What is a self-directed IRA?

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If you’ve ever heard the term and wondered, “what is a Self-Directed IRA,” you’re not alone. But if you’re looking for an individualized investment opportunity, a Self-Directed IRA (SDIRA) could be a viable option. That said, there are guidelines and regulations surrounding Self-Directed IRAs that you need to be aware of. As always, to get the most out of your investment, it’s best to do your research. Let’s take a look at what a Self-Directed IRA is, how it works, and what you need to know about this particular retirement account.

What is a Self-Directed IRA?

A Self-Directed IRA is an individual retirement account that allows you to invest in more diverse and less common assets. A Self-directed IRA can be either a Traditional IRA or a Roth IRA.

While regular IRAs offer options to invest in stocks, bonds, and mutual funds, for example, a savvy Self-Directed IRA holder can invest in an array of areas that would be otherwise unavailable. 

Additionally, Self-Directed IRA assets must be held by a custodian or trustee. And since custodians aren’t allowed to give investment advice, as the account holder, you’ll need to personally manage these assets.

What are the benefits of a Self-Directed IRA?

Diversifying your portfolio. On top of the built-in tax benefits of holding an IRA, a self-directed IRA has additional perks including portfolio diversification. Diversifying your portfolio is often tied to unsystematic risk reduction. By supplementing your traditional investments with a dynamic range of investment options spanning various industries, you counterbalance your portfolio in case one industry is negatively affected by market volatility. This strategy can help protect your investments in an economic downturn.

Increasing your investments’ potential. The potential benefits of investing in a variety of industries are twofold. Along with protecting your assets during market fluctuations, you can also increase your growth opportunities. Rather than relying on the growth of just one industry, you can reap the benefits of multiple industries gaining value simultaneously.

Leveraging your expertise. If you’re already involved in the real estate industry, for instance, you can leverage your expertise to make investments in that space. As we mentioned, the brunt of the research is on the IRA account holder, so having that knowledge in your back pocket prior to investing can serve as an advantage.

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How does a Self-Directed IRA work?

In many ways, Self-Directed IRAs work much like other types of IRAs—they provide investors long-term tax-efficient investment accounts for retirement. Given the increased responsibility of the account holder, however, these IRAs are ideally held by seasoned investors and those who are already familiar with alternative investments. 

It’s worth noting that rules and regulations surrounding self-directed IRAs are unique to this type of retirement account, so it is important that even experienced investors thoroughly familiarize themselves with these rules before opening and investing with a Self-Directed IRA. Below are a few things to take into account when deciding whether a Self-Directed IRA is right for you.

Self-Directed IRAs have contribution limits just like other IRAs. Just like Traditional and Roth IRAs, if you’re under 50, the maximum contribution you can make to your Self-Directed IRA is $6,000. This increases to $7,000 if you are over 50 years old.  

There are some prohibited transactions when investing with your SDIRA. According to the IRS, prohibited transactions are certain transactions that occur between a retirement plan and a disqualified person and investing in assets not eligible in retirement plans. What is a disqualified person? Great question. A disqualified person includes your fiduciary (someone who acts on your behalf to manage your assets), lineal descendants, and their spouses. These prohibited transactions are specific to Self-Directed IRAs. Below are just a few examples of prohibited transactions:

  • Purchasing property for personal use
  • Paying too much for the management of your IRA plan 
  • Investing in the business of a friend or family

With a Self-Directed IRA, you need to think about your exit plan. If you’re using your Self-Directed IRA to invest in alternative investments—for example real estate—it can be more illiquid than, say, investing in stocks or bonds. This is important to take into account, especially if you have a Traditional Self-Directed IRA and are reaching the age when distributions become mandatory (currently, when you reach 70½ years old).

What is the difference between a Self-Directed IRA and a Roth or Traditional IRA?

The primary differences between a Self-Directed IRA and a Roth or Traditional IRA are the areas you can invest in and who manages these investments.

Roth and Traditional IRAs are typically used to invest in mutual funds, bonds, and CDs—the usual suspects. Unlike Traditional IRAs and Roth IRAs, in which people often invest in stocks, CDs, mutual funds, cash, and bonds, Self-Directed IRAs allow you to invest in alternative assets that such as real estate.

Investing in these assets gives the account holder flexibility, but at the same time requires increased due diligence. As the name suggests, these accounts are self-directed, therefore you manage them yourself. This requires more time and initiative on your end, as you do not necessarily have a third party advising you.

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Are there different types of Self-Directed IRAs?

