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Why Self-Directed IRAs Are a Bad Idea

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While the freedom to choose among a wider range of investments  and thus earn a greater profit – is enticing, self-directed IRAs are probably a bad idea for you and me. Once you take into account the tax regulations and extra research you'll need to put in to vet investments, the cons outweigh the pros.

It's important to understand that just about all IRAs are self-directed in the sense that you choose the investments for your retirement account. But when people talk about self-directed IRAs, they're usually referring to financial institutions that allow you greater flexibility to go beyond stocks, bonds, and funds in your IRA.

Pros to a self-directed IRA
That flexibility is the first and main benefit of a self-directed IRA. Unlike most typical IRAs, self-directed IRAs give you the chance to invest in something "unusual" or "alternative." For instance, if you think a privately held business will hit it big, a self-directed IRA might let you invest your retirement dollars in that business. PayPal CEO Peter Thiel did just that when he earned more than $30 million tax-free after eBay bought his company. His self-directed IRA swelled once again as Facebook went public. 

Another example is real estate, where self-directed IRAs let you choose specific properties. While you could buy a mortgage REIT like Annaly Capital (NYSE: NLY  ) to give you more diversified exposure to the real estate market, the only way to put a particularly attractive piece of real estate into an IRA is through a self-directed option.

The big cons to a self-directed IRA
In order to get something, you have to give something. In this case, the self-directed IRA gives you flexibility at the price of great complexity.

Alternative assets -- a private business or a piece of real estate -- are hard to value. Often, those with a self-directed IRA must hire a financial advisor for valuation help. Not only does this add to the cost of investing, but you also get into the habit of listening to "experts."

Moreover, there are still other tax and legal regulations that you must be wary of with the self-directed IRA. Provisions against self-dealing and avoiding too much involvement in the operation of a business are just a couple of the potential pitfalls. To make sure you don't cross the line, you'll probably have to hire a tax and legal advisor -- once again, increasing your investment costs.

Do you really need it?
By contrast, sticking with a regular IRA is more than adequate for most investors. If you properly diversify your retirement money with several different index mutual funds or ETFs, you won't have to pay anyone for advice and do the extensive research needed to vet individual properties or businesses. And so far, that strategy has performed phenomenally, with many index strategies beating actively managed stock portfolios and even many private hedge funds.

While self-directed IRAs may give you the opportunity to invest in a private business or real estate, the financial and legal regulations can be a huge pain. More importantly, it's not guaranteed that you'll strike it rich with your new, alternative investment. There's a good chance that you'll lose your retirement money, which may force you to work well into retirement!

So, if you think you're savvy enough and have the money to pay for a team of financial, legal, and tax advisors, by all means open a self-directed IRA. Most of us, though, will be best off keeping our retirement investments boring but safe.

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Read/Post Comments (3) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2013, at 11:11 AM, prginww wrote:

    Completely inaccurate and misleading.There are quite respectable, regulated self directed account custodians that manage accounts according to IRS regulations. While they are not responsible for the account holder's decisions, they certainly will help steer clear of prohibited transactions.

    The need to hire financial, legal and tax advisors exists (or not) dependent on an individual's skills, knowledge and expertise irrespective of whether the investment is in a self directed IRA or not. In the case of buying mutual funds , fees are imbedded in the funds' management fees.

    Many investors purchase real estate, notes, LLCs, and other assets outside of their IRAs. Their need for outside advice (or not) is no different. Many individuals use financiall advisors for all investments.

  • Report this Comment On July 17, 2013, at 9:01 AM, prginww wrote:

    I also disagree with Kevin Chen's article "Why Self-directed IRA's are a bad idea."

    A self-directed IRA is managed by a regulated custodian who, manages your account, & also advises you on the legality of your investment.

    As an example, let's put an IRA, which invests in stocks, in apposition to a self-directed IRA, using real estate as the investment: you buy into a mutual fund stock at retail price, you have zero collateralization, & no set return. Conversely, you invest with a real estate investor, using your self-directed IRA. Your investment is collateralized by real property, as you are on grant deed, you are named on the insurance binder, & you have a promissory note, guaranteeing your rate of return, regardless of what the investor sells the house for. Your initial investment, along with your profit, returns to your IRA, through escrow at COE. You've added substantially to your retirement account, with little risk, & the entire investment was secured by real property.

  • Report this Comment On October 02, 2013, at 7:15 PM, prginww wrote:

    Quite disagree. Not to mention, the comment in the article, "so if you think you're savvy enough to hire a team ...." either way you are paying for a team. Most investors are savvy enough to know how to research on their own - without paying fees, some hidden, some not. Incredibly condescending remarks. If you weren't offended by this commentary, you should have been. Most brilliant minds know to always gather a team of people that are smarter than you for advice. Financial Obviously the Fools would prefer these readers not, and follow the herd. Perhaps the author should read the 2009 Motley Fool article FOR the SDIRA!

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