The buck stops with you in self directed IRA (individual retirement account). The responsibility of managing and making decisions on the direction and investments of your SDIRA is directly on your shoulders. Self directed IRAs are not for passive investors. When the buck is on you, you have to put in your knowledge, skills, effort, and time to ensure your investments are performing as you want them to, or better. If you’re not scared by that prospect and challenge, then the SDIRA might just be the right fit for you.
What is a self directed IRA?
As it says in the name, you direct what kind of investments you want to potentially grow the savings in your retirement account. Regular IRAs are typically limited to common investments like stocks, bonds, certificates of deposit (CDs), mutual funds, and exchange traded funds (ETFs). SDIRAs are open to more alternative investments from real estate and precious metals to cattle, oil, Bitcoin, and private equity in your local coffee shop. In short, you can choose whatever you want to put in your retirement account from a broader range of investments in your SDIRA.
They can be in the form of a traditional IRA or Roth IRA, the difference being when you pay the taxes, now or later. Traditional IRA pays tax later on withdrawals/distributions from the account, none on contributions. Roth IRA pays tax now on contributions into the account, none on distributions. The funds in the accounts are invested with the aim of increasing your retirement savings. All the provisions which apply to the IRAs such as eligibility and allowable contributions, also apply to the SDIRAs.
SDIRA is not new. It has been around since 1974 when Congress authorized the Employment Retirement Income Security Act (ERISA). If it’s new to you, it is probably because it may not be in the best interest of the banks, brokerage firms, and other financial institutions to offer you options beyond the common investments. It is going more mainstream as people become more conscious of their money and personal priorities following economic downturns, Wall Street volatility, and other domestic and global issues such as covid-19 hitting the Main Street.
SDIRAs give you the control and freedom to choose what is best for you – as long as you play by the rules. The penalties can be steep if you are caught breaking the rules. It is important for you to understand the basics and boundaries of SDIRAs before you begin.
How does Self Directed IRA work?
In self directed IRA, you are the driver and the custodian is the car. You bring in the capital, knowledge, skills, time and your own financial, legal, and tax advisors (if need be) to help you do the due diligence on where your investments are going.
A custodian, in the form of an SDIRA provider or firm, cannot give you investment advice. It only holds your account, executes your directions and approves transactions, maintains records and reports to the IRS.
The Securities and Exchange Commission (SEC) stated that SDIRA custodians “generally do not evaluate the quality or legitimacy of any investment in the [SDIRA] or its promoters” and “most custodial agreements between a [SDIRA] custodian and an investor explicitly state that the [SDIRA] custodian has no responsibility for investment performance.”
You have to find an IRA custodian who best serves your specific needs (investments and services), at an acceptable price and convenient to you.
If you want to enjoy the ride, get a good car or be a damn good driver. It is best to have both, of course. The investments are the engine and fuel of the ride to help you get where you want to go. Start, stop, fast, slow, forward, detour, are all up to you.
What can you buy with Self Directed IRA?
Anything except these three:
- Life insurance
- Collectibles such as jewelry, antiques, artworks, wines, cars, memorabilia, and rare coins (with some exceptions under precious metals)
- Stocks in S Corporations
The investment options are unlimited as long as they do not fall into any of the categories above.
Some alternative investment options you can own
- Precious metals such as gold, silver, platinum, and palladium
- Real estates, domestic and foreign
- Farms and livestock
- Equipment leasing
- Mining and timber ventures
- Oil, gas, and pipeline investments
- Sports teams
- Shopping centers
- Private equity
- Micro loans
- Private placements
- Limited partnerships
- Tax lien certificates
- Marine finance
- Litigation finance
- Forex and more.
With the work experience and knowledge you have in your industry, you can be creative in finding potential areas to invest in. The alternative assets tend to be less liquid than in regular IRAs, so it is better to include an exit strategy in your retirement planning so you can meet any required minimum distributions (RMDs) or other needs for withdrawals. Keep an investment advisor handy in case you need help ensuring that the potentials comply with the IRS requirements.
SDIRAs provide an investment with greater diversification and opportunities for you to gain higher yield as you have more familiarity and control in your chosen asset. Alternative assets do not tend to mirror the US stock market, so you may have less volatility too. High risks, high returns ring true when you’re managing your own investments. Due diligence is on you with self directed IRAs.
What are the rules of Self Directed IRA?
While you have more freedom to create your self directed investment portfolio, there are some rules you have to follow.
1) IRA requirements
SDIRAs have the same requirements and tax-advantages as the traditional IRA and Roth IRA from eligibility and maximum contributions to withdrawals. You may have multiple retirement accounts. The provisions for retirement accounts may be updated from year to year, so check the latest IRA guidelines.
For example, for 2019-2021 the combined annual contribution limits for all your individual retirement accounts are $6,000; and $7,000 for those aged 50 and above. For 2015-2018, the maximum combined contributions to all your traditional IRA and Roth IRA were $5,500; and $6,500 if you’re 50 years old or older.
The Fair Market Value (FMV) of all your self directed accounts must also be updated and reported to the IRS annually.
2) Types of investment and account structure
As mentioned previously, you are not allowed to invest in these three types of investments: life insurance, collectibles, and S Corporation shares. The amount you have invested in them is considered a distribution and subjected to penalties and taxation accordingly.
Aside from those, any common investments like stocks and mutual funds, and alternative assets such as real estate and gold, are acceptable for your self directed retirement savings.
