IRAs have long been considered reliable investment vehicles. However, most traditional Roth IRAs often limit customers to conventional investments, such as stocks, bonds, and mutual funds.
But if you’re an investor looking to pad your retirement portfolio with alternative assets, such as cryptocurrency, gold, and real estate, then a self-directed IRA is perfect for you.
What is a Self-Directed IRA?
A self-directed IRA is a tax-advantaged account that allows investors to amass wealth for retirement using alternative investments, not available to traditional or Roth IRA accounts. In addition, self-directed IRA investment decisions are often made by the investor and are not controlled by your custodian, like many traditional IRA accounts.
Self-directed IRAs share some of the fundamental features of traditional or Roth IRAs, including eligibility requirements and contributions limits. However, the primary difference between the two investment options is how and where you can invest your funds.
Traditional IRAs and Roth IRAs generally rely on stocks, bonds, and mutual funds for growth. Self-directed IRA owners can invest their money in those financial staples, but an SDIRA opens up several other investment channels, including:
- Precious metals
- Real estate
- Private equity
- Promissory notes
- Tax leans
- Business entities, such as LLCs and LPs
- Private placement
Most banks and traditional financial institutions offer SDIRAs. However, if you want to invest in alternative assets, you’ll need to find a specialized firm that invests in these assets.
Self-Directed IRA Contribution Limits
Despite their differences, the IRS views IRAs and SDIRAs the same, particularly concerning contribution limits. For example, during the 2022, 2021, 2020, and 2019 tax years, SDIRA contributions were limited to $6,000 a year for an individual and $7,000 for individuals 50 years of age or older.
In addition, if your earned income is less than the current contribution limits, your contribution can’t exceed your modified adjusted gross income (MAGI) for the year. In other words, if you earned $5,000, your maximum contribution limit would be $5,000.
As a side note, contribution limits do not apply to rollover contributions or qualified reservist payments.
If your annual SDIRA contributions exceed the limits set by the IRS, they get taxed at a rate of 6%. This tax applies for each year the excess funds remain in your account, meaning if you exceed contribution limits in 2019 and don’t resolve the issue until 2022, you’ll be penalized each year until the issue is corrected.
If you do exceed contribution limits, you must withdraw the excess funds, as well as any earnings made of those funds, by the time you file your tax return.
Are Self-Directed IRAs FDIC Insured?
Self-directed IRAs are not FDIC insured. The Federal Deposit Insurance Corporation (FDIC) insures “traditional deposit accounts.” These accounts typically include funds in a checking or savings account, money market deposit accounts, and certificates of deposit (CD).
However, if funds from your self-directed IRA are housed in one of the accounts listed above, and an FDIC-insured financial institution holds the account, then your funds are likely insured by the FDIC.
For the most part, the FDIC does not cover many types of investment accounts commonly found under the SDIRA umbrella.
The list of excluded investments includes stocks, bonds, and mutual funds; government, municipal, and U.S. Treasury securities; cryptocurrencies, etc.
Do You Pay Taxes on a Self-Directed IRA?
SDIRAs are tax-advantaged accounts similar to Roth and Traditional IRAs. The tax implications of an SDIRA depend on the type of SDIRA account you hold.
When you open a self-directed traditional IRA, you reap the benefits upfront. Your account will grow tax-deferred. Once you hit retirement age (59 ½, according to the IRS), you can withdraw funds without penalty, but you will need to pay taxes on your withdrawals. Tax rates for traditional IRAs are based on your income, so the amount you pay will depend on your income.
With self-directed Roth IRAs, any contributions get taxed upfront. Withdrawals made before age 59 ½ will be penalized, much like they are for traditional IRAs, but after that point, you won’t need to pay taxes on withdrawn funds.
What’s the Difference Between a Traditional IRA and Self-Directed IRA?
There are two primary differences between a traditional IRA and a self-directed IRA, including account management and asset classes.
Traditional IRAs and self-directed IRAs must be held by a qualified custodian. The difference is that most major custodians don’t offer many of the assets used in an SDIRA. For that reason, opening an SDIRA often requires a specialized firm.
Traditional IRA investments are limited to stocks, bonds, and mutual funds and are typically limited to the products offered by the bank or financial institution that holds the account. However, with a self-directed IRA, you can extend your investment avenues to include alternative assets, like cryptocurrency, precious metals, real estate (including land and livestock), etc.
Can a Self-Directed Ira Invest in a Business?
Yes, you can use a self-directed IRA to invest in a business. However, there are some restrictions:
- Family Business: If you or your parents own a business, you are prohibited from investing in that business using your SDIRA account. On the flip side, you can invest in siblings,’ cousins,’ or any friends’ business.
