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How to Convert Your Captive IRA to a Self-Directed IRA


Jul 12, 2020 by Carole VanSickle Ellis

Less than a decade ago, it was very unusual to meet an investor who had "freed" their retirement capital by converting their individual retirement account (IRA) to a self-directed IRA (SDIRA). Today, however, the term "self-directed IRA" is so attractive and popular that many IRA custodians who do not offer truly self-directed accounts still attempt to leverage the attraction by using this nomenclature and distorting the definition to meet their own ends.

While this advertising strategy may work for some custodians, and even their clients, investors who want a truly self-directed IRA must understand the distinctions between self-directed accounts and "captive" accounts. Then, they must carefully evaluate their custodial and administrative options so they can conduct the account conversion that will best suit their goals for their retirement capital.

This might sound complicated, but the reality is that the process of converting your captive IRA to a self-directed IRA is relatively simple. Once you have the information you need to evaluate your future IRA account custodian or administrator, you will be ready to take this important step toward financial security and investing freedom.

The Captive IRA litmus test

One stumbling block for many would-be self-directed investors when it comes to identifying the right custodian for their account is that self-directed IRAs and captive IRAs are absolutely identical under the law. Neither term actually exists in the legislation that created the IRA, 26 U.S. Code § 408. That code simply states that the individual retirement account (IRA) will be subject to a certain set of rules, including:

Every IRA must be permitted the same advantages in those regards and is subject to the same restrictions. However, that does not mean that every IRA custodian must permit the same type of investments, and that is where the "captive vs. self-directed" nomenclature comes into play.

If your IRA is currently a captive IRA, then you are limited in terms of the assets in which you can invest. This is true whether you hold a captive IRA with a custodian that permits you to invest in stocks only, as many do, or whether you hold a captive IRA with a custodian that permits you to invest in only one alternative asset, like gold.

The "gold IRA" is often billed as a self-directed IRA because it permits the account holder to invest in an alternative asset class, precious metals, but it is not truly self-directed because the assets in which you can invest are still limited not by IRA regulations from the IRS but instead by the custodian holding your account.

So, how can you find out in five minutes or less whether your IRA is captive or self-directed? Use the "Livestock Litmus Test" to get your answers. It goes like this:

  1. Call your IRA custodian.
  2. Ask them if you can invest in cattle using your individual retirement account.

If the answer is "Yes!" then you have a self-directed IRA.

If the answer is "No!" then you have a captive IRA.

This litmus test works because even though many IRA custodians describe their accounts as self-directed because the custodian permits investors to select from a predetermined list of assets, they limit the choices on that list.

That limitation means that the IRA is still captive to the custodian's preferences rather than fully subject to the account holder's direction. Unless you happen to have an account with a "cattle IRA" custodian, then the Livestock Litmus Test will probably settle the question once and for all.

4 simple steps to converting your captive IRA to a self-directed IRA

Once you have determined that you need to convert your captive IRA to self-directed status, the process of doing so is relatively simple. However, prepare to be patient. This is not always the fastest of experiences! As most retirement account custodians do not particularly like sending accounts in their custody elsewhere, they are unlikely to prioritize the process.

Step 1: Find the right self-directed IRA custodian for you

Not every self-directed IRA custodian is the right fit for every self-directed investor. After all, with nearly limitless strategic options when it comes to leveraging the capital in a self-directed account, self-directed investors have a lot of options.

Take the time to interview some self-directed IRA custodians. Questions to ask include:

  • What types of transactions do you handle on a regular basis?
  • How long should I expect to wait for you to handle my transaction-related requests?

This will help you determine whether the custodian is a good fit for you.

Finally, tell the custodian about your plans for your retirement capital. This will help both you and the custodian identify potential problem areas. For example, many self-directed IRA custodians permit just about every type of alternative investment except cryptocurrencies. They have concerns about how the digital wallet affects transparency of accounts or the legality of cryptocurrency transactions. The cryptocurrency investing space is new and evolving, so they feel it is too uncertain to permit.

If you never plan to invest in cryptocurrency, then this may not be an issue for you. On the other hand, if bitcoin investments are a big reason you want to self-direct, you absolutely require a custodian that will permit them!

More often, self-directed investors are interested in making real estate investments using their self-directed capital. While most self-directed custodians permit this, not all of them are equipped to effectively work with self-directed real estate investors. Tell the custodian not only that you are interested in real estate investing but also about your preferred strategies.

This is important because a self-directed IRA custodian often has a legal window of 30 days or more in which to respond to requests from account holders. If your real estate strategy requires fast action, you need a custodian that is equipped to respond rapidly so you don't miss out on opportunities.

Once you find the right custodian for you, they will provide you with the information you'll need to convert your captive IRA to a self-directed IRA. In fact, most custodians will handle nearly everything for you. However, you should take one crucial step before making your move.

Step 2: Consult with your trusted self-directed accounts attorney

Before moving forward with your IRA conversion, it helps to have a conversation with a self-directed account legal expert. This will help you manage your expectations for how long the process will take, how much it may cost, and what you should and should not do with retirement capital and account contributions in the meantime.

This is also a good time to consult your IRA attorney to find out if you might be eligible for a self-directed 401k. These accounts have all the advantages of a self-directed IRA and also offer protections for the account holder that a self-directed IRA cannot.

While self-directed 401ks are not available to everyone, many real estate investors are eligible for them and don't realize it. This may be the case even if you are not a full-time investor and instead work a full-time job for an employer other than yourself.

Once you have considered all of your options for your self-directed investing capital, it's time to move forward once again.

Step 3: Contact your current IRA custodian and instruct them to move your assets to the self-directed IRA custodian of your choice

In most cases, your new self-directed IRA custodian will walk you through this process. It is in their best interest to make this part easy for you so you don't give up and leave your account with the former custodian.

However, you should be prepared for this part of the process to take some time. Depending on your former custodian, they might opt to wait 30, 60, or 90 days or more to respond to your request. Having all the information and paperwork in order on your end may help move things along.

Step 4: Start self-directing!

The best thing about a self-directed retirement account is that you control your own investments. The worst thing about a self-directed retirement account is that you control your own investments. That means the responsibility is solely on you now to self-direct your retirement capital. If you do not do so, then it will not earn any returns at all, and you will be in worse shape than if you had left that capital in its captive state.

So, once you have converted your captive IRA to a self-directed IRA, start directing that capital into wise investments that will yield the returns you require.

Only you can prevent IRA stagnation

There are billions of dollars held in self-directed IRAs, and that number is growing daily. However, much of that capital is just sitting in self-directed retirement accounts because the account holders are not leveraging it into wise investments -- or any investments at all, for that matter!

Once you have control of your self-directed IRA capital, you must put it to use. The U.S. government itself created the IRA and opted to permit self-direction and provide significant tax advantages to investors who leverage these accounts to provide for their own future financial security. Don't waste the opportunity that a self-directed IRA provides you.

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