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Self-Directed IRA Definition – Pros & Cons, Prohibited Investments


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Individual retirement accounts (IRAs) come with plenty of advantages. You can either deduct the contribution from your taxable income in the case of traditional IRAs or let your money grow tax-free and pay no taxes on withdrawals in retirement through Roth IRAs.

But, being operated by brokerage services, IRAs typically only allow traditional paper assets like stocks, bonds, ETFs, mutual funds, and similar securities. Which raises a question for advanced investors and free spirits: what if you want to invest in alternative assets through your IRA?

Enter: the self-directed IRA.

What Is a Self-Directed IRA?

As the name suggests, a self-directed IRA (SDIRA) allows you to pick and choose your own investments beyond those available on public stock exchanges. You get the same tax benefits as a traditional or Roth IRA, however, and the same contribution limits apply ($6,000 in 2020, $7,000 for taxpayers age 50 and over).

But self-directed IRAs come with a deluge of rules, stipulations, and restrictions. First among them: you have to hire a trustee or custodian to hold your IRA assets on your behalf.

Self-directed IRAs are most commonly used by experienced real estate investors looking to double down on tax benefits while earning the high returns they’ve learned how to achieve as a professional investor. But taxpayers can also use SDIRAs to invest in franchises, precious metals, private equity, and other alternative investments like real estate through Fundrise.

Advantages of a Self-Directed IRA

Beyond all the normal advantages of IRAs, self-directed IRAs bring a few extra perks to the table.

Keep these pros in mind as you explore SDIRAs as a versatile tax-sheltered account option.

1. Flexibility

If one advantage stands out above all the others, it’s the flexibility that SDIRAs allow.

You can invest in almost anything you like through an SDIRA. Almost, but not quite anything — more on prohibited investments later.

For professional investors who know they can earn higher, more predictable returns in their own area of expertise, SDIRAs make a perfect retirement investment vehicle. After all, if you know you can predictably earn 15% on real estate investments, you may be loath to accept the volatility and 10% long-term average returns of the stock market.

2. Managerial Control

When you buy a stock or corporate bond, you hope for the best. The company could continue growing. Or a CEO embezzlement scandal could break in the news tomorrow, imploding the company into bankruptcy.

With SDIRAs, you play the role of CEO. Not only do you get to choose any investment you like, you also get to manage those investments if you so choose.

Say you invest in a four-unit rental property through your SDIRA. You can renovate the property to boost asking rents and force equity and appreciation, or leave it as is. You can hire a property manager or not, screen tenants aggressively to ensure timely rents and minimal wear and tear, even buy rent default insurance to protect against the risk of lost rents.

The managerial decisions all start and stop with you, not a distant board of directors.

3. Checkbook Control

The traditional model of SDIRAs involves the custodian approving all financial transactions, which gets tedious quickly. But you don’t have to live with that model.

Instead, many account holders set up a legal entity such as an LLC, and direct the custodian to invest their retirement funds in that LLC. The account holder, who owns the LLC, can then operate their investing business day in and day out without constant interference from the custodian. They can send and receive payments such as rents and repair bills on their own.

The custodian can still oversee the business’s finances, however, and the account holder must still play by the IRS’ many rules — more on them shortly.

4. Potential for Higher Returns

Expert investors often use SDIRAs as a vehicle to secure higher returns within their own area of expertise.

The classic example is real estate, but it’s far from the only example. If you’ve built a business around franchises, you can open a franchise specifically to invest in through your SDIRA. If you vet private equity funds for a living, you can undoubtedly earn more by investing in them than in an index fund.

Take advantage of your specialty knowledge and investing expertise if you have it to earn higher returns through an SDIRA than you could in a typical brokerage account.

5. Asset Protection

Your assets held in a self-directed IRA get better protection against lawsuits, judgments, collections, and bankruptcy losses than most other assets.

The exact degree of protection depends on the creditor, your state’s laws, and a range of other factors. For example, little can protect you from IRS tax liens.

But as asset protection strategies go, an SDIRA creates a better barrier than most. The Bankruptcy Abuse Prevention and Consumer Protection Act allows you to exempt up to $1 million of your SDIRA’s assets from creditors.

If you’re interested in using SDIRAs as an asset protection vehicle, speak with an attorney specializing in asset protection, as it’s an extremely complex and ever-evolving legal niche.

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Drawbacks of a Self-Directed IRA

For all SDIRAs’ strengths, they come with significant downsides.

Before you rush out to open an SDIRA, consider the following drawbacks carefully, and speak with an investment advisor to weigh the pros and cons.

1. Administrative Hurdles

To begin with, you have to hire a custodian licensed by the IRS to oversee and approve your investments. That adds an extra layer of complexity to your IRA investments, compared with simply opening an IRA through a broker and buying a handful of index funds.

Don’t expect the custodian to silently rubber-stamp your investments either. Your SDIRA custodian must countersign all the contracts you sign, for example, and they may ask plenty of probing questions.

