Guide to Self-Directed IRAs

Bag of money labeled retirement

A self-directed IRA could give you a bigger bag of money for retirement. But they carry their own set of restrictions — and risks. Photo: 401(k)

The history of retirement plans in the United States is neither as old nor as extensive as most people think.

The first private pension fund was introduced by the American Express Co. in 1875 as a means of improving employee retention. By 1900, there were only 13 private pension funds in the entire country, and 75% of men over the age of 65 were still working and expected to do so as long as possible. In 1913, Congress enacted the first federal income tax, and by 1914 the IRS ruled that pension contributions were tax deductible.

The next big step in retirement came in 1935 when the Social Security Act established 65 as the retirement age. The life expectancy for a child born that year was 58 years for boys and 62 for girls. If you were lucky enough to make it to 65, you could expect to live to be 78.7 years old, on average.

Social Security was the only form of retirement funding for the 85% of American workers who were not covered by a private pension. Retirement funding other than Social Security reached its peak in 1974 when 45% of American workers were covered by a private pension.

ERISA

In 1974, for the second time in U.S. history, Congress passed a law designed to help average Americans have a means of retirement. The Employee Retirement Income Security Act (ERISA) was intended to establish minimum standards and rules for pension plans.

Among all the regulations regarding how pension funds must function was a provision that allowed for the creation of individual retirement accounts, or IRAs.

An IRA is an investment device that enables individuals to contribute funds to a savings plan to provide for their needs in retirement. Unlike money that is set aside in a savings account from after-tax income, IRAs allow savers to make contributions with pre-tax earnings.

That difference allows retirement savers to put aside earnings without having to pay taxes on them. Of course, taxes are due when the funds are withdrawn, but at a lower tax rate because your income during retirement is usually lower than in your prime working years.

Self-Directed IRAs

The term “self-directed IRA” is a bit of a misnomer because all IRAs are self-directed; you decide where to invest your IRA funds.

Typically, an IRA is entrusted to an IRA custodian, which is usually an investment firm that manages the funds of multiple investors. You choose the investment firm and the general mix of investments, such as stocks or bonds or ETFs. The investment firm then selects the actual stocks or bonds or ETFs to buy and sell. A self-directed IRA can be either a traditional or Roth IRA.

Traditional IRA – Contributions are tax deductible or made with pre-tax dollars. The funds that accumulate and increase in value within the IRA have no effect on your taxes until they are withdrawn.

Roth IRA – This newer type was created in 1987 as part of the Taxpayer Relief Act and allows contributions to be made with post-tax income. The funds within the IRA grow and have no effect on taxes. Unlike a traditional IRA, withdrawals from a Roth IRA are usually tax-free.

An IRA by Any Other Name

So if all IRAs are self-directed, what is a self-directed IRA? It comes down to the degree of control you have over the investments. These types of IRAs are sometimes called checkbook IRAs because the investor has direct checkbook control over investments.

In order to have a truly self-directed IRA, the 1974 law requires that you create a limited liability company (LLC) to act as the fiduciary for the funds. The LLC will then be able to enter into partnerships and make investments in anything from real estate to commercial paper and private loans.

The IRS has rules for investing your IRA dollars. For example, you can invest in a private liquor store, but not in alcoholic beverages such as a wine cellar stocked with rare vintages. You may invest in an art gallery, but not in art for your personal collection. The same rules apply to all collectibles, even if you expect them to appreciate in value. You are also restricted from investing in personal property such as a ski chalet in Steamboat Springs, unless you plan to rent it out to people other than you.

Before you think you’ve found a loophole big enough to drive a truck through, IRS rules prohibit you from helping your family. That means even though personal loans are permitted, they are not allowed for family members.

The no-family rule applies to all “lineal descendants,” including those of your spouse and your descendants’ spouses. Lineal descendants include children, grandchildren, and so on down the line. That includes investing funds in life insurance. You are also not allowed to borrow money from your IRA or sell property to it.

Long story short, even though you have direct checkbook control over the investments your LLC makes, you and your family are prohibited from benefiting in any way.

Self-Directed IRA Custodians

While you can exercise nearly unilateral control over the investments your self-directed IRA makes and you’re the beneficiary of those investments, you are not permitted to hold those assets. The IRS requires that IRA funds (from all types of IRAs) be held by a licensed custodial firm.

The rules state that the trust or custodial account must be in the United States and for the exclusive benefit of you and your beneficiaries. The account must be set up in writing and meet the following criteria:

“The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.”

A complete list of all the requirements a custodian must meet, along with all of the requirements of an IRA, may be found in Title 26 of the Internal Revenue Code.

Your choice of custodian is just as important as the investments you choose for your self-directed IRA. Despite the fact that all IRS-approved custodians are bound by the same rules, there can be important differences.

Custodial fees can vary substantially from one custodian to another, which is why it’s essential to shop around for the best rates. Equally important is how your uninvested funds will be treated — for instance, will they be in an FDIC-insured account?

The Investment Process 

It may be your money and your investment decisions, but before funds can be dispersed there is a process that must be followed:

  1. You identify an investment you want to make.
  2. A contract is drawn up in the custodian’s name and for the benefit of your IRA account.
  3. You submit an investment authorization form detailing what the money is for and where it is to be sent.
  4. The custodian either approves or denies the request.

When choosing a custodian, you should think about your investing strategy and what sorts of time frames for action you anticipate. For example, if you plan to make investments that require a quick turnaround between decision and payment, it is wise to make sure your custodian can act within those constraints.

The Good, the Bad, and the Ugly

It should go without saying that not all investments are right for all investors. While self-directed IRAs are not investments, but a vehicle for investments, they are not right for everyone either.

The same list of pros and cons that applies to both traditional and Roth IRAs that are administered by an investment firm, bank, or other professional applies to self-directed IRAs as well. In addition, self-directed IRAs come with unique advantages and disadvantages.

Pros of a Self-Directed IRA

The advantage of a self-directed IRA that’s cited most often is the latitude you have in making investment decisions. Not only are your investment choices greatly expanded, but you have near-complete control over those investments.

Control means you can fine-tune your investment mix to more precisely match your goals and risk tolerance. So if you wish to use your IRA funds to act as a venture capitalist and invest in startups, you can. Unlike a traditional or Roth IRA that can only invest in real estate through a real estate investment trust, you are free to snatch up profitable residential or commercial rental properties or undeveloped land.

Cons of a Self-Directed IRA

The associated custodial and trustee fees may be higher with a self-directed IRA. Depending on the custodian you select, the higher fees can range from mildly annoying to money-losing.

An often-overlooked expense of self-directed IRAs is the time required to perform adequate due diligence on prospective investments. Simply put, your time is worth something, even if you’re not billing yourself for the time you spend doing research. The value of your time when deducted from your gains may leave you losing money.

The opposite side of the potentially large gains from alternative investments is the risk of even greater loss. Unlike investments that are made in public companies, the disclosure requirements when it comes to most private investments are a matter of negotiation and carry a greater risk of fraud. In either case, the risk of catastrophic loss is much higher than with a professionally managed IRA.

It’s Personal

Everything about self-directed IRAs is personal, from the fact that they benefit you, to the investment decisions and the risks and rewards, and most importantly whether or not they are right for you.

Before you set up a self-directed IRA, you should carefully consider the advice and expertise of investment and financial professionals. You should make certain you fully understand the expenses and risks, including the tax implications of disqualifying your self-directed IRA. Finally, you should have an honest conversation with yourself to be sure you are making the right choice for you.

Loading Disqus Comments ...
Loading Facebook Comments ...