As we just mentioned, there are different kinds of IRAs, the two most common being Roth and Traditional. A Self-Directed IRA can be either a Traditional IRA or a Roth IRA. Before jumping in and opening an IRA, it’s important to do your research and to determine the best IRA type for your goals and investment experience

The primary differences between these two IRA types lie in the way they’re taxed, income limits, early withdrawal rules, and their required minimum distributions. Below is a brief introduction to each.

Roth IRAs: Your contributions are not tax-deductible, so you are taxed when you contribute to your IRA rather than when you withdraw from it. There are also income restrictions on Roth IRAs, so you must make less than a certain amount to contribute. Additionally, you have the freedom to withdraw from your IRA at any time.

Traditional IRAs: Your contributions are tax-deductible; therefore, you are taxed on your withdrawals. Unlike Roth IRAs, traditional IRAs do not have any income limitations, but they do insist that you start withdrawing from your accounts at age 70 ½. 

How do you open a Self-Directed IRA?

When it comes to opening a Self-Directed IRA, there are steps to follow to help ensure you get the most out of your investments. Following these steps will help you start on the right track.

Step 1: Understand the SDIRA process

Before making any concrete decisions, you’ll first want to familiarize yourself with the SDIRA process. You can then build a plan of action—determining possible industries you would like to invest in, shopping around for reputable SDIRA custodians, choosing which type of account you want to open, and deciding on an exit plan should you need to sell quickly.

Step 2: Decide where you want to invest

This is the exciting part, but it also requires significant research. Be sure to do your homework when exploring various industries and their investment opportunities to ensure you’re well-versed in the asset you plan to invest in. You may also want to hire, or at least speak with, a financial advisor at this time as they can help you make the most appropriate decisions for your retirement and overall financial goals.

Step 3: Select a custodian

A self-directed IRA custodian is a financial institution that holds an individual’s investments. Banks, brokerages, credit unions, insurance companies, and non-bank trust companies can all serve as custodians. As we mentioned earlier, they are also required by the IRS, meaning you must hire a custodian before investing in any assets. 

When looking for a custodian, feel free to shop around to find one that fits your price bracket and to ensure they specialize in the industries you’re looking to invest in. Additionally, protect yourself from fraud by checking potential custodians’ licensing and registration. 

Are there risks to a Self-Directed IRA?

They’re complex. While additional investment opportunities are exciting and can help protect your assets from market swings, depending on your knowledge and your custodian, they can be complicated. Since you’re managing your investments yourself in this case, the stakes can be higher for new investors.

They hold potential penalties. Being aware of the rules and regulations surrounding Self-Directed IRAs is important to avoid getting hit with fees and penalties. As mentioned above, there are prohibited transactions to avoid such as the “no self-dealing” rule, which prevents you from borrowing money from your IRA or using it as security for a loan. Breaking these rules can come with heavy penalties, so it’s important to familiarize yourself with prohibited transactions.

Fraudulent investment issuers. Finding the right custodian for your Self-Directed IRA is important. In 2018, the SEC alerted investors to fraudulent custodians who had given poor or self-serving investment advice and even spent client funds. The SEC warned the public that fraudsters were hiding behind custodians, making it appear as if the investment was either produced by the custodian or approved by the custodian. Custodians don’t look into the quality of investments, only into making sure it is properly held in the IRA. To avoid getting duped, steer clear of any custodian that is eager to give you investment advice (this is prohibited by the SEC).

As you shop around for a Self-Directed IRA custodian, be as rigorous as you would with vetting the asset classes and actual investments you invest in. Be sure to check their licensing and registration, verify prices, asset values, and other account information before hiring your custodian.

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Are there fees associated with a Self-Directed IRA?

While the fee structure does vary depending on the investment offering and the custodian you choose, there are consistencies between the types of fees that you can potentially accrue.

Custodian fees are fairly common as they generally serve as fees for the various services they provide. From collecting rent on your properties to account holding fees, you can end up paying anywhere from $500 into the thousands of dollars per year on custodian fees alone. As a general rule, custodians charge the following fees at various rates, depending on factors including the portfolio value and their specialty:

  •     Establishment fee
  •     Annual maintenance fee 
  •     Paying bills via cashier’s check
  •     Paying bills via wire transfer
  •     Moving an IRA to another custodian
  •     Termination fees

Now that you know what a Self-Directed IRA is, and the benefits and drawbacks of opening one, you can decide whether this is the right retirement account for your goals.

Interested in opening a Self-Directed IRA? We can help. The Yieldstreet platform allows accredited investors to help diversify their retirement portfolio by investing in alternative assets with their SDIRA.

Have additional questions about investing with your Self-Directed IRA? Reach out to us at [email protected].

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