5 Reasons You Need a Self-Directed IRA

Personal Finance April 4, 2024 Adam Easton
self-directed ira

  • Self-directed retirement accounts, known as a self-directed individual retirement arrangement (IRA), were created in 1999 by an act of Congress after intensive lobbying of small business owners and associations.

  • The beauty of a self-directed IRA is it allows you to invest up to $6,500 into a tax-deferred account where you control the investments. Many of those investments include alternative vehicles not available in a traditional IRA.

  • These alternative investments include real estate, private mortgages, private company stock, oil and gas limited partnerships, precious metals, horses, and intellectual property.

Many retirement investors who know about individual retirement arrangement (IRA) accounts nevertheless often do not realize that they can open and manage a self-directed of the IRA — and then use the tax-advantage features of the account for a variety of nontraditional investments.

Research shows that less than 1 percent of the U.S. population currently has a self-directed IRA, yet the total holdings of those IRA accounts is over $100 billion and growing.

Internal Revenue Service (IRS) regulations require that a qualified trustee, or custodian, hold IRA assets on behalf of the IRA owner.

The custodian provides custody of the assets, processes all transactions, maintains other records pertaining to them, files required IRS reports, issues client statements, helps clients understand the rules and regulations pertaining to certain prohibited transactions, and performs other administrative duties on behalf of the self-directed IRA owner.

This often is a CPA or accounting firm hired by the account owner to assist in the creation, maintenance, and disposal of funds in the account.

The account owner for all IRAs chooses among the investment options allowed by the IRA custodian.

For regular IRAs these options usually include stocks, bonds, and mutual funds, but with a self-directed IRA, the term “self-directed” refers to the significantly broader range of alternative investments available to the account owner.

There are some restrictions of asset classes, such as no investments in life insurance, collectibles such as artwork, rugs, antiques, metals, gems, stamps, coins, or alcoholic beverages.

You also cannot invest in a company where you are already a partner or on the board of directors.

Taking all these guidelines into consideration and playing by the rules will allow you to create returns unheard of in a traditional IRA and also prevent the IRS from taxing those returns until the day you retire.

Given the complexity of self-directed IRAs you might want a financial advisor with experience managing investment deals for self-directed IRAs to help you with due diligence on the investments.

Here are five reasons why you should consider opening a self-directed IRA:

Higher returns

The number one reason investors use self-directed IRA accounts is the ability to pursue much higher returns compared to stocks and bonds.

If you make a 25% return on a real estate investment and are able to build on that profit cumulatively for 10, 30, or 30 years it can be life-changing.

“If you understand investments, particularly in certain segments, you can take advantage of higher yields and maybe less volatility,” John O. McManus of the estate-planning firm McManus & Associates in New York and New Providence, New Jersey told NerdWallet.

McManus has invested in real estate and other assets through a self-directed IRA for about 15 years, he says. 

A 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.”

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, an investment advisory firm that specializes in self-directed IRAs, told NerdWallet he met an experienced real-estate investor who’d been buying properties with his IRA.

He’d find underpriced properties with potential, have his IRA put, say, a $5,000 down payment on the property, then sell or assign the contract to a real-estate investor, in a process some call “bird dogging.”

“You’re using $5,000 to make $20,000 to $40,000,” Chisholm says.

“You may not be able to do that at scale but certainly some people have done things like that. There are ways to make quite sizable returns if you’re creative and knowledgeable enough to use self-directed IRAs in the right way. That’s not to say that everybody should do this.”

Better diversification

Traditional IRAs allow you to invest in stocks, bonds, and mutual funds, including ETFs.

That might seem like a huge number of investments, and traditionally stocks and bonds acted as counters to one another in bull and bear markets. If stocks go down, bonds did better and vice versa — usually.

The reality is almost those asset classes are controlled by Wall Street. Though historically they offer a reasonable rate of return, they don’t often offer entrepreneurs the opportunities out there or the diversification they are used to.

Traditional IRAs also don’t allow entrepreneurs and small business owners to invest in what they know best, their own businesses.

