For many people, there is no reason explaining what an IRA account is. We all know it is an individual retirement plan that can be either Traditional or Roth with a maximum contribution limit of $5,500, or $6,500 if 50 or over, for 2016. But in addition to a Traditional or Roth IRA, many of you have probably heard of a so-called Self-Directed IRA (SD IRA). Let’s take a detailed look into a SD IRA and see if it is advantageous to open one.
What is a SD IRA?
A SD IRA is a special IRA account that has been getting some buzz recently. In a nutshell, it is pretty similar to a Traditional or Roth IRA, but it has two key differences:
- You have complete control over your retirement account. By that I mean you are the only one who makes investment decisions.
- Investment flexibility and alternative investments. With an IRA account you can invest only in exchange-traded investments. But with a SD IRA you can invest in a variety of investments outside the traditional scope.
Some examples of alternative investments include but are not limited to:
- Real estate and/or foreign property
- Precious metals
- Private company’s stock or privately-held businesses
- Art galleries
- Horse-breeding business
Of course there are some restrictions on what you cannot invest in. For example, the IRS prohibits investing in collectibles, alcoholic beverages, and life insurance.
The annual contribution limit is $5,500, or $6,500 if you are older than 50. However, if you are a small business owner or a sole proprietor you can drastically increase the contribution limit by establishing either a Solo 401k or SEP IRA. Both plans have a total annual contribution limit of $53,000, and an additional $6,000 as a “catch-up” contribution if you are older than 50.
Besides a high degree of investment freedom and control over the account, additional benefits of a SD IRA include:
- Protection from bankruptcy and creditors for up to $1,000,000.
- The ability to invest in industries where you have the greatest knowledge and expertise.
- The account is not taxed until you start withdrawing funds.
Is a SD IRA Good For You?
With the investment freedom, absolute control, and other advantages mentioned above, a SD IRA sounds like a “must have” retirement vehicle for all of us. Yet, SD IRAs represent only about 2% of the overall IRA market. Obviously, people remain hesitant and there are a few reasons for that.
The first one is the SD IRA is not for everyone. If you have a special knowledge and expertise in a given field then it may be a very good fit for you. For example, if you are a real estate broker, why wouldn’t you invest in properties or land with your retirement money? You know how to do it; you make a living doing it. So it may be a smart idea to invest your retirement savings in it. Or let’s say you love horses and know everything about them. You can go ahead and invest your retirement money into a horse breeding business.
However, you have to be an expert and have to have a deep knowledge in the field you are considering to invest in. If you want to invest in real estate or any other field just because a friend of yours is doing so – it can be a very slippery path. Become an expert first and then act, not vice versa.
Another good reason to consider a SD IRA is if you don’t trust anybody, and think you know what to do with your funds better than anyone else. Especially those Wall Street guys who manage investment funds.
Furthermore, there are a few other reasons that make people uneasy when it comes to a SD IRA.
- A SD IRA can a very risky endeavor. They tend to be highly concentrated in one asset class. In other words, they are not well diversified. Meaning that if something bad happens, you put your retirement at risk.
- Assets within a SD IRA are rarely liquid. As with other retirement plans (except for the Roth IRA) you will have to start taking required minimum distributions (RMD) at the age of 70 ½. Can you be sure that your asset will generate enough cash to take the RMD? If not, you will have to pay a whopping 50% penalty on the difference of what you actually took out, and what you should have taken.
- Less transparent. Since alternative investments have lower regulations, or none at all, it is easy to become the victim of a scam or fraud. Think twice before investing your hard-earned retirement money into a business or project with “sky‘s the limit” returns.
- More hassle opening one. You have to open an account with an IRS approved, FDIC backed custodian who allows investing in alternative investments. That’s the easy part. In addition, you need to set up an LLC and direct the custodian to invest the IRA funds into this newly formed LLC. This multiple steps process alone makes a lot of people wary.
- You cannot hold assets that benefit you and your family directly. Formally known as prohibited transactions. For example, you cannot buy/sell properties or any other assets from you directly to you. You also cannot rent your property to yourself or any other family members. You cannot borrow from your SD IRA, nor can you lend money to it. If the IRS catches you in self-dealing, chances are your SD IRA will be disqualified and you will have to pay all of the taxes plus penalties. Make sure you know all of the prohibited transactions in advance.
- More administrative and paperwork involved. For example, who is going to deal with tenants, make all repairs, and take care of this rental property you have? To avoid any violations you need to keep a meticulous record of all transactions within your SD IRA. Not many custodians do that, so for many people it may be a huge headache.
Whether a SD IRA is good for you or not heavily depends on what you are looking for. If you want to exercise full control over the account and make all investment decisions personally, then you don’t necessarily have to open a SD IRA. You can achieve the same level of control within your traditional or Roth IRA account by investing in stocks, bonds, mutual or exchange-traded funds and even invest in real estate via Real Estate Investment Trusts. But that will be in a more transparent and liquid way.
However, if you indeed need to buy a piece of land or real estate property, or any other alternative investment, then a SD IRA may be a very good option. But as I mentioned before, be sure you have enough knowledge, sophistication, and know the rules of the game. With a SD IRA the stakes are high. Any rash act can have a detrimental effect on your retirement.
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I appreciate the honesty about the potential AND complexity of self directed IRA’s. Some people argue that it’s not particularly relevant to use a self directed IRA for real estate investments because a 1031 tax deferred exchange provides very similar tax benefits. What do you think?
Hi Mike,
Thanks for bringing up Section 1031.
Basically, Section 1031 Exchange gives real estate investors the ability to exchange one property for ‘like-kind’ without having to pay capital gain taxes on the appreciated property value. While it is indeed a very important tool for real estate investors, there are at least two situations where a Self-directed IRA still makes sense.
1. Section 1031 is deferral but not avoidance of tax. Eventually, you may want to sell the property and go into cash. This is when you will need to pay the tax. With Self-Directed Roth IRA you may completely avoid tax.
2. Income that a property will be generating would still be taxed. With SD-IRA that would not be the case.
Point 2 is usually key factor why people, at least regular folks, prefer SD IRAs.