The requirement of third-party approval can throw a wrench in your investments too. For example, many real estate investors secure outstanding deals by offering a lightning-fast settlement within five to 10 days. If you need approval from a custodian at every step of the way, that could slow your deals enough to eliminate your competitive advantage.

2. Cost

Custodians don’t offer their services out of the kindness of their hearts. They charge fees — plural — and sometimes many of them.

Keep an eye out for the following types of fees:

  • Setup Fee. This is a one-time fee for creating the SDIRA account with a custodian.
  • Annual Fee. This could be flat or based on the asset type or its value.
  • Transaction Fees. Every time money moves, the custodian takes their cut. For example, real estate investors could end up having to pay fees when they issue an earnest money deposit, when they settle, or when they need to make monthly mortgage payments, pay a homeowners association, utility bills, or any other transaction.

These costs typically add up to hundreds and sometimes thousands of dollars every single year.

3. Complex Regulation

The IRS can disqualify your investments in a self-directed IRA if they don’t meet IRS standards. If that happens, the assets held in your SDIRA suddenly become subject to taxes and penalties, which can add up quickly.

To qualify, your investments must meet a series of rules and requirements. First, you cannot buy a property with your SDIRA that was owned by you personally, or by a “disqualified person” — generally your family members. Second, you cannot gain “indirect benefits” from your SDIRA investments. For example, you cannot buy a rental property through your SDIRA then move into a basement apartment in the property.

You must hold any properties you own through an SDIRA in a unique title, such as an LLC specific to the SDIRA, rather than your personal name. Similarly, all expenses associated with your investment must be paid out of SDIRA funds, not your own personal funds. That adds some wrinkles when a $5,000 roof repair bill pops up, and you don’t have the money in your SDIRA to cover it.

The income generated by assets in your SDIRA must also remain in it, rather than peeled off as personal income. Continuing the example of a rental property, you can’t touch any of the rental income — it stays within the SDIRA’s accounts.

The rules get more complicated if you want to use financing.

4. Financing Hassles

You can use financing to partially pay for assets held in a self-directed IRA. But that portion of the asset falls outside of the tax protections provided by the SDIRA.

Say you buy a rental property for $200,000, make a down payment of $50,000 through your SDIRA, and finance the other $150,000 with a mortgage. Only 25% of the asset qualifies for the tax benefits, while the other 75% gets taxed regularly. In practice, that means you can deduct 25% of the income, and the other 75% gets taxed as unrelated debt-financing income (UDFI).

While real estate is the most common example, it’s far from the only one. If you invest in a franchise through your SDIRA, you may want to borrow a business loan to help you get the franchise off the ground, for instance.

The IRS does allow some exceptions to UDFI, so speak with a tax expert before making a decision about using debt to partially fund assets held by an SDIRA.

5. Limited Upside for Real Estate

Self-directed IRAs attract many real estate investors looking to capitalize on their existing expertise. But real estate already comes with a variety of tax advantages, which limits the usefulness of an SDIRA to further reduce investors’ tax burden.

For example, real estate investors can defer paying capital gains taxes when they sell a property, by using a 1031 exchange. Investors can deduct every conceivable expense, including some paper expenses like depreciation.

With so many inherent ways for real estate investors to lower their tax bill already, the additional tax benefits from an SDIRA often fail to outweigh the headaches and downsides.

6. Low Contribution Limits Make It Hard to Buy Large Assets

The kinds of assets that investors most often use SDIRAs for, such as real estate and franchises, tend to cost a lot. As in hundreds of thousands of dollars.

Yet the same low contribution limits apply to SDIRAs as regular IRAs, with most taxpayers capped at $6,000 in 2020. How many years would it take you to save up even a down payment for a property at $6,000 per year?

According to the Federal Reserve, the median U.S. home price as of this writing is $313,200. Even if you found a lender willing to lend you 80% of the purchase price, you’d still have to come up with $62,640 as a down payment — which would take more than 10 years’ worth of contributions.

Granted, you could invest in a regular IRA until you had enough for a down payment, then liquidate and move the money into an SDIRA. But the low contribution limits still add a severe speed limit to buying large assets like real estate or franchises.

7. Diversification Challenges

Large, expensive assets make it harder to diversify because each individual asset costs so much money.

Look at the median U.S. home cost above. You need more than 10 years’ worth of contributions to afford even a low down payment — all concentrated in a single asset. In contrast, you can spread $100 over hundreds of companies simply by buying shares in an index fund.

8. More Management Required

By their nature, self-directed IRAs require more, well, direction.

No one sets up an SDIRA to invest completely passively, such as through a robo-advisor. You don’t need to — you can use robo-advisors to completely automate your investments through a regular IRA.