In a self-directed IRA you can invest in a horse farm, a single-family home, a multi-unit commercial project, tax liens, even crypto-currencies.

Cryptocurrency investors, anyone who invested in Bitcoin, Ethereum, or Stellar or the many other alt coins, would be able to grow their profits without taxation until they retire, allowing them to potentially become tax-advantaged billionaires!

Investing in private equity

Self-directed IRA funds also are allowed to be invested in private companies, something entrepreneurs are comfortable with and often enjoy. However, they cannot purchase private equity stock in a company that the IRA holder already owns.  

Since private equity investments are often held for long term with a goal of significant profits, they are ideal for self-directed IRAs.

For instance, a private equity investment in business might grow from $7,000 to $7 million in a few years.

Famously, former governor and presidential candidate Mitt Romney reportedly grew a $102 million tax-deferred investment by dumping stock in the consultancy Bain Capital into his IRA while it was worth almost nothing.

It’s tricky and really pushes the envelope in terms of tax planning, but tax-deferred is tax-deferred.

Putting assets to work

The most obvious reason why investors consider a self-directed IRA is that for many people their IRA is their largest source of potential investment capital.

If you’ve saved in an employer 401(k) plan your entire career, then you could easily have hundreds of thousands of dollars locked up in retirement assets. Rolling that money to an IRA is easy when you leave work, while withdrawing it completely from your account has huge tax consequences.

A self-directed IRA gives you the best of both worlds as you can use it while it stays tax-deferred.

Entrepreneurs and business owners often have more opportunities come across their desks then they have capital to invest in.

Likewise, the number one cause of start-ups and new business  failing is lack of capital or cash flow. Self-directed IRA financing can be a benefit for both the investor and the investee who needs funds.

Investing in cryptocurrencies

The Treasury Department announced in 2017 that cryptocurrencies would be taxed as assets each and every time they were transferred.

The decision struck fear into the hearts of some cryptocurrency investors who have thousands of transactions and multi-million dollar profits.

With a self-directed IRA the investor can invest in as many crypto assets as they want for the entire life of the IRA and nothing is taxed until the owner takes payments in retirement.

This has not been marketed to a wide crypto audience yet, but it could revolutionize how cryptocurrencies are invested, transferred, and cashed out.

Theoretically, anyone who launches a token, crypto coin, or ICO could do so in their own self-directed IRA account and profit tax-free for decades until they retire.

The risks of self-directed IRAs

Fees: Self-directed IRA fees can be steep, ranging from $250 to $450 or more for moving your IRA to a new custodian and quarterly fees for management.

With fees as high as 10% of the total annual investment, the investments need to pay out double-digit returns just to stay profitable. Some firms will negotiate these fees, so don’t be shy asking what’s possible and also shopping around.

Poor liquidity: Self-directed IRAs allow you to invest in a wide variety of investments but those assets often are illiquid, meaning that if you run into an emergency you would be hard-pressed to get money out of your IRA.

Sometimes there are no buyers for your investment and due diligence for private equity can take months or years, leaving the account holder stuck with no liquid funds.

Poor transparency: The Securities and Exchange Commission (SEC) warns investors that self-directed IRA promoters sometimes list the purchase price, or the purchase price plus expected returns, as the valuation.

But that figure isn’t the actual amount you’ll get for the asset, leading to a gradual self-inflation of assets and their value based largely on wish fulfillment.

“Investors should be aware that none of these valuations necessarily reflect the price at which the investment could be sold, if at all,” read a recent SEC alert.

Likewise, partnerships can be tricky at the best of times, and those investments can take power and agency out of the investor’s hands.

Say you invest in an office building thinking that you will develop them into condominiums. Instead your partners vote to flip the building. You might be out of luck.

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 approves of the underlying investment.

As the SEC notes, custodians generally don’t evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”

The rate of fraud among these investments have been rising as the plans become more popular. The requirement for due diligence is much more stringent and losses from fraud are non-refundable from the SEC or any other federal organization.

Even with these caveats, however, a self-directed IRA can shorten your path to retirement from decades to years.

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