Self-directed IRAs differ from the standard IRA you would open for conventional ‘stocks & bonds’ investing. The types of investments held in a self-directed IRA are known as alternative investments. Alternative Investments are any investment that is not publicly traded, such as real estate, digital currency, precious metals, natural resources, and more.
Just like conventional IRA’s, you can elect to establish a Traditional IRA (tax-deferred) or a Roth IRA (tax-free). Self-directed IRAs abide by the same IRS rules and regulations as a conventional trading IRA, including contribution limits.
A self-directed Traditional IRA is a pre-tax retirement account. When you are employed and contribute into 401k, your funds go into that 401k pre-taxed (unless your company offers a Roth 401k). These funds will remain pre-tax as long as you keep them in a qualified pre-tax retirement account, like a self-directed Traditional IRA. Taxes are not due until you make a withdrawal or distribution, from the account.
A self-directed Roth IRA is a post-tax retirement account. The taxes on the funds within the self-directed Roth IRA have already been paid and thus, any gains made on your investment are made tax free. There are certain rules regarding contributing to a Roth IRA related to the client’s income. It is advisable to speak with a financial advisor before opening any type of retirement account.
Unlike a conventional IRA where you have an advisor assigned to your account making decisions about your money and investments, having a self-directed IRA puts you, the account owner, in the driver’s seat. You are the one making all the decisions about your account. You will instruct your self-directed IRA custodian on how allocate your funds and what investments you would like to use those funds towards. The custodian cannot make any transactions on your account without your instructions to do so.
With it being true that the self-directed IRA account owner is in control of who and what they are investing in, the client needs to be aware of IRS rules and regulations. They especially need to pay attention to the “self-dealing” rule, which prohibits the account holder or any ‘disqualified person’ from benefiting from the IRA.
For example, if you own real estate, such as an investment property, in your self-directed IRA, you or anyone in your immediate family cannot live in, property manage or renovate the property. This would be considered a prohibited transaction in the eyes of the IRS and would put your IRA at risk of being disqualified, which can result in additional taxes, penalties and fees. If you disqualify your IRA, your custodian may end up resigning on the account, resulting in your assets being distributed directly to you, which is a taxable event.
Disqualified persons include the IRA account owner, their spouse, grandparents and great-grandparents, children and their spouses, grandchildren and great-grandchildren and their spouses. Disqualified persons also include a provider such as a financial planner, tax professional and the IRA Custodian.
Typically, clients who are looking to open a self-directed IRA already know what avenue they want to go down for investing. Self-directed IRA custodians do not offer investments and are not licensed to give investment advice; this means that it is the responsibility of the client to do their research and perform due diligence when selecting an investment sponsor.
Unlike conventional investing, alternative investments often have a lack of liquidity. Publicly traded investments are easily liquidated so that the investor can access cash if needed. However, many alternative investments are illiquid, meaning that the client would need to find a buyer for their investment, depending on the type of investment.
An example of this is when your self-directed IRA is invested in Precious Metals. Precious Metal investing can be time consuming and complicated for the average investor. Precious metal purchases and sales are not quick transactions, and this can be frustrating for a client when they need to withdraw funds from their account quickly .
If the client is invested in precious metals and needs to withdraw cash, the first step would be for the client to reach out to a precious metal dealer. The client will provide the dealer with a list of the metals held in their account and work with the dealer to determine which metals to sell and negotiate a sale price. Next, the dealer will provide the sale invoice to the self-directed IRA custodian. The custodian works with the depository where the metals are stored to move the metals from the client’s storage account to the precious metal dealer’s account. Once the dealer has the metals, the dealer will send the cash proceeds from the sale to the client’s IRA. Finally, when the funds have been posted to the client’s account, the client can then request a distribution of the cash.
Certain alternative assets are unable to be liquidated. If the client holds Trust Deed Notes or Private Placement investments within their self-directed IRA, the client will need to reach out to their investment sponsor and work within their parameters to see if they are able to find a buyer for the investment. There is no guarantee that this is possible.
Self-directed IRAs allow clients to choose how their retirement funds are invested, but with that, just like any investment, comes risk. There are many people out there looking to take advantage of investors, and it can be easy to become a victim of fraud. Because self-directed IRA custodians cannot give financial advice, it is extremely important for the client to perform their due diligence and research who they intend to work with as an investment sponsor. A great place to start is to read reviews left by past and current investors.
Let’s go back to our previous example, precious metals. When a client is purchasing precious metals as an investment within their self-directed IRA, the client needs to find a precious metal dealer. Not all precious metal dealers are created equal. Recently, there has been an uptick in exploitative practices by some precious metal dealers, especially against the elderly. One of these practices is the markup of the metals that are being purchased.
When a client holds precious metals in their self-directed IRA, they are held at spot price. The market value of the metals cannot be determined by the IRA custodian; only a precious metal dealer can place value on the metals. It is important for the client to understand what the spot price is for the metals they wish to purchase and compare it to what their precious metal dealer is charging them. It is imperative for clients to do research, ask questions, and shop around when determining who to work with.
Self-directed IRA’s cannot hold publicly traded assets, however, clients have the option to establish a checkbook LLC within their IRA. This gives the client direct access to the funds via a checking account they will open for the LLC. This allows the client to invest in both publicly traded and alternative assets. It is important for the client to speak with licensed professionals before making financial decisions.
Investing through a self-directed IRA has several advantages, offering clients diversification and more control, but it also comes with increased responsibility and risk. It is always advisable to seek advice from a licensed professional when it comes to your retirement funds. If you are an investor, looking for outside the box diversification, a self-directed IRA may be just what you are looking for.