What is a Self Directed IRA?
A Self Directed IRA is like a traditional or Roth IRA, but it allows you to invest in different things like real estate, precious metals, debt, businesses, and even racehorses and Bitcoin. Since your investments are up to you, you need to know what you are doing. Because the investment options are so broad, there are a lot of rules that you have to follow to avoid getting in trouble with the IRS. If you violate these rules, you could be subject to tax penalties that eliminate any tax advantages that a Self Directed IRA offers, or even lose the balance of the IRA.
- Flexibility and diversification.
- Gives you the opportunity to pursue assets that have the potential for higher gains than traditional IRAs.
- Can offer tax advantages for high-net worth individuals who have specific investment goals in investments that they understand.
- May offer asset protection for bankruptcy.
- Not offered at most traditional brokerage firms.
- The companies that specialize in them have higher fees.
- Requires research and investment experience.
- Tricky tax and legal regulations may require the additional expense of professional tax and legal professionals.
- Certain investments such as businesses are hard to value. (You are required to report the value of your IRA annually.)
- You can be exposed to more risk than traditional IRAs.
- If not structured properly, you could lose your tax advantage status with the IRS and be on the hook for penalties.
- Self Directed IRAs are subject to Unrelated Business Income Tax. If your IRA holds a business, you could be subject to this.
Who is it for?
Self Directed IRAs are clearly not designed for the average individual. In fact, you may have a tough time finding a custodian that will even open one for you with your $5,500 annual contribution. Usually, they are sought after by those who already have enough assets in their IRAs to risk alternative investments. In short, Self Directed IRAs require a lot of cash and investment savvy. This does not necessarily mean you have to be rich to pursue a Self Directed IRA, but you do have to understand what you are doing to the extent that you can clearly see how a Self Directed IRA might or may not benefit you.
How do I start?
If you think you have a good reason to look into a Self Directed IRA, your first step is to find an IRA custodian that offers them. You can’t just put assets you already own in a Self Directed IRA. A custodian must purchase them on your behalf. Your choices of custodians are somewhat limited because Self Directed IRAs require extensive research, legal and IRS paperwork that most brokers don’t want to deal with. Here is an updated list of custodians that offer Self Directed IRAs.
You need to remember that the custodian does not make decisions for you. They can’t offer investment advice. You will also want a professional legal or tax advisor to help you make sure you are following the rules. If you don’t follow the rules, not only could you lose the tax advantage, but you could even lose the balance held in the IRA. Keeping this in mind, the actual steps to opening a Self Directed IRA are relatively simple.
- Choose a custodian.
- Fill out their paperwork and pay their fees.
- Rollover and/or contribute funds to the IRA.
- Start investing.
Alternatively, you can open a Self Directed IRA LLC. This type of IRA allows you complete control over your assets directly. You set up an LLC and direct your custodian to use your IRA funds to purchase the LLC. The LLC then holds the assets and you control the checkbook. This type of Self Directed IRA is often called a Checkbook IRA. If you see an investment you want in your IRA, you can write a check for it from LLC business account.
While a Checkbook IRA gives you more freedom and makes investing quicker and easier, it can also get investors in trouble for exactly those same reasons. In most cases, you will need to hire an attorney to advise on the creation of the LLC and the IRA. And because there is no custodian to review your investments, you’ll probably need to consult legal counsel from time to time to make sure you are keeping it clean, as well as to help you submit the annually required valuation of the IRA’s assets. If you violate the IRS Rules and Regs knowingly or unknowingly, you can be subject to fines and penalties.
The bottom line?
If you believe that a Self Directed IRA could benefit you, be prepared to do your research. Make sure that you have clearly defined goals that prove how using this IRA can bring you prosperity in the future, rather than complications. Decide how much control you want and how much counsel you should hire to protect yourself from costly mistakes. For certain investment strategies, the Self Directed IRA could be quite lucrative. But there is nothing done-for-you about it. And it costs a bit change to set up.
Retirement tip: Got a 401k? Make sure you understand your investment.
Photo by Ahmad Ossayli
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