Taxpayers create SDIRAs specifically to chase higher returns from alternative investments. But in many cases, those alternative investments require work. Landlords have to deal with bad tenants, with maintenance and repairs, with turnovers, screening applicants, and angry neighbors. Franchisees have to build a business with every cog in place, from marketing to managing personnel, overhead expenses to inventory.

It’s a lot of work that you wouldn’t necessarily incur with a regular IRA and paper assets.

Prohibited Investments in SDIRAs

The IRS unconditionally bans certain types of investments inside IRAs under any circumstances. Not even self-directed IRAs allow the following types of investments.

  1. Life Insurance. While the IRS does allow annuities, you cannot purchase whole, universal, or variable universal life insurance inside any type of IRA. This rule also applies to life insurance in qualified plans, although the Incidental Benefit Rule provides an exception for very small amounts of coverage. Although you may use life insurance to fund many types of nonqualified plans, these IRA restrictions apply to all types of qualified defined-contribution plans.
  2. Certain Types of Derivative Trading. Financial derivatives include futures and options contracts on securities or commodities. Many of the more aggressive self-directed IRA custodians permit the use of derivatives inside their accounts, but the IRS does not allow any type of trade or position that has unlimited or undefined risk, such as selling naked calls. They reason that such a high level of risk is inappropriate inside an account that is designed to provide financial security during retirement.
  3. Collectibles and Antiques. Unfortunately, you can’t place that priceless family heirloom inside an IRA, nor the electric train set that your grandfather played with as a boy. Furniture, wine, fine art, stamps, precious stones, porcelain and pottery, silver and dinnerware, jewelry, comic books, baseball cards, and other collectibles cannot be titled in the name of any type of IRA.
  4. Your Personal Residence. You can’t hold any property that you personally use — including your primary residence, vacation house, or spare bachelor pad in the city — inside an IRA. Rental properties that you own in your personal name are also prohibited. Other types of real estate holdings, like undeveloped land, may be permissible, but anything that you use personally is off limits. This means you can’t use IRA funds to buy yourself a first or second home or investment property from which you will directly benefit in any sense. Likewise, if you manage rental or investment properties you must invest through a separate legal entity to avoid commingling personal and SDIRA funds for that property.
  5. Certain Types of Coins. In general, you can’t hold any type of coin made from gold, platinum, or other precious metals inside an IRA. To be allowed in an IRA, a coin’s actual currency value must exceed its value as a collector’s item. The IRS does have a list of exceptions, however, including:
    • American Eagle coins that have never been in circulation
    • Proofs of American Eagle coins
    • American Buffalo coins
    • Canadian Maple Leaf coins
    • Australian Gold Philharmonic coins

It is also impermissible to take out a loan from your IRA to yourself or any family member, or transact business relating to any property held inside your IRA account with any lineal descendant or ascendant, such as renting out a house to your kids or parents.

Who Should Invest Through an SDIRA?

The short answer: SDIRAs are best for professional investors or investment experts.

For most Americans, self-directed IRAs add more complications and wrinkles than they’re worth. Most people are better off opening a regular IRA, potentially through a robo-advisor to automate their investments and asset allocation based on their age, retirement plans, and risk tolerance.

Expert investors, such as experienced real estate investors who can reliably earn high returns from their investments, can accelerate those returns through the tax advantages of an SDIRA, however. Even so, start with a regular IRA and only consider moving funds to an SDIRA after you’ve established a reliable track record with alternative investments.

An Alternative Retirement Investing Model to Consider

As a real estate investor myself, I understand the temptation to use your IRA to invest in what you know. Yet I resist that temptation for several reasons.

First, I believe that every investor should own stocks as part of their portfolio. You may love real estate and earn spectacular returns from it, but that doesn’t mean you should ignore every other asset class. Doing so leaves you vulnerable to shocks in the real estate sector, not to mention poor liquidity and diversification.

So if you’re going to invest in stocks anyway for long-term wealth building, why not use a regular IRA? You save yourself a slew of headaches and expenses by skipping the SDIRA, and leaving your IRA to equities.

Besides, you already get plenty of tax advantages inherent to real estate. I’d just as soon apply the tax advantages of an IRA to my stock investments, where I don’t have the same built-in tax benefits.

As a final thought, I automate my stock investments and retirement accounts. I don’t have to spare them a thought. Which works out well, because my real estate investments require a great deal more labor — labor that doesn’t need compounding with all the added wrinkles of an SDIRA.

Final Word

Self-directed IRAs offer a chance for expert investors to put their retirement funds into what they know best. But for most of us, SDIRAs cause more headaches than they’re worth.

Start with a regular IRA to begin funneling money into your retirement investments now. If the day comes when you absolutely refuse to put another retirement dollar into paper assets because you’ve built an impeccable track record of higher returns elsewhere, you can switch to an SDIRA to invest in nearly any investment you like.

What do you want to invest in that your regular IRA doesn’t offer? What will help you decide whether to set up a self-directed IRA?


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G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.