The Complete Guide to Self-Directed Individual Retirement Accounts (IRAs)
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Individual Retirement Accounts aren’t sexy. What is sexy, however, is retiring with enough money to live your best life after decades of hard work. Today, we’re going to cover how you can leverage self-directed IRAs to invest in non-standard assets that may help diversify away some of the risk present in holding traditional retirement accounts that often consist primarily of equities and fixed income securities.
In a time of increasing demand for flexible and personalized financial services, popular thinking about funding retirement accounts hasn’t seemed to change much over the past twenty-odd years. The basic idea is that you should contribute regularly to an account such as a 401(k) or an Individual Retirement Account (IRA) throughout your working life, in order to accumulate the necessary savings for retirement. These accounts are usually administered by banks or large financial institutions and offer a limited menu of investments of which you as the account holder may or may not be able to select as you see fit. A classic example being a retirement account where you have a limited menu of bonds, stocks and exchange-traded funds to choose from.
For many individuals, this conventional path towards funding retirement is good enough. But for investment savvy do-it-yourself types, self-directed IRAs (SDIRAs) are becoming an increasingly popular way to combine the significant tax benefits of IRAs with the ability to personally direct investment decisions towards a much wider range of alternative investments.
Despite sounding daunting, opening a self-directed IRA isn’t that hard. It only takes selecting a suitable SDIRA custodian and opening an account to begin generating retirement income through investment decisions which are entirely your own.
A Brief History of Individual Retirement Accounts
IRAs were legally established following the Employee Retirement Income Security Act (ERISA) of 1974. ERISA largely laid the groundwork for the regulatory framework and fiduciary responsibilities in the process of opening and maintaining a qualified retirement account.
Traditional and Roth IRAs are the two most popular types of IRAs. The major difference between the two lies in the tax treatment of contributions, as Traditional IRAs enjoy a tax deduction at the time of contribution and defer the tax obligation until the time of withdrawal. Meanwhile, Roth IRAs prohibit tax deductions at the time of deposit but do not apply any taxes upon withdrawal.
It is required by law that all funds within an IRA account must be held by a custodial institution. This custodial institution bears a number of responsibilities such as holding the assets within the account, processing all transactions on behalf of the account owner, advising and ensuring compliance with regulations and undertaking miscellaneous administrative duties to keep the account running smoothly.
Since custodians have typically been institutions such as banks, credit unions and brokerage firms, the range of investment products offered to retirement account owners has traditionally been limited to a limited mix of stocks, bonds and mutual funds–typically, products these institutions already offer.
Within this backdrop, Self-Directed IRAs (SDIRAs) have steadily gained popularity in recent years. The appeal of SDIRAs lies in their ability to allow account holders to pursue investments in alternative asset categories, apart from stocks, bonds, and mutual funds. In contrast to more traditional bank offerings, the options available to SDIRAs are limited only by the account custodian, a small list of legal prohibitions, and the imagination of the account owner.
What is a Self-Directed IRA (SDIRA)?
As mentioned previously, an SDIRA is any IRA where the account holder directs all of the investment decisions made within the account. Colloquially, however, it usually refers to a retirement account in which the owner pursues alternative investments. Any kind of IRA can theoretically become self-directed, whether it is Traditional or Roth or even a SEP for self-employed individuals.
The alternative investments offered by SDIRA custodians can be more volatile than standard stocks and bonds, so it is especially important to be aware of the risks when deciding to go with a self-directed account. In addition, owners of SDIRA accounts must be especially vigilant in monitoring how certain alternative investments impact regulatory concerns such as tax requirements and prohibited dealings, as some SDIRA custodians leave that task solely to the account owner.
Why Invest in SDIRAs?
The allure of holding an SDIRA account instead of a standard IRA lies in the flexibility and personalization made possible by directing the investment decisions yourself. The aforementioned risks also can serve as an SDIRAs greatest advantage, as the extra risk can potentially pay off with significantly higher portfolio returns.
