse, child, grandchild, parent, or grandparent.
For instance, you cannot take out a loan against your account, purchase an asset from a disqualified person, or live, vacation, or maintain office space in IRA-held real estate. The same is true for disqualified persons.
If you engage in a prohibited transaction, you can face penalties until the issue is resolved. If you don’t resolve the issue, your account can be disqualified, meaning it will no longer be considered a tax-advantaged IRA account. The funds in the account will be considered income, which can lead to significant tax ramifications.