Your Guide to Self-Directed IRAs
How to navigate self-directed IRAs and get more from your savings
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
If you do a Google search of “self-directed IRAs”, you’ll find a sea of questionable information. Companies you’ve never heard of selling products you don’t understand. It’s no surprise that self-directed IRAs have the reputation of being hard to understand.
I’m here to change that for you.
Self-directed IRAs are incredible investment vehicles because they combine the tax benefits of regular IRAs with the flexibility of investment funds.
And what’s more? They’re astonishingly useful AND straightforward once you understand their basic concepts.
As always, I recommend my readers reach out to an investment pro before making a final investment decision. There are few things more important than getting your nest egg invested correctly. But to get you started here’s a basic guide on self-directed IRAs as well as the five biggest myths surrounding them.
What is a Self-Directed IRA?
Before we dive into self-directed IRAs, let’s take a broader look at properties shared by all IRAs.
What are IRAs?
IRAs (Individual Retirement Accounts) are savings plans that shield your investments from all capital gains and dividend taxes. You still have to pay income taxes, but all investments in IRA accounts grow tax-free.
Why taxes matter
Capital gains taxes typically range from 15-20% and are due anytime you sell an investment for profit. Dividends are also taxed at your ordinary-income rate.
These taxes reduce the effectiveness of compound interest. That’s because every time you sell investments to rebalance your portfolio, capital gains taxes will eat into profits.
For example, let’s assume you rebalance your portfolio yearly and have a capital gains rate of 20%.
$10,000 growing at 8% for 35 years does the following.
How do IRAs work?
Think of IRAs as a tax-advantaged investment container. The IRS places contribution limits on these accounts, but everything in them will grow tax-free.
- Contribution limits. The IRS limits contributions to $6,000 per year. People over age 50 qualify for catch-up contributions, allowing an additional $1,000 per year.
- Traditional vs. Roth IRA. Those earning under $122,000 can contribute to either a traditional or Roth IRA. Roth IRAs get phased out for higher earners.
- Traditional IRAs: pay income taxes LATER when you withdraw money
- Roth IRA: pay income taxes TODAY, but pay no income taxes later.
- Withdrawal limitations. IRAs are subject to a 10% penalty if you withdraw your savings before age 59.5. Exceptions are made for buying a house, funding an education, or helping with a disability.
- Minimum withdrawal. Traditional IRAs have minimum withdrawal amounts when you reach age 70.5. Roth IRAs have no minimum withdrawal amounts.
Third-party custodians. All IRAs require you deposit your savings with a third-party custodian. These are outside companies authorized by the IRS to hold your assets. Because you’re not holding the money yourself, you’re never subject to capital gains or dividend taxes.
Activities of third-party IRA custodians:
1. Asset holding. Handles your IRA funds at your direction
2. IRS reporting. Deals with the tracking and reporting required by the IRS
The largest IRA custodians are all household names. These include Vanguard, Fidelity, Charles Schwab, and TD Ameritrade.
How are self-directed IRAs different?
Usually, online brokerages only allow you to invest in stocks, bonds, and funds. Want to invest in real estate? Nope. You’re limited to a relatively small universe of investments by these brokerage firms.
On the other hand, self-directed IRAs let YOU choose your investment universe. So long as a licensed third-party custodian maintains the IRA, the IRS will allow you to invest in a far wider variety of investments, subject to certain restrictions.
Self-Directed IRA custodians allow YOU to direct your investing.
Self-directed IRA custodians have the same responsibilities as regular custodians. The most significant difference is that self-directed IRAs don’t limit themselves to holding just stocks, bonds, and funds on your behalf. If you want them to hold onto an investment property for you, they can!
What can you buy with a self-directed IRA?
There are hundreds of investments you can make with a self-directed IRA. Some of these include:
- Investment real estate (non-primary residence)
- Raw land
- Options with limited downside
- Gold bullion
- Private placement
- Tax liens
What you can’t buy with a self-directed IRA
There are also some limitations to self-directed IRAs. The IRS prohibits particular IRA transactions, including
- Self-dealing. You can’t buy assets from yourself or family members.
- Collectibles. To combat the use of IRAs in Nazi-looted art, the IRS prohibited transactions of artwork and other collectible items.
- Life insurance. The IRS doesn’t view life insurance as a retirement asset, and so bans them from IRAs
To learn more about prohibited transactions, you can visit the IRS website directly for a detailed series of guidelines or give me a call today. When it comes to managing taxes, it’s often worthwhile to talk to an investment pro to make sure you’re working within IRS guidelines.
The Five Myths of Self-Directed IRAs
Now that we’ve covered the basics of self-directed IRAs let’s take a look at the most common myths surrounding these accounts.
Myth #1: Self-directed IRAs somehow skirt the law
Often, when things sound too good to be true, there’s a catch somewhere.
How can you invest your own IRA and have the IRS still approve?
Self-Directed IRAs are perfectly legal
Most people look at me skeptically when I say this. But in truth, self-directed IRAs are the same thing as regular IRAs. The only difference is the custodian lets you choose your investments rather than offering a standardized menu. That means you need to put in a bit more work to identify the right investments.
The fear of the IRS holds a lot of people back from making the best use of their IRAs. But I tell my clients: investing for your retirement is one of the most crucial things you can do. It’s better to get good advice and do things well.
Worried about an IRS audit?
With a great advisor, you also greatly reduce the risk of breaking IRS rules. That’s because it’s the professional’s JOB to stay up-to-date with IRS regulations. They will also work with IRA custodians to coordinate your investments.
