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 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.
Fool contributor Kevin Chen has no position in any stocks mentioned. You can follow him on Twitter at @TMFKang or on Google+. The Motley Fool recommends and owns shares of eBay and Facebook. 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.