If you could buy a private business, a rental property or racehorses in your Individual Retirement Account (IRA), would you do so? Even if you could, would that be a wise choice? Self-directed IRAs (SD-IRA) offering non-traditional investments have become increasingly popular and more broadly available.
The self-directed IRA is a traditional or Roth IRA in which the custodian, the financial institution which keeps records and reports to the IRS, permits the full range of investments allowed by law in retirement accounts. Many types of investments are permitted in IRAs, but there are certain things you can’t do, like buy collectibles (such as art and coins) and life insurance, as well as investment strategies that require borrowing, such as shorting stock or certain options strategies. However, the reality is the vast majority of financial institutions limit retirement account investments to the more traditional ones like stocks, bonds, mutual funds, CDs and exchange-traded funds.
“Self-Directed” Really Means “Alternative Investments Accepted”
The term “self-directed” is a bit off base. What it means is that alternative investments are accepted or offered by the IRA custodian. Technically, at most financial institutions, IRAs default to the more literal interpretation of “self-directed,” in that the account owner makes the final decisions on what investments to buy or sell, unless they have given discretion in writing to an investment advisor.
A custodian who offers self-directed IRAs agrees to keep required records of your non-traditional investments in the IRA and report them to the IRS. The custodian may or may not offer physical custody of the investment, depending on type, or may just house the records of investment activity and valuation. Common alternative investments available in SD-IRAs are precious metals, real estate, loans, and private equity. Certain custodians of self-directed IRA accounts will accept just about anything allowed by the IRS, including tax lien certificates and dairy cows.
Very High Risk
Many alternative investments available in SD-IRAs carry a high risk of losing all or most of your money due to lack of diversification or the inherent risk of the investment itself. You may not be able to sell the investment later (lack of liquidity), meaning that you won’t be able to access the value of it to make distributions in retirement. Keep in mind that the entire burden of investigating the investment (doing your “due diligence”) is on you, the account holder. This could be a benefit when you are investing in an area of your professional expertise (e.g., the experienced real estate investor). However, it can also lead to fraud, when investors are duped into Ponzi schemes or other types of investment scams through slick offerings and piles of legal paperwork.
Beware of investing in anything you don’t understand and can’t explain easily to others. If you are considering an investment within an SD-IRA, read this pamphlet from the SEC first and do your homework. Use the checklist at the end of this post. Remember, if it sounds too good to be true, it probably is.
Fees in self-directed IRAs are generally much higher than more traditional types of IRAs. Expect to pay set up fees, custodial fees and annual fees to value the investment. Many of the types of alternative investments offered in SD-IRAs are hard to value, so this can get quite pricey.
Keep in mind that the IRA or Roth IRA is the owner of the investment, so you don’t have direct control over it. With investments like real estate or a business, for example, that means you have to pay the custodian to do things like collect rents or business income. (Per this Bankrate article, some custodians propose that you set up a an IRA LLC to address this issue, which may give you checkbook control but is costly to establish and has legal risk.) No matter what, make sure you do some comparison shopping for a custodian who specializes in the type of investment you want to own in your SD-IRA.
Potential Tax Problems
Investors often get tripped up by unexpected tax consequences in SD-IRAs. Most importantly, in a traditional IRA, distributions in retirement are taxed as income, not the lower capital gains rate. The investor may have been better off holding the asset outside of a retirement account. Additionally, investors miss out on the ongoing favorable tax treatments for some common types of investments, such as real estate.
Depending on the type of investment income, a self-directed IRA may not be completely tax-deferred and a Roth IRA may not be completely tax-free. For example, if the investment generates Unrelated Business Income, the IRA or Roth IRA would be taxed at the high trust rates for the tax year in which it occurs. Those taxes must be paid by the IRA, not the account owner separately.
Can’t Invest in Yourself or Your Family
Don’t get too excited about selling the family business to your IRA! Certain transactions are prohibited in retirement accounts to prevent self-dealing, including transactions with people within your linear family, such as your spouse, your parents, your children, your grandchildren and their spouses. Most of your family could not work in or on behalf of the investment or live in a property held by the IRA.
When to Consider a Self Directed IRA?
SD-IRAs are not suitable for many people. Use this checklist to see if you might be a good candidate for self-directed IRA accounts: (Aim for at least 4 out of 6.)
- I am an accredited investor. (If you don’t know what it is, you probably aren’t.) While you don’t need to be an accredited investor to open an SD-IRA, being one means you have the income and net worth to consider alternative investments.
- I don’t need my IRA or Roth IRA for future retirement income. Either:
- I am fully on track to completely fund my retirement with my employer-sponsored retirement plan, e.g., 401(k), 403(b), etc.
- I have a pension or other investments (e.g., rental income) which will fully cover my retirement income needs.
- I have well-diversified traditional investments in my work-sponsored and non-retirement brokerage accounts that can be liquidated to pay future living expenses if needed.
- I have professional expertise and experience in the SD-IRA investment which I am considering.
- I want to add a target percentage of precious metals to my retirement portfolio for diversification.
- I am considering making a small private equity investment that might pay off big (a possible strategy in a Roth SD-IRA) but could also go bust.