And if you do get audited, a great investment advisor can help you decide whether to contest the findings or take immediate corrective action, reducing the burden and stress on your part.
Myth #2: Self-directed IRAs are unsafe
Many people think self-directed IRAs are somehow less safe than regular IRAs. In fact, self-directed IRAs can be just as safe.
But how did this myth come about?
Self-directed IRAs allow for more (bad) investments
The larger your investment universe, the greater the chance you can invest poorly.
The IRS allows many types of investments for all IRAs. These investments range from the regular (stocks, real estate) to the speculative (cryptocurrencies, gold, options). Regular IRAs will steer you towards more traditional investments like stocks and funds. Self-directed IRAs, however, don’t have that safety net. So if you’re investing by yourself, make sure you understand what you’re buying
Self-directed IRAs are as safe as their underlying investments
The IRA custodian isn’t what you need to worry about. Instead, you should focus on the risk of the underlying investment.
Let’s use an example of an investment property. When you use your self-directed IRA to buy a house, the value of your IRA is dependent on the home value and the rental income it generates. If you want a more conservative portfolio, you should buy a house in a good neighborhood for a reasonable price. If you wish for more aggressive growth, you might consider purchasing a property in a more up-and-coming area.
Even if something happens to the self-directed IRA custodian, your real estate investment is still made to your benefit, and so you’ll still own the property.
And if you’re in doubt, you can always choose an investment advisor to help you with investing.
Self-directed IRA custodians must be IRS approved
Third-party custodians must adhere to strict regulatory oversight and audits, vastly reducing the risk of fraud or deception. It still pays to do your research on your custodian before investing, but sticking to the larger firms tends to be a safe strategy.
Myth #3: Self-Directed IRAs aren’t diversified
Many real estate investors use self-directed IRAs to buy real estate property. At first glance, this might seem the antithesis of diversification! (You can read more about diversification here). But keep in mind, self-directed IRA investments should fit in with your overall wealth plan.
If your IRA is small relative to your total net worth, holding a single asset in that IRA might seem overly concentrated when looking at only the IRA. But once you view your total investment picture, the IRA might make up only a very small percentage of your underlying assets.
You can use self-directed IRAs to buy multiple investments.
Alternatively, self-directed IRAs can be extremely diversified too. In addition to real estate, you can use them to buy tax liens, mortgage notes, metals, foreign currencies, gold, private placements, and more. That’s why I so strongly advocate my clients use self-directed IRAs: they provide excellent diversification to 401(k) plans.
Most 401(k) plans only allow investments in stocks, bonds, and funds. In contrast, IRAs give you a far grander investment universe. Why not use that advantage to diversify?
Myth #4: Self-Directed IRAs Must be Roth IRAs
Even those who are familiar with self-directed IRAs often mistakenly believe self-directed IRAs must start life as Roth IRAs.
In truth, you can convert ANY IRA into a self-directed one. Eligible IRAs include Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs. The thing to keep in mind is that your new self-directed IRA will maintain the original IRA’s characteristics. (i.e. Traditional IRAs will turn into a Traditional Self-Directed IRAs)
How to convert into a self-directed IRA?
To convert an existing IRA into a self-directed one, you would generally do what’s known as a direct rollover.
With a direct rollover, you take assets of an existing IRA and transfer them directly to a self-directed IRA custodian.
1. Form submission. Submit your transfer request to the self-directed IRA custodian
2. Transfer approval. The self-directed IRA custodian will contact your current firm on your behalf
3. Fund transfer. After your current firm processes the application, they send your assets to the new firm
4. Invest. Select your investments and send in an application for approval
There are two other ways of creating a self-directed IRA.
- Indirect rollover. With an indirect rollover, you withdraw assets yourself and re-deposit within 60 days to avoid early distribution penalties. Most custodians are required to withhold taxes, so you have to make up the difference with additional funds when you redeposit the money.
- Direct investing. With the direct investment, you deposit your annual IRA contribution directly to a self-directed IRA custodian.
Myth #5: Self-Directed IRAs are complicated
Yet another myth!
Self-directed IRAs can be as simple as you want. Many Self-Directed IRA custodians allow you to open accounts online and fund them easily with an online transfer. The process of buying investments is relatively straightforward.
1. Identify an investment to make. You can include any allowable transaction that’s in-line with IRS rules.
2. Request funds to purchase IRA investment. Self-Directed IRA custodians will review the request to make sure you’re investing in an IRS-approved transaction
3. Receive the money and buy the stake. The custodian will then why are you the money and maintain all vital records like deeds, notes, and operating agreements.
4. Maintain your IRA investment. If you have additional investment or expenses, you’ll have to fund them from your self-directed IRA.
5. Decide whether to keep your investment for income or sell it for profit. Once you are investment starts generating revenue, you can maintain it or sell it tax-free. All proceeds will return to the self-directed IRA custodian for tax-free holding until you want to withdraw it.
Next Steps In Your Self-Directed IRA
If this seems like a lot of information, don’t worry. The great news is that help is available. You can reach out to a qualified investment pro who understands the importance of investing your nest egg in a way that’s right for you.
And if you’re interested in pursuing a self-directed IRA but are worried about advisory costs, I tell people to give me a call anyway. It’s worthwhile to spend 3-4 hours with an investment pro today because even a single phone call can improve your investments for DECADES to come.
Where to find more resources
If you’re looking for even more investment tips, you’ve come to the right place.
That’s because I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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