Financial Poise

Self-Directed IRAs Span Every Asset Class

IRAs Defined

Self-directed IRAs, or any individual retirement accounts (IRA), are exactly that – accounts in which an individual, without the assistance of an employer (like a 401k requires), invests money that will grow over time. The purpose is to provide a nest egg for retirement. An IRA can be invested in a variety of assets, including stocks and bonds, index funds, or mutual funds, among others. There are two types of IRAs: traditional and Roth.

Traditional and Roth IRAs

The money put into a traditional IRA can be deducted from taxable income. For example, if you earn $100,000 in a year and invest $10,000 in an IRA that same year, you would only pay taxes on $90,000. Furthermore, any future income earned from the IRA will not be taxed until those funds are withdrawn. This is referred to as “tax-deferred growth.” However, keep in mind that retirees are required to withdraw their money starting at a certain age. According to bankrate.com, retirees must begin taking annual withdrawals from their tax-deferred retirement accounts at age 70½.

Unlike traditional IRAs, Roth IRAs do not provide an initial tax break. Instead, they require no additional taxes to be paid until after retirement. This is referred to as “tax free growth.” Roth IRAs do not mandate an age by which money must be removed from the account.

Self-Directed IRAs: Not a Game for the Unsophisticated Investor

Both types of IRA accounts are typically directed by professional money managers. In most cases, the financial institutions that manage IRAs limit the types of assets into which an IRA may be invested.

A self-directed IRA allows you to invest in a broader array of assets. Generally speaking, those who use self-directed IRAs do so in order to invest in alternative assets.  Self-Directed IRAs: What You Need to Know says

“If you understand investments, particularly in certain segments, you can take advantage of higher yields, and maybe less volatility,” when investing in self-directed IRAs. “But,” he warns, “This is not a game for the unsophisticated.”  —nerdwallet.com, John O. McManus.

McManus founded an estate planning firm in New Jersey and has been investing in real estate and other assets through a self-directed IRA for 15 years.

James A. Jones, founder of the Self-Directed IRA Investment Institute, points out, “a self-directed IRA is an IRA like any other under IRS Publication 590 in terms of annual contributions, required minimum distributions.” But, unlike traditional IRAs, self-directed IRAs are often invested in asset classes such as “private equity and debt, hedge funds, real estate, precious metals, real estate, and trust deeds.”

Caveats and Rules

Self-Directed IRAs do not come without caveats. Investors must adhere to contribution limits. For 2022, the annual maximum is $6,000 in a single year for those under the age of 50 and $7,000 for those over 50.

The general rule for IRAs, as of 2022, is that the retiree cannot touch his investment money until age 59½. If a retiree decides to take money out of a self-directed IRA before that age, they will pay 10% to the government as well as taxes on that income. There are some exceptions to this rule including death or disability of the account holder, medical expenses not covered by insurance, paying an IRS levy, and others.

[Editor’s Note: For more information about protecting your assets, read Money Basics Series – Part 6: Protect Assets and Your Future Nest Egg]

Background of Self-Directed IRAs

Self-directed IRAs were conceptualized and written into law in 1974 through the Employee Retirement Income Securities Act (ERISA).

The legalities of self-directed IRAs are complex, and navigating them can be confusing to non-experts. Investors looking to strike out on their own will need more than a dollar and a hunch. “Self-directed IRAs are not for the faint-hearted,” attorney Patrick J. Felix III told Forbes. “You better damn sure know the rules.”

While certainly not a comprehensive treatment, there are key things to keep in mind outlined in greater detail below.

Self-Dealing is Verboten

One cannot borrow against a self-directed IRA, nor can one put its assets up as collateral. Any investments you make cannot be tied to you personally. IRS Code 4975 guides and defines “prohibited transactions” and “prohibited people.” A “prohibited transaction” involves buying, selling, leasing, exchanging or receiving any use, benefit, or compensation, directly or indirectly from an asset in an IRA. A prohibited person is the IRA holder and spouse, parents and spouse, children and spouse, fiduciary, etc. This means one cannot purchase a guest house in the mountains and use it for vacation or rent it to family members, as this would be considered a prohibited transaction despite whether the price was paid at a fair value.

Fees to Consider for Self-Directed IRAs

Even if an investor decides to forgo hiring a tax and/or legal advisor, either of which are costly, paying a custodian instead is not optional. A custodian, for the price, will not do much more than send a paper statement of the account through the mail each month. For that luxury, investors can expect to pay fees to open the account, fees to maintain an account, a fee per asset or security held, and transaction fees – each of which are going to be significantly steeper than fees in other alternative investment vehicles. Some typical costs of a self-directed IRA include:

  • Set-up Costs: $0-$2,500 flat fee
  • Custodian Fee: $20-$100 per year
  • Administration Fee: 0%-2% per year
  • Trading Costs: $0-$1,000 per trade

Beware of Scams

Because of limited protection that custodians or trustees of self-directed IRAs are able to offer, scammers and fraudsters may be more likely to target these investments. The fraud may look like this:

  • Misrepresentations regarding custodial responsibilities — fraudsters may misrepresent the duties so the investment custodian believes that their investments are legitimate.
  • Exploitation of tax-deferred account characteristics — The fact that there are penalties that come with withdrawing money early may help scammers participate in the fraud for longer amounts of time.
  • Lack of information in alternative investments — Unlike publicly traded securities, self-directed IRAs fly under the radar; a public accounting firm may not have access to them. This makes it easier for fraudulent activity to occur.

[Editors’ Note: If you’d be interested in more about avoiding investment fraud, read Protection from Investment Fraud: Who’s Got Your Back?]

Takeaways for Starting a Self-Directed IRA

While different from traditional or Roth IRAs, self-Directed IRAs have their own appeal, the investor should consider carefully. Self-directed IRAs can be a good option for housing retirement money, but are not without their own caveats and rules that must be obeyed. They are not without the threat of fraud.


[Editors’ Note: If you enjoyed this article, you may also be interested in reading Beyond the Fringe: Alternative Asset Classes Go Mainstream or articles from our Money Basics series. To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

This is an updated version of an article originally published on April 9, 2019. It has been updated by James Howley.]

©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

About Alicia Purdy

With a Master’s degree in Journalism and extensive experience as a freelance writer and editor, Alicia has found success across genres including: news, business and finance, government/politics, faith and family as well as blogging.

Read Full Bio »   •   View all articles by Alicia Purdy »

Article Comments

>