Things to Know About Self-Directed Roth IRAs (SDIRA)

There is no question regarding the popularity of IRAs (Individual Retirement Accounts) for retirement planners. According to a report from the Investment Company Institute, over 43.9 million households in the U.S. own at least one type of IRA. IRAs are popular because of several reasons. In simple terms, these retirement accounts are tax-deferred savings accounts that allow you to save money for retirement. These accounts allow your funds to grow tax-free until withdrawn.

IRAs are held by trustees and custodians, such as banks, brokerage firms, federally insured credit unions, and other entities approved by the IRS (Internal Revenue Services). These custodians pool your funds and invest them across different financial products of your choice. Most commonly, the investment choices in a traditional IRA include stocks, bonds, mutual funds, and ETF (Exchange Traded Funds). Typically, there are four types of IRAs. In a traditional IRA, you contribute pre-tax dollars, and your funds grow tax-free in the account until withdrawn. In a Roth IRA, you contribute after-tax dollars, and your money grows tax-free in this account without you having to pay any taxes at withdrawal. These are two of the most popular types of IRAs.

A traditional and Roth IRA offers wide investment choices than an employer-sponsored program like a 401(k). However, these accounts prohibit some assets, which might interest you. If you feel a typical traditional or Roth IRA does not provide you with the investments opportunities you need, you can opt for a self-directed Roth IRA. A self-directed IRA allows you to contribute funds and avail of the same tax advantages as applicable to a standard traditional or a Roth IRA. The difference between a self-directed Roth IRA and a Roth IRA is the type of assets in your portfolio. If you need further assistance in understanding how a self-directed Roth IRA fits in your retirement plan, consult with a professional financial advisor who can take you through the same and clear up any doubts that you may have.

Here is everything you should know about a self-directed Roth IRA:

What is a self-directed IRA?

A self-directed IRA (SDIRA) is an IRA that allows you to invest across alternative asset classes, which are not available in regular IRAs. Regular IRAs typically give an option to invest in stocks, bonds, mutual funds, Cash Deposits (CDs), and Exchange-traded funds (ETFs). However, a self-directed IRA allows you to invest in these securities and many other additional alternatives, such as:

• Real estate
• Undeveloped or raw land
• Precious metals like silver, gold, etc.
• Debt instruments like tax lien certificates
• Promissory notes
• Commodities
• Water rights
• Cryptocurrencies like Bitcoin
• Livestock
• Limited Liability Company (LLC) membership interest
• Franchises
• Private placements
• Start-ups through crowdfunding platforms
• Foreign currency

Available as an IRA or a Roth IRA, a self-directed IRA gives you the same tax advantages as an ordinary IRA. In a self-directed Roth IRA, you make after-tax contributions, and in a self-directed IRA, you make pre-tax contributions. In both cases, your funds grow, compound, and generate dividends tax-free. The withdrawal rules of a self-directed IRA depend on its type. If you have a self-directed IRA, you pay taxes at the time of withdrawal. However, if you have a self-directed Roth IRA, you do not pay any taxes on withdrawals because your contributions comprise after-tax dollars. Further, you can withdraw penalty-free funds from your self-directed IRA once you are 59.5 years, but you have to pay taxes on the money withdrawn. In a self-directed Roth IRA, you can take your money any time, for any reason, without any tax or penalty. However, you must be 59.5 years and should have held the Roth IRA for at least five years before withdrawing the sum. The rule of RMDs (Required Minimum Distributions) applies to a self-directed IRA too. In the case of a traditional self-directed IRA, you have to take RMDs at age 72. If you have a Roth self-directed IRA, you have no RMDs for the lifetime.

Further, the contribution limits for a self-directed IRA remain the same as its forerunners. For 2021, you can contribute up to $6,000 in your self-directed IRA. If you are 50 years or older, you can contribute up to $7,000 in 2021.

What are the eligibility self-directed IRA rules?

Anyone of any age can contribute to an IRA, but there are specific income restrictions. The IRS allows you to make contributions from your earned income towards a self-directed IRA. Earned income refers to wages, salaries, self-employment profits, etc., and is exclusive of Social Security benefits or similar help from the government.

The earned income criterion is also applicable for a self-directed Roth IRA. Further, for 2021, if you are a single filer, you can make a full contribution to a self-directed Roth IRA if your modified adjusted gross income (MAGI) is less than $125,000. You can make a partial contribution if your MAGI is more than $125,000 but less than $140,000. Additionally, if you are married, a full contribution is permissible if your MAGI is less than $198,000. If your MAGI is above $198,000 but less than $208,000, you can make a partial contribution. In another case, if you are married but filing separately, you can make a full contribution if your MAGI is less than $10,000. You can make a partial contribution if your MAGI is above $0 but less than $10,000.

