For many people, retirement planning is done out of a sense of obligation to maintain your current standard of living during your golden years. And let’s face it, obligations are rarely fun.
But that’s where a tool called the Self-Directed Retirement Account comes in.
While self-directed IRAs have been around for a while, they’ve been gaining in popularity over the past few years among do-it-yourself investors looking for options beyond traditional stocks and bond portfolios.
And although these accounts have the potential for tremendous upside, many experts warn that they aren’t for everyone. Here are a few tips to help you decide if a self-directed IRA is right for you:
What is a Self-Directed IRA
Unlike other IRAs, a self-directed IRA is an account that gives you complete control over your investment choices. In other words, your options are not limited to stocks, bonds, or mutual funds.
This means that you can take advantage of a wide array of non-standard assets to fund your retirement such as real estate, commodities, and other alternative investments – all within your retirement account.
How does a Self-Directed IRA work
While both regular and self-directed IRA plans are managed by a custodian (brokerage or financial institution), the role that they play is quite different depending on the option chosen.
As the name implies, a self-directed IRA puts more responsibility on you. This means that you are ultimately responsible for performing due diligence and understanding the tax implications for any investment you choose. As a result, the custodian managing your account plays a more passive role than in a regular IRA, and simply executes what you want your IRA to purchase/sell, and at what price.
Who is a Self-Directed IRA right for
If you have specialized expertise in a particular industry or niche, a self-directed retirement account may be a good fit. For example, if you have experience as a realtor or property manager, you might do well holding rental real estate within your retirement account because you are familiar with the market and have professional insight otherwise unknown to the general public.
Keep in mind that since most self-directed retirement accounts generally have just one asset class in them, they are much riskier than regular IRAs with diverse funds set among a variety of asset classes.
So while your potential upside is much greater due to the concentrated nature of your portfolio, you stand to lose a great deal if you don’t have substantially more than a casual understanding of what you are invested in.
Potential Benefits
Growth Opportunities
A self-directed retirement account allows for the freedom and flexibility to invest in almost any type of asset. This means you have the ability to directly determine the amount of risk you’re willing to take on for the potential of a higher rate of return.
You control your financial future
If you have inside knowledge of a particular industry, a self-directed retirement account allows you to put that expertise to good use and make investment decisions based on what you know and understand.
Wealth Preservation
The ability to diversify your portfolio by investing in alternative assets such as real estate and commodities can act as a hedge against volatility in the market.
Tax-advantages
Investing over time in a self-directed IRA that allows for tax-deferred or tax-free growth can significantly affect future wealth.
Potential Downsides
Aside from the inherent risk involved in concentrating on a limited number of asset classes, there are some additional disadvantages you should be aware of.
Prohibited Transactions:
The IRS has a number of restrictions on what you can and can’t do with IRAs to prevent self-dealing. It’s really important to understand these rules, because if you make a mistake — even accidentally — you risk forcing an immediate distribution and some severe penalties.
These include:
- Personally borrowing money from the IRA
- Accepting unreasonable compensation for managing property or assets held by the IRA
- Using the account as security for a loan
- Transferring plan assets, lending money, or providing good and services to disqualified persons*
(*the account holder and his or her spouse, lineal descendants, account fiduciaries, trustees, investment managers and advisers; and any corporate entity in which the account holder has at least a 50 percent ownership)
Required minimum distributions (RMD)
As is the case with any tax deferred, non-Roth retirement account; you must begin taking required minimum distributions at the age of 70 ½. But if you’re stuck with an illiquid asset that just isn’t generating much cash, it could be tough to sell it and generate your RMD. To avoid this situation, anticipate your distribution amount a year or two ahead and plan accordingly.
The Bottom Line
The self-directed retirement account isn’t for everyone, in fact, most people are probably better off with the traditional mix of stocks, bonds, and mutual funds found in a traditional retirement account. However, if you have the knowledge base and can tolerate the additional risk, the growth potential is unmatched.