The Self-Directed IRA: Pros, Cons and FAQs
Kim Butler
I help young families get to Accredited Investor status and not slide backwards via our Prosperity Pledge which utilizes an Income Under Management approach with Currence and Whole Life.
Mitt Romney came under scrutiny during his presidential run when it came to light that he had socked away a fortune in his self-directed IRA. Romney’s IRA was worth between $20.7 and $101.6 million, according to Forbes.com. How was it possible that he could have acquired such wealth in the qualified plan environment?
The answer lies in the descriptor “self-directed.” Because Romney’s IRA was self-directed, he was able to use his IRA to fund venture capital and private equity investments inside of his retirement account. When Bain Capital (in which Romney was a partner) became highly successful, Romney’s wealth ballooned.
The exact strategies to produce such a hefty sum remain a mystery and doubtlessly involved—as The Atlantic surmised—“the alchemy of the private-equity business itself and the opportunities that come out of that insular world for people like Romney, who was the founder and chief executive of Bain Capital.”
While few people have the ability to turn what started as modest sums into many millions, the financial container Romney used to grow his investments tax-deferred is not reserved for multi-millionaires. Any American can open a self-directed IRA and use it to invest in (almost) anything they wish.
In this article, we outline self-directed IRA pros and cons and the basics of self-directed IRAs, including:
- What is a self-directed IRA—the definition?
- How do self-directed IRAs work?
- Who might benefit from one?
- What are self-directed IRA pros and cons, advantages and disadvantages?
- What can you invest in within a self-directed IRA?
- What is the process and how do you begin it?
Then at the end of this article, we’ll list links to additional resources for further information. (If you still have questions… please leave a comment or send us an email with YOUR question!)
What is a self-directed IRA?
A self-directed IRA is a type of traditional or Roth IRA. It allows you to save for retirement on a tax-advantaged basis and has the same eligibility and contribution rules as other IRAs. The difference between self-directed and other IRAs is simply the type of assets you can own in the account.
Typically, you would hold only stocks, bonds, mutual funds and other relatively common investments in a regular IRA. By contrast, you could invest in an endless array of assets in a self-directed IRA. A sample of possibilities could include:
- a triplex rental property
- a dairy farm
- mineral rights leases
- a peer lending portfolio, or
- life settlement funds (which purchase life insurance policies from seniors who no longer want or need them).
Although many people have never heard of them, they are anything but new. Self-directed IRAs started in 1974 when the Employee Retirement Income Security Act of 1974 (ERISA) ushered them into existence. Roth IRAs were created with the Taxpayer Relief Act of 1997.
They aren’t that well known (even amongst accountants and advisors) because financial institutions offering very limited choices have been the main force behind the proliferation of IRAs. According to TrustEtc.com:
“Investing in alternatives to stocks, bonds, and mutual funds has always been allowed by the IRS (see IRS Publication 590). Self-Directed IRAs have not received large attention because many custodians who offer IRAs (banks and brokerage firms) typically offer traditional investments.”
Now, let’s look at self-directed IRA pros and cons.
What are the advantages of a self-directed IRA?
Diversification. The ability to utilize different asset classes is an enormous advantages of a self-directed IRA. Unfortunately, qualified plans have become almost synonymous with “mutual funds,” leaving many investors at risk of stock market downturns.
Leverage yourself. Do you have unique experience and expertise? The ability to leverage your intellectual capital is another big advantage of self-directed IRAs.
Tax advantages. As with other traditional and Roth IRAs, self-directed IRAs (traditional or Roth) will either allow you to:
- defer taxes (traditional) or
- earn tax-free profits with after-tax dollars (Roth).
(One financial analyst wondered why Mitt Romney used a traditional rather than a Roth IRA, and it is a good question!)
Creditor protection. As with other IRAs, self-directed IRAs can protect assets from creditors under bankruptcy law—often up to one million dollars. However, the protection varies from state-to-state, so be sure to research the rules in your state.
What are the disadvantages of a self-directed IRA?
Risk. Just as a self-directed IRA allows you to invest in nearly anything, it also allows an investor a wide range of risk. For instance, putting money into Bitcoin, other cryptocurrencies, or ICOs (initial coin offerings) is extremely risky business. It is not, however, prohibited in a self-directed IRA.
Additionally, there have been some frauds perpetrated on investors. Unfortunately, self-directed IRAs can be used as a stamp of legitimacy on questionable schemes. If you are told the IRA custodian has “vetted” or “approved” of the underlying investment, that could actually be a warning sign. As the SEC notes, custodians generally don’t evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.” That it is actually your job—so do your due diligence and keep track of your balances.
Fees. You will typically pay additional fees to open and maintain a self-directed IRA. These fees might be a disadvantage for someone with a very modest IRA, as it represents a larger percentage of the investment. For larger IRA balances, the fees are well worth the advantages and opportunities.
