What is a Self-Directed IRA?
Most IRAs are set up with mutual funds or banks. They decide what investments to make and your decision is limited to whether or not you want to continue to do business with them. A self-directed IRA has a broker as a custodian, but you determine what to invest in.
How to Set Up a Self-Directed IRA
Setting up a self-directed IRA is a simple process: contact the broker who holds your current IRA and ask for the necessary forms to open a self-directed IRA. Fill them out, submit them, and wait.
There are three types of self-directed IRAs:
Simple account
You decide which investments you want to include in your portfolio and you direct the broker to purchase them for you. You cannot acquire the investments on your own. If you are following a “buy and hold” strategy and plan to make relatively few transactions, you may prefer this type of account.
The iTrust
You open a self-directed IRA and the broker who acts as custodian opens up a separate trust account that the IRA invests in. If there is a checkbook connected with this system, you remain in control of it. This option is often chosen by people who have invested in real estate and need to pay for taxes, maintenance, and other expenses related to the upkeep of the property. This set-up allows you to avoid many of the state filing fees and franchise fees that are often associated with limited liability companies, or LLCs.
Limited Liability Companies (LLCs)
Limited Liability Companies (not corporations) offer more convenience and control for the investor but also require more work and more knowledge. You may also have to pay more in fees. The advantage is that you get much more flexibility than you do with a simple account and somewhat more flexibility than with an iTrust. Note that setting up iTrusts and LLCs involves more time, more paperwork, and more money.
Fees for Self-Directed IRAs
Fees for some self-directed IRAs may be greater than those for conventional IRAs. It is impossible to generalize because fees vary from broker to broker. However, if you are a novice investor, seek the advice of a financial planner you trust and read all paperwork carefully.
Advantages of a Self-Directed IRA
According to the investment site Motley Fool, 9 out of 10 mutual funds under-perform the market. Therefore, if you are a knowledgeable investor, you may want to take your chances by picking your own investment vehicles.
Another advantage of the self-directed IRA is that it allows a wider range of investments. In fact, you can invest in nearly anything except collectibles: coins, stamps, art, and antiques, for example. Many people prefer self-directed IRAs because it allows them to invest more easily in real estate.
Disadvantages of a Self-Directed IRA
One major advantage of any IRA, whether self-directed or not, is that it offers substantial tax savings. However, poor planning with a self-directed IRA can negate that advantage. For example, if you buy stock and hold it for a year or more before selling, you will typically pay capital gains taxes of 15 percent. However, if you sell stock that is part of an IRA, you may pay income taxes, which are usually higher. If you buy and sell stock several times a year and are thus ineligible for the lower capital gains rate anyway, it may be worth it to have a self-directed IRA. However, if you buy and hold, you may pay less in taxes if you simply invest in the stock without opening an IRA.
For similar reasons, real estate may be a risky choice for a self-directed IRA. You won’t be able to deduct depreciation or other expenses related to the property and you may end up forfeiting the ability to pay at the lower capital gains rate.
Another problem is that IRS rules governing self-directed IRAs can be quite complex, especially for a beginner, making it easy to make honest, unintentional and yet costly mistakes. Avoiding these pitfalls may require the professional, and expensive, advice of lawyers and certified public accountants.
These pitfalls do not mean that a self-directed IRA may not be a good option. If you have knowledge of a particular field – real estate or oil for example – the drawbacks may be offset by the potential gains. The best advice, however, is unoriginal yet valuable: do your homework before signing on the dotted line.
Sources
Jessica Ramer - Jessica Ramer has a B.A. in mathematics and an M.A. in psychology (psychobiology track). She is also a certified macrobiotic instructor. ...
Join the Conversation