Have you ever come across a great investment and wished you could unlock previously saved retirement money? How about receiving the tax benefits of a retirement account with an investment of your choice? What if you could do both? Enter the self-directed IRA- a type of traditional or Roth IRA, that allows investors to save for retirement on a tax-advantaged basis and has the same IRA contribution limits.
The typical IRA houses stocks, bonds, mutual funds, and other relatively common investments and is usually directed by a fund manager. Self-directed IRAs allow investors to invest in the same type of assets, but investments are made and controlled by the investor, while the structure offers many more possibilities, like real estate or a privately held company.
Sold huh? So now, what’s next...
To open a self-directed IRA you will need to find a brokerage firm to act as the custodian for your account. Unfortunately, most household-name brokers don't offer self-directed IRAs. Self-directed IRA custodians are often companies that specialize in them, including some banks and trust companies. They can differ from each other in the types of investments they'll agree to handle, so you'll have to shop around. Self-directed IRAs can be complex so you may consider working with a financial advisor experienced with the fund structure to help you with the opening of your account, investment due diligence, and management.
The two main reasons investors take on the risks of self-directed IRAs are to seek higher returns and greater diversification. “If you understand investments, particularly in certain segments, you can take advantage of higher yields and maybe less volatility,” says John O. McManus, who has invested in real estate and other assets through a self-directed IRA for about 15 years. McManus founded the estate planning firm, McManus & Associates, in New York and New Providence, New Jersey. His self-directed IRA also lets McManus invest in companies that aren’t publicly traded, which “a mutual fund will not allow you to do,” he says. But, he warns, “This is not a game for the unsophisticated.”
Self-directed IRAs are also a way to invest your retirement money into modern asset classes like cryptocurrencies or fledgling businesses like tech startups. Since early-stage startups are typically a medium to long-term investment, finding a startup syndicate fund is a perfect way to set yourself up for retirement down the road. Just be sure to do your due diligence as these investments can be very risky.
The benefits of the self-directed IRA are obvious, but investors need to consider the substantial risks:
Prohibited transactions- The IRA tax benefit evaporates if you don’t follow the rules, and you might end up owing penalties and interest, so make sure you are informed.
Lack of liquidity- Self-directed IRAs allow you to invest in a wide variety of investments, but those assets are often illiquid, meaning that if you run into an emergency, you might be hard-pressed to get money out of your IRA. You’ll need to find a buyer for the investment. This also can be an issue for owners of traditional self-directed IRAs when required minimum distributions come due at age 72.
Fraud- Fraudsters have used self-directed IRAs as a way to add a stamp of legitimacy to their schemes. One common ruse is to say the IRA custodian has vetted or approved of the underlying investment, when, as the SEC notes, custodians generally don’t evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”
Just like any investment, there are certain risks associated with a self-directed IRA. Similarly, if you are informed, and make good decisions, your self-directed IRA can outperform traditional retirement accounts with great tax benefits and on your terms.