Since you will ideally use the self-directed account to invest in alternative investment options in which you have a specialty or interest in, a motivated investor will most likely enjoy the combined tax benefits of IRAs and the investment flexibility offered by self-directed accounts.
While the expanded investment options and the more hands-on nature of the account is great for individuals looking for potentially high returns outside of traditional stocks and bonds, SDIRAs are not recommended for those who merely want to passively deposit money in an account only to withdraw years later as retirement income. Guiding and maintaining the performance of a self-directed retirement account requires careful planning and proactive due diligence regarding investment decisions. The work isn’t that burdensome, but if you’re just looking to ‘set it and forget it,’ a more traditional retirement account is probably best for you.
Investments You Can Make with an SDIRA
Real estate and precious metals are two of the most popular alternative investment categories for SDIRA owners, although the breadth of available options spans from private securities to limited partnerships to crowdfunding investments and even tax liens. Cryptocurrencies have also recently become an outlet for self-directed retirement funds, although the persistent volatility in the crypto market has caused most SDIRA custodians to require the purchase of cryptocurrency via an LLC, in a somewhat complex process.
Real estate can be held either in the form of physical property or through REITs, which are companies that operate or finance real estate themselves. One can even hold private mortgages within SDIRAs. It is important to be aware that an account owner is not permitted to make personal use of any property held within a retirement account, as described in more detail in the following section detailing SDIRA prohibitions.
Investing in equity-based crowdfunding startups has also gained popularity in recent years. In contrast with Kickstarter, which provides pre-defined rewards for financial backers, equity-based funding campaigns allow investors to receive equity in exchange for their investment. There are a number of different equity crowdfunding platforms currently offering equity in exciting startups and more popping up all the time, so its a good idea to pay attention to this innovative space if you are looking to open an SDIRA of your own.
Investments You Cannot Make With an SDIRA
While the list of prohibited investments from the IRS is actually quite small, the penalties for violation are severe. As such, it is vital to understand what you cannot do with an SDIRA at the time of opening an account.
Holding life insurance within a retirement account is strictly prohibited, as well as what the IRS considers antiques or collectibles. The definition of collectibles extends from stamps and baseball cards to fine art and vintage toys.
Any coins that the IRS deems to bear more collectible value than currency value also cannot be held in an SDIRA, although some government-minted coins such as American Eagles and American Buffalos are permitted.
Also prohibited are any derivative positions that bear unlimited or undefined risk, such as selling naked call or put options. However, hedged positions with clear payoffs such as covered calls are permissible.
Transactions between a qualified SDIRA plan and a so-called “disqualified person” are also prohibited. This means that an asset may serve to benefit either the account holder or the retirement account itself, but not both. This idea can best be illustrated by looking at the case of real estate. While real estate can be held within an SDIRA for the purpose of generating rental income within the retirement account, this precludes the account holder or anyone directly related from actually using or living on the property.
How to Open an SDIRA
It is possible to open an SDIRA with any of three different types of providers: custodians, administrators, and facilitators. However, only custodians are approved by the IRS and are legally permitted to hold assets or issue funds. Therefore, we highly recommend you limit your initial search for a provider to administer an SDIRA only to custodians.
If you are interested in opening a self-directed retirement account, chances are you already have an idea what asset class you are looking to invest in. In that case, you should find a custodian which offers a selection of alternative investments that most closely match your preferences or at least one that will not restrict investment in the category of your choice.
Other factors to consider when looking for an SDIRA custodian include the transparency of fees, flexibility in moving funds, and the track record of the institution. There will most likely be an initial fee to set up the account as well as an annual custodian fee, but look out for additional fees and make sure they are clearly spelled out before opening an account. You should also consult the Better Business Bureau or the Business Consumer Alliance to check the rating of a prospective custodian and check for any qualifications they may possess.
Once you find the right match for your unique SDIRA needs, it simply takes filling out some forms to open the account, arranging for funding, and picking the investments you want. It shouldn’t be much more difficult than that, and quality custodian institutions will offer assistance every step of the way.