How and where to open a self-directed IRA

Self-directed IRAs are held by custodians or trustees, such as banks. Each custodian or trustee differs from the other in terms of investment options, rules, etc.

Given below are the names of the organizations that provide self-directed IRA custodians:

• The Entrust Group
• Equity Trust
• Madison Trust and Millennium Trust Company

The custodians levy charges for establishing and monitoring the IRA funds. However, you are solely responsible for managing the self-directed IRA. The self-directed IRA custodians or trustees only act as a third party for establishing the account and monitoring the investments.

The primary step in opening a self-directed account is to find a reliable trustee or custodian. Since each custodian differs in their services, investment choices, fees, etc., it is beneficial to research and select a self-directed IRA custodian that best meets your requirements. Once you finalize the custodian, you can pick the investments you want to make after studying the options in-depth.

Once through, you have to find the broker to purchase the investment and ask your self-directed IRA custodian or trustee to carry out the transaction. But, as an account owner, you are responsible for managing the account, and are solely accountable for the due diligence of your investments and managing your underlying assets. Managing a self-directed IRA requires extensive knowledge about the market and different assets. You should also know how each security functions and the risks associated with the investments.

Given the complexity involved with a self-directed IRA and choosing investments that best align with your goals, it is wiser to consult a professional financial advisor. These experts have market and asset knowledge and can help you select the right investments per your risk tolerance, financial objectives, and investment horizon. However, keep in mind that the IRS prohibits particular investments in a self-directed IRA. Some of these assets include collectibles, life insurance, S Corporation stocks, etc. Collectibles include antiques, artwork, baseball cards, alcoholic beverages, stamps, jewelry, rare coins, etc. If you invest in these assets through your self-directed IRA or self-directed Roth IRA, the amount you spend will be considered a withdrawal. Your financial advisor can guide you if you are not violating any rules in your self-directed Roth IRA. If you do not have a financial advisor, this may be a good time to find one. Use our free advisor matching tool to find the right financial advisor for your needs.

What are the benefits of a self-directed IRA?

There are three prime benefits of investing through a self-directed IRA. These include:

1. Potential for higher returns: One of the biggest advantages of a self-directed IRA is that it can help bolster your retirement savings. You get greater flexibility in terms of investments you hold in a self-directed IRA. You can invest in alternative assets like real estate, LLC membership, precious metals, commodities, etc., which are otherwise not permissible in a traditional IRA or a Roth IRA. You also have the option to put your money in high-risk and high-reward investments like cryptocurrencies, early-stage private companies, etc. Investing in these assets gives your portfolio an edge over the traditional or Roth IRA portfolios. You can earn much higher compared to investing in just the stock or bond market. You have the freedom to make investments that align with your passion, knowledge, and experience. However, investing in alternative assets also comes with higher risks, and it is advisable to be cautious before making any decision.


2. Increased diversification: A major concern for retirees or those nearing retirement age is market volatility and the steeply rising inflation. Stock market volatility coupled with inflation can consume a large share of retirement savings. Hence, for this section of people, a self-directed IRA is a diversification opportunity. Investment in alternative assets implies that your portfolio is secure against downturns or time eroding the value of your money. For instance, investment in gold provides optimal diversification to your retirement portfolio. Gold prices rise with time, offering the much-required financial security against stock market downturns and inflation. Safe investments like gold and cryptocurrency can help diversify your portfolio, but there is no protection against losses. In the short term, investments in gold or cryptocurrency are as volatile as stocks.


3. Tax advantages: Depending on the type of self-directed IRA, you can avail of significant tax advantages. In a traditional self-directed IRA, you can lower your existing taxable income by deferring taxes on contributions in the present, as well as enjoy tax-free growth of savings. Alternatively, in the case of a self-directed Roth IRA, you make after-tax contributions to the account and pay taxes in the present, allow your funds to grow tax-free, and enjoy tax-free withdrawals in the future, subject to specific conditions.

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What are the disadvantages and risks of investing in a self-directed IRA?

