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A self-directed IRA enables investors to buy into asset classes that are often outside of the purview of fund companies and brokerage firms. These investments may include non-publicly traded real estate, private equity, and partnerships and joint ventures that may exhibit radically different performance patterns than stocks and bonds, a quality that bear-market-battered investors could be craving. In some respects, all IRAs are self-directed, in that as the account owner, you're entirely in control of what you put inside of your account. And on the surface, self-directed IRAs have features that are comfortably similar to conventional IRAs that hold stocks, bonds, or mutual funds. The contribution limits are the same, rollovers from other IRAs are permitted, and you can opt for a traditional or Roth version. However, investing in a self-directed IRA isn't as simple as sending a check and tuning out; far from it. In addition to analyzing the merits of a prospective self-directed IRA investment, it's also important to consider how the inclusion of a single, possibly large, and undiversified investment interacts with your other holdings. You also need to be aware of the different rules governing these accounts because you could run into serious trouble if you run afoul of them. Here are some of the key questions to consider before taking the plunge into the world of self-directed IRAs.
What will it cost? If you hold stocks or mutual funds in an IRA, your costs will be pretty transparent: mutual fund management fees and any commissions you might pay to buy and sell. Self-directed IRAs charge another layer of fees because you must go through a custodian, who in turn will invest in the assets on your behalf. As a result, there's typically a setup fee for a self-directed IRA as well as ongoing administrative costs; these costs can vary widely by custodian, so you really need to do your homework. Of course, investing in mutual funds or individual stocks isn't free, but taken together, the extra costs associated with self-directed IRAs mean that your investments will need to perform that much better than traditional stocks and funds just to pull ahead.
How does it fit with the rest of your portfolio? Even if you're sold on the merits of an investment you'd like to put inside of a self-directed IRA, such as a rental property, it's still important to consider how it fits with your overall portfolio. Are you sinking a disproportionate amount of your money into a single asset?
Do you thoroughly understand the rules? Self-directed IRAs come with a separate set of rules, the majority of which are designed to prohibit self-dealing, which is, essentially, obtaining use from an asset even though you're receiving a tax deferral on it. If the Internal Revenue Service learns of self-dealing, the entire sum in that IRA could be considered taxable and subject to the 10% early withdrawal penalty.
Funds in a traditional IRA grow tax-deferred and are taxed at ordinary income tax rates when withdrawn. Contributions to a Roth IRA are not tax-deductible, but funds grow tax-free, and can be withdrawn tax free if assets are held for five years. A 10% federal tax penalty may apply for withdrawals prior to age 59 1/2. Please consult with a financial or tax professional for advice specific to your situation. Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while returns and principal invested in stocks, commodities and real estate are not guaranteed. Real estate investment options are subject to certain risks, such as risks associated with general and local economic conditions, interest rate fluctuation, credit risks, liquidity risks and corporate structure. Investors should read the prospectus and carefully consider a fund’s investment objectives, risks, fees, and expenses before investing.