You may consider doing an account structure known as Checkbook IRA. This can make a difference in the disbursement of funds and asset protection. In standard IRA, the custodian disburses funds at your request, which may take time, involves paperwork and incurs some fees.
A Checkbook IRA is where a single-member limited liability company (LLC) is established and owned completely by your SDIRA. Your self directed IRA funds the LLC checking account. The LLC account does the investing. You are named as the LLC manager, a position that has total control of disbursing funds, writing checks, and wiring money for investments.
This gives you more flexibility and efficiency as an investor as you have direct authority on managing the cash and assets. It also saves you money since you can reduce the transaction-based fee to the custodian.
Take note that an account-owned entity has the same requirements imposed on any other business entity and is subject to IRS audit. All applicable state laws have to be observed as well.
Each type of asset and investment approach available to self-directed IRA carry their own risks and benefits. The responsibility is on you to understand and learn more about them before proceeding. Do your own homework, and work with expert advisers to keep everything legal and profitable for you.
3) Prohibited transactions and self-dealing
Certain transactions are prohibited in SDIRAs. If you invest in real estate, for example, the transactions include selling property, lending money, using the IRA funds as loan collateral, and buying property for personal use. The banned transactions particularly involve self-dealing and disqualified persons. Retirement accounts are meant to benefit you during retirement in the future, not before. If you use your funds before you retire, it defeats the purpose of having an IRA.
Self-dealing means having a personal gain from the transaction. You, the account owner, are considered as one of the disqualified persons. Transactions between your IRA and any of the disqualified persons will incur hefty penalties.
- Your spouse
- Your lineal ascendants and their spouses (ancestors, grandparents, parents)
- Your lineal descendants and their spouses (children, grandchildren, great-grandchildren, sons-in-law, daughters-in-law, grandson’s spouse, and so on)
- A beneficiary of the IRA
- Investment advisers and managers
- Any corporation, partnership, trust, or estate which you, directly or indirectly, have at least a 50% stake in
- A person providing services to the self directed plan such as your custodian and trustee.
It is imperative that you keep your personal and family finances separate from any of your SDIRA transactions. For example, if a house is in your real estate SDIRA, you are not allowed to even stay a night in it. Your kids cannot rent it from you for college. Your contractor son-in-law cannot even do a quick fix for free or put any sweat equity into it. You have to pay a non-disqualified person to do the repairs and maintenance. Any rental income should go into your individual retirement account, not your personal account.
If something is in your SDIRA, you and your family should keep away from it. Your IRA is a separate entity, not to be combined with your personal funds. Any benefit you gain, either directly or indirectly from the IRA transaction between yourself or any other disqualified person, can spell trouble for your IRA.
Dealing with prohibited transactions can make your self direct IRA lose its tax-deferred status. It is no longer considered an IRA. It is treated as you having made taxable distribution of all assets in the account as of January 1 of the year. You will have to pay a 10% penalty on top of that if you were under 59½ years old (premature withdrawal penalty). Any future tax deferrals on earnings from those investments are also gone.
4) Unrelated Business Taxable Income (UBTI)
If your SDIRA earns more than $1000 in UBTI, taxes have to be paid on the income. The account can generate income from:
- Operating an active trade or business
- Receiving passive income via a pass-through entity such as an LLC or a partnership
- Using a non-recourse loan to finance investments
Consult your financial and tax advisers to make sure you do not overlook any possible taxes due from your SDIRA activities. You can be penalized for failing to file the relevant taxes.
How to set up a Self Directed IRA
1) Know what you want
You have to be actively involved in your SDIRA decision making. Consider what kind of investments are suitable for you based on your expertise, willingness to learn, risk appetite, and intention. Determine your preferred type of tax-advantaged IRA – traditional or Roth. Be conscious
and informed of possible risks and pitfalls of managing your own investments such as taxes, concentrated portfolios, and fraud. Have a relevant adviser to help you navigate the financial, legal, and taxation issues that can come with SDIRA.
Choose your funding method. It can be done through cash contributions, transfer, or rollover of your existing IRA. Understand the restrictions on timing and frequency of rollovers and be careful not to exceed the annual contribution limit before you proceed.
2) Pick a custodian
Once you have an investment in mind, research and get to know the IRS-approved SDIRA providers to see which one matches your personal and investment subject needs. Custodians cannot give you financial advice, they just hold your account and help ensure you meet the IRS regulations.
Some of SDIRA custodians and brokers are Alto IRA, Charles Schwab, Entrust Group, Equity Trust, IRA Financial, PENSCO, Rocket Dollar, STRATA Trust Company, TD Ameritrade and Merrill Edge, and uDirect.
3) Open your account
Set up a new account with your chosen custodian. Some can be done online. Start contributing, investing, and keep up due diligence in directing your portfolio to build up your retirement nest egg.
Summary of Self Directed IRAs
- A self directed IRA can be traditional or Roth IRA depending on your preferred tax treatment.
- The onus is on you to do the due diligence on the risks and benefits of investments in SDIRA.
- SDIRAs are not for casual and passive investors.
- SDIRAs provide investment options and alternative assets which are practically limitless. Only three categories are prohibited: life insurance, collectibles, and S Corporation stocks.
- An IRA custodian is an intermediary between you and your investments. The custodian cannot give you investment advice and is not expected to assess the legitimacy or value of an investment. That’s your job.
- Prohibited transactions, such as those involving self-dealing and disqualified persons, could incur stiff penalties.
- Open your SDIRA with IRS-approved custodians.
- Do not break the SDIRA rules.