For instance: $500 would represent five percent of a $10k IRA balance. If you wanted to invest in peer lending with just a few thousand dollars, it would be more efficient to do so outside of an IRA. With a six figure IRA balance, the fee would be well worth the opportunity. By investing in non-correlated assets, you could protect your account from the stock market volatility that low-fee options tend to represent!
Of course, the unique investments you choose to put in a self-directed IRA may also have additional fees. While fees are (and should be) a big concern with mutual funds, index funds, ETFs and the like, it is important to consider the big picture, the risk profile, and the “net” profits of potential alternative investments.
Time. It may take more time or effort to explore your options, educate yourself or use your expertise with a self-directed IRA. On the other hand, while defaulting to hands-free “automatic” investment options such as target date funds may be easier, that does not make them better!
Rules. You may encounter limitations with investments within a self-directed IRA. For instance, if you use your IRA to purchase real estate, you cannot use the property yourself—not even intermittently. You cannot live there, stay there, or rent office space to yourself there. There’s a strict “no self-dealing” rule that will even prevent you (for instance), from making your own repairs, because now you’ve “furnished services” to the asset owned by the IRA. That can turn into a big problem if the IRS finds out!
Financing a property is also more complicated. Typically a non-recourse loan is required, also a larger down payment than if you were purchasing property as an individual. And remember—any profits generated are now also part of your IRA and subject to qualified plan rules and restrictions.
Who can best benefit from a self-directed IRA?
A self-directed IRA is ideal for an investor who:
- Has knowledge or expertise in a particular field or investment.
- Enjoys having greater involvement with their investments.
- Has primarily stocks and bonds in their portfolio and sees the advantage of greater balance and diversification.
- Has built up lump sums of $50k or more and/or is now an accredited investor with the ability to invest in a wider range of investments.
- Desires to benefit from tax deferral strategies or tax-free income from a self-directed Roth.
What can you invest in?
There is a key scene in the romantic comedy Hitch in which Albert Brennaman, an awkward accountant, played by Kevin James, catches the attention of the Allegra Cole, the beautiful heiress played by Amber Valletta. Cole meets with her investment team, including Albert, and explains that she would love to invest in her friend Maggie’s new fashion business. She receives a dismissive response from the lead advisor who suggests that they put together some “appropriate investments” for her to consider instead.
What happens next is great fun and a turning point in the plot. Besides creating a scene, Brennaman tells Allegra that if she wants to invest a half million dollars in her friend’s business, that’s exactly what she should do!
While the fictional heiress was probably not concerned about an IRA, if Allegra Cole had a self-directed IRA, this is exactly the type of investment that could indeed be made inside of it.
Investments that can be made inside of a self-directed IRA include:
- Real estate (single family, multi-family, land, farms)
- A privately held company (just not one you manage or have ownership interest in outside of your IRA)
- Business partnerships (again, certain rules apply)
- Bridge loans
- Tax liens
- Life settlements
- Gold or other precious metals
- Crypto-currencies
- Energy investments
- Individual stocks
(Note: Just because something is on the list above does not mean we endorse the investment or recommend it for every situation! We invite you to talk with Kim to discuss self-directed IRAs.)
There are a handful of investments that are NOT allowed in a self-directed IRAs, including:
- Life insurance
- Collectibles and antiques
- Certain types of derivative trading
- Property that you or a family member live in, rent, or currently own.
What is the process for beginning a self-directed IRA?
Many investors start the process by researching IRA custodians. However, this is the wrong place to begin! That’s because many IRA custodians work with a limited number or type of investments. Too many people choose a custodian first then discover that custodian doesn’t deal with the investment they want!
First, you want to understand and select the investments you wish to hold in your self-directed IRA. Research the pros and cons. Find out investment minimums and investor requirements, if any. Understand any specific rules that may affect your flexibility or control with that investment. Know what your investment “exit strategy” will be. Be well aware if there are issues with taxation, such as Unrelated Business Income Tax (UBIT) that might make certain investments problematic.
(Booking a complimentary call with Kim Butler can be a great way to get some of these questions answered, but always do your own due diligence as well.)
How can you learn more about self-directed IRAs?
We have several resources that can help you better understand different aspects of self-directed IRAs. Additionally, by contacting us directly, we can give you more detailed information about certain investments that can be held in an IRA.
From The Prosperity Podcast:
“Self-directed IRAs: The Lesser-Known IRA”
“Learning More About Self-Directed IRAs”
Articles from the Prosperity Blog:
“The Best Investments for Your Retirement Account”
“The Self-Directed IRA: Alternative Investments for Your Retirement Account”
Book a call with Kim.
Want to know whether a self-directed IRA might be a good option for you? Would you like to explore some of the alternatives available? We invite you to schedule a call with Kim. In addition to being a best-selling financial author, Kim Butler has been named an Investopedia Top 100 advisor two years in a row. Partners for Prosperity specializes in alternative solutions and we are here to help!