Most people have heard of IRAs, and many know the difference between a traditional IRA and a Roth IRA. Few, though, are aware of the self-directed IRA. Take a little time to learn about it and see whether it makes sense for you.
IRAs help you sock away money for your retirement while giving you a tax break. With traditional IRAs, you contribute money on a pre-tax basis, so the value of your contributions is subtracted from your taxable income, thereby reducing the tax you pay now. The money grows tax-deferred in the traditional IRA until you withdraw it in retirement, when it's taxed as ordinary income. The Roth IRA, meanwhile, accepts only post-tax contributions, so you get no tax break up front. But if you follow the rules, it's withdrawn in retirement completely tax-free.
In a nutshell
Most people hold IRA accounts at brokerages or other financial services companies, where they invest in stocks and/or bonds through their IRAs. With thousands of stocks available in the U.S. markets and thousands more beyond our borders, there are countless investing choices. Mutual funds and exchange-traded funds can also be invested in through IRAs. Nevertheless, there are many more investments out there that can't be had through these standard IRAs.
That's where the self-directed IRA comes in. The self-directed IRA allows a greater range of investments, such as rental properties, small businesses (including franchises), partnerships, private tax liens, notes, and even a horse, if it's an investment.
Note that there are restrictions on "self-dealing." You can't invest in your own small business, for example, and you can't rent a real-estate investment held in your IRA to yourself. (It can be smart to consult a tax pro or lawyer familiar with these investments for advice before plunging in.) You're also still restricted by the prevailing IRA contribution limits. For 2014, that's $5,500, plus $1,000 for those aged 50 and older.
Pros and cons
Clearly, the main attraction of a self-directed IRA is that it permits a wider range of investments. And another advantage is that it lets wealth grow in the account (assuming you've made good investments) in a tax-deferred or tax-free manner -- you can have a Roth self-directed IRA, as well as a traditional self-directed IRA. But there are some downsides, too.
For one, the tax treatment cuts both ways. While you're not paying taxes on gains from year to year, you're also not able to harvest losses and deduct them. With a traditional self-directed IRA, when you make withdrawals in retirement, they'll be taxed at your income tax rate at the time, not at the prevailing capital-gains tax rate, which might be lower.
Perhaps the biggest danger with a self-directed IRA is that you're, well, directing it yourself. If you invest in mutual funds or stocks, your money will be managed by financial professionals or company executives. And the companies behind publicly traded stocks are subject to investor-friendly requirements such as quarterly reports and regular auditing. If you invest instead in a partnership or an apartment building, it can be a riskier move, as you won't enjoy that level of transparency.
Know, too, that there have been some cases of fraud, in which scammers have misled investors in order to get them to make questionable investments through self-directed IRAs. These unsavory salesmen will tell you that your self-directed IRA custodian is looking out for you, investigating your investments to make sure they're legitimate. This is not the case; self-directed IRA custodians have few obligations to their clients and are primarily responsible for simply holding and administering clients' assets.
The self-directed IRA is probably not the best route for novice investors and those who expect to depend heavily on their IRA in retirement. But if you're interested in alternative investments and think a self-directed IRA might serve you well, do more digging and get some professional advice.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. Nor does The Motley Fool has. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.