Self-directed IRAs are a good fit for investors who are risk-takers and have considerable market knowledge. However, self-directed IRAs carry a higher degree of risks and downsides than standard IRAs. Some of the disadvantages and risks involved in a self-directed IRA include:

1. Lower liquidity: Self-directed IRA or self-directed Roth IRA allow you to invest across different investments, most of which are illiquid. In case of an emergency, you might have to struggle to get any money from your self-directed IRA. Selling alternative assets like gold, real estate, etc., generally takes longer than stocks and bonds. You will have to find a buyer for your alternative investment. Further, if you try to liquidate funds quickly, you could be forced to sell at a lower rate than the market value or even lesser than what you paid for them originally. In contrast, securities like stocks, mutual funds, etc., are highly liquid, meaning you have a better chance to sell them quickly and at the market value in case of an unforeseen emergency. The illiquidity of alternative assets becomes a matter of concern when the RMDs begin at 72 years.


2. Higher fees: Traditional or Roth IRAs generally do not levy any account management or trading fees. However, in a self-directed IRA, the custodian may charge an account-related fee along with the investment charges for the securities you invest in. For instance, if you invest in gold through your self-directed IRA, you will have to pay the maintenance fee, storage fee, and insurance charges related to the investment. You can also expect to pay about $250 for shifting or changing your self-directed IRA custodian. Hence, before making any investment through a self-directed IRA, be aware of all the fees involved.


3. Prohibited transactions: The IRS restricts owners of a self-directed IRA to hold specific assets like collectibles, life insurance, S Corporation stocks, etc. If you break this IRS rule and invest in any of these assets, you could be liable to pay hefty penalties and taxes. This will defeat the primary purpose of a self-directed IRA, which is to generate potentially higher returns. The IRA tax benefit vanishes when you invest in any of the prohibited assets. Instead, you become liable to penalties and interest. The IRS also has self-directed IRA rules. For instance, you cannot borrow money from an IRA, sell or buy property from an IRA, or use an IRA as security for a loan. These rules are easier to adhere to when you invest through a traditional or Roth IRA. However, the lines are often blurred when you invest in alternative investments like real estate. For instance, if you buy a rental property but use it for your personal purpose, the entire account will be considered distributed to you if the IRS learns of the misuse. You would be liable to pay taxes along with a penalty.


4. High risk: The custodians or trustees of your self-directed IRA only administer and hold your investments. They are not responsible for investigating the quality of the legitimacy of the investment options available in the self-directed IRA. You have to undertake due diligence to understand the investments you choose in your self-directed IRA. For instance, if you buy gold or another precious metal from your self-directed IRA but the gold does not meet the purity standard required for your IRA. Hence, you will lose the investment money on the fraudulent purchase and also incur tax penalties.


5. Low transparency: In many cases, the self-directed IRA custodians and trustees list the purchase price plus expected returns of an investment as its valuation. However, in reality, that is not the sum you get for the asset. As an investor, you have to do a detailed analysis to uncover the actual price and return of the investment.

Is a self-directed IRA the right choice for you?

After evaluating the pros and cons of a self-directed IRA, choosing it as a retirement savings account depends on your risk tolerance, return expectations, market knowledge, investment horizon, and more. If you aim to finance your retirement with income from alternative assets, consider a self-directed IRA, provided you are investing for the long-term and have considerable knowledge about these alternative assets.

However, if you are a casual, low-risk, and average investor, a self-directed IRA can be a bit complicated for you to handle. With a self-directed IRA, you are at a high risk of making mistakes and falling into a trap leading to fraudulent transactions, hefty penalties, and additional taxes. For most retirement investors, options in a traditional and Roth IRA can create a diversified portfolio. For instance, ETFs available in these standard IRAs are a viable and safer option to diversify your retirement portfolio. An ETF allows you to invest in alternative investments like commodities, metals, private equity, etc. Standard IRAs are easy to open, close, sell, and manage and provide the same tax advantages as a self-directed IRA without any risk of breaching IRS rules.

To conclude

Overall, a self-directed IRA opens up new investment opportunities for your retirement portfolio. However, it is vital to study the pros and cons of these accounts before making any investments. As general advice, experts do not recommend investing your entire savings in alternative assets. However, holding 10% of your money in alternative assets is a feasible bet. If you are serious about using a self-directed IRA for retirement savings, consult a professional financial advisor to help you navigate the process of creating the account and selecting and managing your investments. To get in touch with a qualified financial advisor, use the free advisor match tool. Answer a few questions and get matched with 1-3 background-verified financial fiduciaries. You may also set up a free initial consultation with them before deciding to hire one.