Retirement savings often conjures up the idea of “set-if-and-forget-it” accounts: the investor decides how much money to contribute, and the rest is up to the discretion of the financial entity overseeing the account.
But what if you want more control over your future? What if you want the final say over when, how, and where your hard-earned cash is invested? For some, self-directed investing using a self-directed IRA is the answer.
What is Self-Directed Investing?
Self-directed investing offers a “do-it-yourself” approach to retirement savings and other forms of wealth accumulation. When you engage in self-directed investing, you take control of how, when, and where your funds are invested.
With a self-directed investing account, you can access traditional assets, like stocks, bonds, ETFs, mutual funds, and other types of assets not commonly held in traditional retirement accounts. These assets include:
- Real estate
- Precious metals
- Promissory notes
- Foreign Currency
- Tax liens
- Private Equity
How Does Self-Directed Investing Differ from Traditional Investing?
Most traditional investment strategies often rely on advice from a third-party investment firm, custodian, or trustee; self-directed investment places the onus of investment decisions on the investor.
If you choose self-directed investing as your path to retirement, you’re in charge of how you want your funds invested and are responsible for exercising due diligence. That means you have the opportunity to thoroughly research and vet any investment opportunity and determine what assets align with your strategic goals.
Once you decide on an investment path, you dictate when and how your funds are invested. The custodian holds your account assets and only plays an administrative role, managing assets, transfers, and trades.
To get started with self-directed investing, you need to open up an SDIRA via a self-directed IRA custodian. Once you have an account set up, you’ll be able to inform your custodian of any investment decisions so that you can execute trades that help build wealth in your portfolio.
The Pros and Cons of Self-Directed Investing
If you’re considering self-directed investing in shoring up your retirement, it’s important to consider all the drawbacks and benefits that come with it.
Pros of Self-Directed Investing
You decide when and how you want to invest your money and maintain the option to extend investments to alternative assets. While most accounts allow you to execute the final decision, self-directed investing with an SDIRA allows you to invest in assets without being restricted by your custodian.
Self-directed investment does place a lot of responsibility on the investor versus the custodian or trustee, but there are protections in place. For instance, the Bankruptcy Abuse Prevention and Consumer Protections Act offer protections to IRA funds if you file for bankruptcy.
Self-directed retirement investments are typically subject to tax benefits, though when depends on the type of account you have. For instance, traditional IRA and 401(k)s contributions are made with pre-tax dollars, which expands growth potential. On the other hand, Roth IRAs provide tax benefits at the time of withdrawal since contributions are made with pre-tax dollars.
Depending on your retirement account, you may also be able to claim contributions on your tax returns. An experienced self-directed IRA custodian can help you understand the tax benefits provided by your self-directed account.
Potential for higher returns
Self-directed investing accounts allow for investments in assets traditionally restricted by several common retirement accounts. Alternative assets like real estate and promissory notes often provide the opportunity for higher returns, often at a faster pace. That’s particularly true when compared to more traditional assets like stocks and bonds.
Cons of Self-Directed Investing
Complex rules and regulations
As is often the case with retirement accounts and strategies, self-directed investing comes with a bevy of rules and regulations, including how much you can contribute, what you can invest in, and when you can access your funds. Failing to follow them can leave you with hefty tax bills or penalties.
Your custodian can help you understand rules and regulations and ensure that your investments meet both state and federal requirements.
Potential UDFI Tax Obligations
If you use self-directed investment funds to purchase real estate and it earns income, the IRS may see a portion of that income as unrelated debt-financing income (UDFI). If that’s the case, you’ll owe taxes. As such, discussing any investments that may result in UDFI with a tax professional is a good idea.
Potential for Limited Liquidity
Traditional retirement assets like stocks and mutual funds are easy to access, meaning they are liquid. That may be true for some alternative assets popular in self-directed portfolios, but that’s not always the case. Other assets, like real estate, may not provide that same level of liquidity.
If you’re concerned about the liquidity of self-directed investment assets, it’s a good idea to balance your portfolio. You can do so by mixing highly liquid assets with others that, though not as liquid, will provide stability.
Heavy Research Required
Custodians do not have fiduciary responsibilities, so they don’t have to offer any advice on your investments. If you practice due diligence, this may not be a concern, but if you’re not fully aware of the implications of your alternative investments or if you’re fairly new to the scene, you may want to work with a third party who can provide insights.
DIY Investing Tools
DIY investing requires ample research, and the right tools can make all the difference.
Financial and Industry Websites
If you’re investing in specific assets, one of the best things you can do is to stay informed about the industry. Trusted financial websites and news outlets can help you do so. They can also help you expand your knowledge base to other investment concepts.
The IRS website is a wealth of knowledge when it comes to rules and regulations that govern various types of investment accounts and practices. This includes information about contribution limits, prohibited transactions, and tax reporting rules and forms.
A quality custodian will provide tools and resources that can help you become a stronger and more informed investor. For instance, Horizon Trust’s Investment Corner provides access to an industry-leading account portal that provides detailed investment reporting, tracking, and real-time status alerts.
Similarly, the right custodian should be able to point you to a collection of white papers, blog posts, and even webinars that can help you hone your skills or learn more about a specific asset or industry.
Paid educational resources
In addition to free resources, a plethora of paid investment tools can help you increase your knowledge. Some may be hosted by your custodian, while others are offered by independent academic or financial entities. And, like other tools, paid educational resources can provide insights into broader investment concepts or specific asset niches, like real estate or cryptocurrency.
Before you pay for an investment course, however, be sure to review the entity that provides the course thoroughly. You can also discuss the resource with your custodian to see if they can provide feedback or suggest another option.
The Importance of Finding the Right Custodian for Retirement
Just because a custodian doesn’t play an active role in your self-directed investing strategy doesn’t mean any will do. Finding the right custodian for your self-directed retirement goals is paramount to success.
Your custodian won’t provide advice or review your investments but they will impact your investment in other ways.
Here are a few additional considerations to remember:
One of the most important ways a custodian can make or break your investment strategies is their experience.
When you venture into alternative assets, each one comes with a specific set of rules and regulations that you must follow to avoid penalties or other issues.
Choosing a custodian with meaningful experience with the asset(s) you want to invest in can help you avoid common pitfalls.
State and Federal Compliance
Self-directed custodians are held to similar regulations as banking institutions. When selecting a custodian, choose one that federal or state agencies regulate. Doing so ensures that the custodian you choose complies with IRS and state requirements.
Your custodian can advise you on investment strategy, but that doesn’t mean they can’t arm you with the tools and information you need to manage your retirement account. Look for a custodian that offers educational tools, knowledge-building opportunities, and experienced financial professionals who understand the rules and regulations relating to your assets.
Fees are inevitable, but they aren’t uniform across custodians. The right custodian for you is transparent about their fee schedule and can tell you exactly how much you’ll pay and when.
Self-directed investing is a great way to take control of your retirement and make investment decisions that best suit your retirement strategy. However, if you choose to get in the driver’s seat, you’ll need a qualified custodian to help you navigate potential complexities, rules, and regulations. Horizon Trust has the experience, tools, and resources necessary to set you up for success. Contact us today to get started.