- UBIT: Any unrelated business income that falls outside the realm of investment income, such as dividends paid to shareholders or capital gains made from the sale of shares, may be taxed at a rate of up to 37%
- S-Corporations: IRA accounts are prohibited from investing in S-Corporations.
While many people are unaware that you can use an SDIRA to invest in businesses, it’s a great way to
What Are the Pros and Cons of a Self-Directed IRA?
Self-directed IRAs have many benefits, but they aren’t right for everyone. If you’re considering opening an account, it’s important to weigh the pros and cons.
- High-Risk, High-Reward Asset Investing. SDIRAs offer all of the same asset classes of a traditional or Roth IRA, with the addition of many alternative asset classes, including precious metals, cryptocurrency, real estate, etc. These assets often come with a higher amount of risk but could yield greater gains in the long-run.
- Diversification. SDIRAs make it easier to round out your investment portfolio and create stability against an often volatile stock market. Many of these assets also provide a hedge against inflation that allow you to protect the value of your contributions since you can’t access your funds until retirement age.
- Tax-Deferred. Unlike traditional investments that require creative ways to avoid taxes and make money, self-directed IRAs host traditional and Roth account options to help you defer your tax burden until you take out the funds from your account.
- Control over investments. Investing in assets like real estate and businesses using an SDIRA gives investors more hands-on control over their investments.
- Potential Checkbook Control. You can form and manage your account under an LLC. Doing so gives you checkbook control and cuts out unnecessary fees and transaction delays.
- Due Diligence. IRAs are managed by the custodian, leaving due diligence on their hands. SDIRA custodians are passive, meaning you’re responsible for exploring and educating yourself about the risks and benefits of any given investment opportunity.
- Increased risk. The enhanced freedoms allotted by SDIRAs allow you to invest in a wide range of alternative assets, but it also increases the associated risk. Some investment opportunities, like cryptocurrency, can be particularly volatile. That’s why you must be well versed in investment and work with a trusted custodian.
- Increased restrictions. Depending on what you invest in, you may face restrictions that limit your ability to use or otherwise enjoy your investment. This is particularly true for real estate, as federal law prohibits SDIRA owners from using their real estate investments. That means you can’t live or let family members live, even momentarily, in a real estate asset that is included in your SDIRA Portfolio. The same is true of commercial real estate.
How to Set Up a Self-Directed IRA
Self-directed IRAs can seem confusing, especially if this is your first time considering or opening one. However, opening an SDIRA is relatively easy, and can typically be completed in five steps:
- Choose a custodian for your account. Many financial institutions offer IRAs, but fewer allow customers to open SDIRAs. If you’re considering an SDIRA, look for an experienced custodian well-versed in alternative investments that offers hands-on legal and investment support to help you navigate your financial journey.
- Decide what type of SDIRA you want to open. Similar to regular IRAs, you’ll need to choose between a traditional SDIRA or a Roth SDIRA. There are pros and cons to both options. A well-versed custodian or financial advisor can help you decide which is right for you.
- Review your investment options. Expanded access to investment options is one of the greatest benefits of SDIRAs, but it also means you’ll need to do due diligence and thoroughly research available assets, risk tolerance, and long-term goals.
- Submit an application. The SDIRA application process varies from company to company, so it’s always a good idea to speak to a representative to find out exactly how you apply and what information is required. Do your due diligence when searching for financial custodians to find one who will provide the amount of service you require to get started.
- Fund your account. Once your SDIRA account is open, you can fund your account through traditional contributions, rollovers from existing accounts, or transfers between same-type accounts (e.g., a traditional IRA to a self-directed IRA).
Do I Need a Custodian to Set Up a Self-Directed IRA?
All IRAs, including SDIRAs, require a custodian, but each custodian’s role may differ. For example, an SDIRA custodian may allow you complete control over your account and which investments you pick.
On the other hand, many specialized firms offer active financial management advice to help you get started and make informed investment decisions regarding your SDIRA.
While searching for the right custodian for your SDIRA, it’s important to thoroughly review their experience, expertise, and self-directed IRA fees before you decide.
Although you have the ultimate say in how you invest your money, the right custodian can ensure you have the support you need and access to the alternative investments you want.
A self-directed IRA can help you create a well-rounded investment portfolio that enables you to invest in potentially lucrative alternative assets, like real estate, precious metals, and cryptocurrency.
If you’re a seasoned investor looking for expanded opportunities or more lucrative investment avenues, then an SDIRA may be right for you. There are increased risks associated with an SDIRA account, however. As such, it is essential that you thoroughly research and understand your options and work with a trusted custodian.
Horizon Trust has decades of experience helping our clients amass wealth through investment opportunities not readily available in mainstream financial markets. Contact us today to learn more about SDIRAs and how they can fit into your overall retirement strategy.