There are many options available for you to build a retirement account. Because of these many options, financial planning can be a complicated area. One of your options is a self-directed IRA. These specialized retirement accounts let you do things you normally can’t in an ordinary IRA, like invest directly in alternative assets.
Before we jump into the pros and cons, let’s first get on the same page about what a traditional IRA entails and how the self-directed IRA differs.
What is a self-directed IRA?
According to Investopedia, a traditional individual retirement account (IRA) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. Traditional IRAs allow you to invest in traditional investments such as stocks, bonds and mutual funds.
While the self-directed IRA is similar to a traditional IRA, the difference lies in the types of assets you own in the account. Self-directed IRAs allow you to hold alternative investments that are typically unallowable in a traditional IRA. Examples include:
- Real estate
- Precious metals
- Rental property
- Cryptocurrency
- Mineral rights, oil and gas
The annual contribution limit is the same as a traditional IRA. You can open a self-directed IRA as a traditional IRA or a Roth IRA with the same pre-tax and post-tax contribution rules.
Advantages
A major advantage of this type of investment account is that you can hold non-traditional investments. So, it’s possible to purchase an investment property with the self-directed IRA. That’s not allowable with a traditional IRA.
Some other advantages include:
- Built-in tax deferral on the earnings from your investments.
- Investments that may align with your experience.
- Greater opportunity to diversify your investment portfolio. You can put some money in a self-directed IRA while maintaining other funds in traditional investment or retirement accounts.
Disadvantages
There are specific rules associated with self-directed IRAs. The IRS ensures people are following the rules and aren’t making prohibited transactions. If prohibited transactions are identified, there can be significant tax consequences.
So, what’s a prohibited transaction? Let’s say you decide to invest in a rental property through the self-directed IRA. At some point, you decide to live in that property. That’s a prohibited transaction and is not allowed. If the IRS finds out about it, they’ll disqualify it. And then, they’ll hit you with adverse tax consequences.
Other disadvantages include:
- Investments tend to have higher risk
- Account maintenance fees can be high
- Record keeping and tax reporting requirements are complicated
So, if you decide to investigate this option for your portfolio, it’s critical you understand all of the rules associated with prohibited transactions. Understand that you will direct many of the decisions of the account so you need to be willing to spend time managing the account. If you learn all of the rules and feel you can abide by them, then the self-directed IRA may work for you.
Before making an initial investment in a self-directed IRA, you’ll want to weigh the potential and risk involved. We always recommend that you get help deciding where you should put your money so that it works for you. If you would like to discuss your options or have additional questions, contact an expert who will help you navigate the right course for you.
