Tax-favored retirement accounts are an important part of your retirement savings strategy, and IRAs are the most flexible of the options at your disposal. In some sense, every IRA is self-directed in that you have the opportunity to buy whatever stocks, bonds, mutual funds, ETFs, and other investments that your provider will give you. That makes IRAs more attractive to many investors than 401(k) plans, which only offer a limited menu of investment choices.
Yet the term "self-directed IRA" more commonly refers to a retirement account with even more investment alternatives available than a typical IRA. A self-directed IRA isn't as easy to find as its run-of-the-mill counterpart, but it can offer advantages that regular IRA investors don't have. Let's look at three things you need to know about the self-directed IRA to decide whether it's the right retirement account for you.
1. A self-directed IRA lets you go beyond securities like stocks and funds
Brokers always tout the extent to which you can diversify your IRA portfolio, choosing from thousands of stocks, funds, and other publicly available investments to achieve exposure to almost any asset class you want. Given the breadth of offerings in the exchange-traded fund arena alone, many IRA participants are content to use regular IRAs for their retirement investments.
But the rules governing IRAs offer much more latitude to hold other investments beyond these securities, and that's the primary reason why self-directed IRAs were created. In particular, self-directed IRAs can own specific parcels of real estate, ranging from raw land to homes and commercial property. In addition, a self-directed IRA can include privately held business interests such as partnerships or limited liability companies.
Those types of assets are extremely appealing to many investors, especially those looking to take advantage of their knowledge of their local area. With locally owned businesses or nearby real estate, retirement savers often feel they have an edge over other investors because of their knowledge of that specific market. In addition, investors can feel a true connection with their investments, which, to many, is more attractive than sending money to Wall Street to be sent around the world.
2. Tax laws limit certain investments and transactions, and if you break the rules, your whole IRA is at risk
A self-directed IRA lets you invest in things that regular IRAs don't, but even self-directed IRAs have limitations. The Internal Revenue Service follows a sophisticated set of rules that prevent IRA owners from engaging in self-dealing or other prohibited transactions with their IRA assets.
Most of the prohibited transaction rules address simple situations. For instance, you can't sell property to your IRA or buy property from it. You can't draw personal loans against your IRA assets. You can't live in a home or other property that your IRA owns. And you can't use any IRA property for personal use. Similarly, if you own or have a leadership position within a privately held business, your IRA invest can't in that company, either through buying shares of stock or by extending a loan to the business.
Self-dealing also extends to family members, including your spouse, parents, and grandparents, as well as children and grandchildren and their respective spouses. You also can't get around self-dealing laws by hiring individuals such as financial planners or accountants to work on your behalf, as they're treated as disqualified people as well.
If you engage in a prohibited transaction, the initial tax is 15% of the amount involved. But if you don't remedy the situation, an additional tax of 100% applies. It's therefore imperative to avoid prohibited transactions at all costs, even when a self-directed IRA makes them seem possible.
3. Most brokers don't offer self-directed IRAs
You won't find self-directed IRAs at most well-known brokers, as the legal liability associated with being an IRA custodian introduces risks that the majority of brokers are uncomfortable taking. It's easier for regulatory-compliance purposes for those brokers to deal with traditional investments rather than taking on the specific risk of overseeing nontraditional investments.
As a result, if you want a self-directed IRA, you'll often have to go with brokers you may not have heard of, and their fees can be higher. Between the account opening fees, annual maintenance charges, and per-asset management fees, the total amount you pay for a self-directed IRA can add up to hundreds or even thousands of dollars annually. Therefore self-directed IRAs are best for those with substantial assets so that these fees don't represent such a large percentage of their overall retirement nest egg. You should also do your due diligence to ensure that your self-directed IRA broker is legitimate, as regulators including the North American Securities Administrators Association and the SEC have seen rising levels of fraud associated with self-directed IRA providers.
Despite the challenges involved, a self-directed IRA can be a useful tool to expand the permissible range of your investment portfolio. So long as you know and manage the risks involved, a self-directed IRA can open up profit opportunities that most retirement savers can't capture.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.