How to Roll Over a 401(k) into an SDIRA
Conducting an IRA rollover is a convenient option for those with a 401(k) or a different retirement plan such as a 403(b) or a 457(b). The process of transferring funds from an old retirement account to a new SDIRA is relatively simple, as it merely requires that you contact both the institution that will receive your assets as well as the institution that will transfer your assets. Most SDIRA custodial institutions provide clear instructions about how to initiate an IRA rollover online, including each of those highlighted in the following section.
Any necessary forms will be issued upon your request and, once completed, your funds will be transferred between accounts. In the case of a “direct” rollover, the 401(k) plan administrator will issue a check that is directly payable to the SDIRA custodian. Meanwhile, an “indirect” rollover requires the account holder to pay a 20% tax to receive the funds from the old account before depositing the remaining funds into an SDIRA of choice within 60 days. Push for a direct rollover if at all possible.
Note that a rollover of either kind is likely not possible if you are still currently employed at the company that offers the 401(k) account in question. You will have to wait until you leave the company before initiating a rollover to an SDIRA.
Notable SDIRA Custodians
Due to the booming popularity of alternative investments, it is difficult to keep track of all available SDIRA custodians these days. However, some have been around longer than others, and have a strong track record of delivering high-quality service.
While the list below is far from exhaustive, it does serve to highlight seven of the most popular and well-established custodians available in the SDIRA space. You should choose a custodian that is best for you, which may or may not be on this list.
Some examples, listed in alphabetical order:
Community National Bank
Established in 1984, Community National Bank advertises a number of tried-and-true alternative investments like private placements, REITS, and limited partnerships.
Equity Trust Company
Offering SDIRAs since 2001, Equity Trust Company encourages customers to allocate funds into their alternative investment category of choice, specifically citing real estate, private equity, promissory notes, and precious metals as popular choices.
IRA Services Trust Company
Chartered in 2008, IRA Services offers a mix of real estate, promissory notes, private equity, managed futures, precious metals, and crowdfunding to SDIRA customers.
Kingdom Trust Company
Kingdom Trust boasts that it was the first SDIRA platform to permit account holders to hold digital assets like Bitcoin and Ethereum, in addition to offering more standard alternative investment products such as real estate, precious metals, private lending and private equity.
Madison Trust Company
Madison Trust Company is a full-service Self-Directed IRA custodian that allows individuals to purchase alternative assets with retirement funds and offers competitive fees and strong technological integrations.
Millennium Trust Company
Millennium Trust has accrued nearly 20 years of experience in the custody of alternative investments such as hedge funds, private equity and debt, real estate, commodities and futures, and marketplace loans.
Pensco Trust Company
Founded in 1989, Pensco Trust encourages customers to invest in whatever they fancy while providing oversight into whether or not a particular investment may legally be administered in an SDIRA. Citing custody of over 45,000 different assets, you can be sure Pensco will be willing to entertain any creative ideas you might have for your own SDIRA.
Provident Trust Group
Provident Trust has specialized in SDIRAs since its founding in 2008 and has earned an A+ rating from the Better Business Bureau. Precious metals, real estate, private company stock and market linked CDs are just a few of the many alternative investments on offer.
Just as the continued introduction of innovative financial technology drives demand for increasing personalization in the personal banking sector, it is no wonder that self-directed IRAs have become a more appealing option compared with standard retirement plans.
Since SDIRAs allow complete control over investment decisions and allow savvy investors the opportunity to balance their portfolio with volatile yet dynamic innovations like equity crowdfunding and cryptocurrencies, don’t expect to see their popularity wane anytime soon. On the contrary, it is likely that you will continue to hear more and more about self-directed retirement accounts in the coming years.
We hope this guide has been useful in helping you understand the basics of a self-directed IRA and how easy it is to set up an account today if you decide that it is the right solution for you. Whether you find traditional instruments like stocks and bonds or alternative asset classes such as precious metals or crowdfunding campaigns more to your liking, we wish you luck and encourage you to invest in what you believe in.
Note: CNote is not a registered investment advisor, and this information should not be relied upon as individualized investment advice. Every financial situation is different and you should seek tailored advice to suit your specific financial circumstances.