A self-directed individual retirement account (IRA) offers the owner the option to diversify their investments into avenues other than stocks, bonds, CDs, and mutual funds. The self-directed IRA may be used to invest in commodities, precious metals, commercial papers, tax lien papers, real estate, and more. Most investors view this as a great opportunity for better returns and retirement savings; however, setting up a self-directed IRA is much more complex than a regular IRA for several reasons. The most basic reason for the complexity is that the Internal Revenue Service (IRS) expects either a qualified trustee or a custodian to hold these assets on behalf of the IRA owner, which, in turn, escalates the holding costs and reduces your profits.
We examine the benefits and pitfalls of the self-directed IRA.
Benefits of the Self-Directed IRA:
- Diversified investment options including real estate, hedge funds, stocks, and bonds
- The account holder can invest in avenues they have knowledge of and are comfortable with.
- Better control over investment decisions and higher returns based on investment class.
- Up to $1,000,000 of IRA assets are exempt from bankruptcy under the US Bankruptcy Code. Many states also prohibit lawsuits to be satisfied by seizing the IRA assets. The exceptional cases in which the asset may be seized include divorce, fraud, tax evasion, and trust deeds.
- Taxes on investment returns are deferred until the funds are withdrawn from the account.
Pitfalls of the Self-Directed IRA:
- The level of risk varies based on the investment avenue you have opted for.
- Real estate purchased using the IRA scheme cannot be used personally.
- Custodian charges include an initial payment of around $50 to set up the account and also has an annual fee of $250-$300 for the account maintenance. The custodian fee is generally charged for every transaction.
- Only savvy investors can make the most of investing in this scheme as the asset classes have to be selected in a fashion that will offset the cost and generate maximum returns with mitigated risks.
What to look out for?
If you want to go ahead and set up a self-directed IRA, here are a few factors you must look out for:
- Seek a custodian who has the experience of managing the investment class you would like to purchase and get a detailed breakup of all the associated costs.
- For rental real estate investments, be sure to get the details of the manner in which the custodian will handle the rent collection and distribute the duties of a landlord.
- Get the details of and negotiate the custodian charges if it will be levied in the form of a wrap-up fee, commission, or as a percentage of your total investment.
- Look out for the cash management options with IRA and find out what the interest rate will be on the cash management fees.
- Do a cost benefit analysis before you opt for self-directed IRA. There are many investment avenues and interesting offers; however, there are various costs and restrictions attached at different levels too.
IRA is a good scheme, but as is the case with most investment options, one needs to read the offer document carefully and check if it will benefit them and also compare with other investment avenues before taking the plunge.