Self-directed IRAs are a powerful tool to diversify your assets and grow your retirement savings. With numerous new investment opportunities, investors can take control of their retirement. However, a self-directed IRA includes several rules that must be followed.
As you navigate your options within self-directed IRAs, it’s important to understand what can and cannot be done, and the most common ways in which self-directed IRAs can fail. Take a look at the top seven ways a self-directed IRA can fail:
1. Using your IRA for the benefit of “disqualified persons”
According to IRS rules, your self-directed IRA may not buy an investment from, sell an investment to, or be involved with disqualified persons. Disqualified persons include yourself, as well as immediate family members and their spouses. For example, this means that you cannot use your self-directed IRA to invest in a company you own, or a company that is owned by a family member.
2. Not understanding allowable investments
One reason many investors choose to open a self-directed IRA is because this type of retirement account allows you to invest in nontraditional assets like cryptocurrency or even livestock. However, it is critical that account owners still understand what is off-limits as an investment. Assets that cannot be included in a self-directed IRA include life insurance, collectibles, derivatives, and coins.
3. Prohibited transactions & indirect benefits
While prohibited transactions include those that benefit disqualified persons, there are more restrictions beyond that, and many investors with self-directed IRAs may not be aware of them. For example, a conflict of interest transaction would include investing in a company in which you own a small stake.
Additionally, indirect benefits can accidentally cost account owners, especially when it comes to real estate investments. For example, you cannot rent your property to a family member or stay in your own rental property that is part of your self-directed IRA. Plus, you cannot make a repair yourself on your real estate investment.
Regardless of the asset type, ensure that you are able to keep an arm’s length from your investment, and understand the limitations of each type of asset in which you invest.
4. Dishonest dealings
While there are some transactions you may not know are prohibited, you must also avoid deliberately dishonest transactions or mishandling of assets. One of the most commonly abused assets is an LLC account, where investors may attempt to avoid paying taxes. This could also include borrowing money from your IRA’s LLC or applying for a credit card in the name of your LLC. When you make this type of mistake, the penalty can put a drain on your retirement savings or disqualify them completely.
5. Spreading investments too thin
One of the main reasons one might open a self-directed IRA is to diversify their assets within their portfolio. However, investors should be cautious of diversifying too much. When you spread your investments too thin, you can limit your potential for growth.
Conversely, another common mistake is putting all your money in one asset. A properly diversified portfolio is key to not only growing your retirement savings, but also shielding yourself in case of a downturn. Be sure that you’ve consulted with a qualified financial advisor to help you properly spread your investments in different assets.
6. Early distribution or withdrawal
Keep in mind, your IRA is for your retirement, and there are penalties for withdrawing from your IRA account before the age of 59 ½.
Additionally, a common mistake is a lack of understanding of how to move funds when purchasing alternative assets. Some who are new to self-directed IRAs may take an early distribution to invest in alternative assets. However, a self-directed IRA account enables you to transfer funds directly from one retirement account to another without paying additional penalties, when seeking to make those investments.
7. Lack of due diligence
When you’re embarking on any new venture, research and understanding is critical before you take action. This includes understanding both the investment opportunities as well as the custodian or provider that you entrust with your investment.
While certain investments may be hot commodities in the moment, it’s important to do your own research and understand the risks of an investment for yourself before investing your retirement savings.