As retirement savers become more sophisticated, and their access to retirement account information grows, they are turning more and more to alternative retirement investments. Rather than trusting in traditional retirement investments like stocks, bonds, mutual funds, and CDs, combined with a Roth or SEP IRA, many have started to explore other avenues for investing their retirement assets. One of those alternatives is the Self-Directed IRA. Self-Directed IRAs give you the power to invest in real estate, private placements, precious metals, and a whole host of other investment options.
Self-Directed IRA: Defined
The critical difference between Roth and SEP IRAs and Self-Directed IRAs is the level of control you have over your account. Standard IRAs that you access through a financial institution limit your investment choices. Most of the time, you will be restricted to stocks, bonds, and mutual funds. Self-Directed IRAs allow you to diversify your investment assets to include vehicles like real estate and private placements.
Differences Between Self-Directed and Self-Managed IRAs
Many retirement savers confuse Self-Directed IRAs with Self-Managed IRAs. While they sound similar, they offer very different paths to retirement. The term "Self-Managed IRA" usually refers to a brokerage industry practice where clients who have traditional IRA accounts are allowed some leeway in picking and choosing the assets in their retirement account portfolios. While these accounts do offer more freedom than a standard managed IRA, they still fall under the umbrella of traditional investment retirement accounts, and they are still limited in terms of the investment alternatives you are allowed to add to the account.
What differentiates a Self-Directed IRA is the ability to add investments of your choice. Your SDIRA will have a custodian who is in charge of executing your investment transactions and nothing more. They do not suggest investments or act as a financial advisor. SDIRA's are regulated differently than standard IRAs, by both government agencies and financial institutions. They represent the regulatory agencies and rules that enable account holders to invest in alternative asset classes with fewer limitations.
Some examples include:
- Real Estate Investments
- Real Estate Crowdfunding Projects
- Limited Partnerships
- Business Private Placements
- Tax Lien Certificates
- Precious Metals
The two key differences between SDIRAs and other IRAs are:
- The account owner is entirely responsible for choosing how investment capital will be deployed.
- SDIRA holders have significantly more options when it comes to investment asset alternatives in their investment accounts.
Self-Directed IRA Custodians
Your SDIRA will require a custodian, and before you get involved with a Self-Directed IRA it is important to know what the custodian is responsible for and the scope of those responsibilities.
Passive custodians do not sell investment products and they are not responsible for providing investment recommendations or advice to clients. They also cannot take any action in the account without the express permission of the account holder. They hold assets and provide administrative services. One of their most important roles is to make sure the IRA plays by the rules so it retains its tax-deferred status.
Pros and Cons of Self-Directed IRAs
Self-Directed IRA Pros
In a word: control. With a Self-Directed IRA, you have the ability to take your financial future into your own hands. If you are an experienced investor, an SDIRA might be a better choice than a standard retirement account. In addition, if you are considering investing in an asset class that is not allowed under a standard IRA, you can use the latitude offered by a Self-Directed IRA to acquire said assets while still maintaining the tax benefits of an IRA.
Self-Directed IRA Cons
There's no getting around it, SDIRAs carry greater risks for investors compared to standard IRAs. If you use a Self-Directed IRA to invest in non-traditional asset classes to increase your returns, you will also increase your risk of potential loss.
The second negative is no financial advisor to guide you through your investment choices. With a standard IRA, you may have someone managing your money or advising you on investment choices. When you choose an SDIRA, as the type of account, the buck stops with you. IRAs have a considerable amount of regulation, and if you fall afoul of those regulations with your investments you will be liable for tax penalties and other financial consequences that come into play if you break the rules.
How to Invest in Real Estate (SDIRAs)
One of the most significant drawbacks to a traditional IRA is that you cannot directly invest in real estate. With a Self-Directed IRA you can invest in various types of real estate alternatives, which have historically performed very well over longer time periods.
You will be responsible for finding the real estate investment, determining its upside potential, and working with the team you hire to manage the property. If you plan on taking an active role in management there will be additional duties like screening tenants, collecting rents, maintaining the property, bookkeeping, etc. In addition, you will be responsible for researching the tax implications and regulations surrounding any real estate asset purchase. If you have the time and specialized knowledge to make direct real estate investments, you have the potential to earn significant returns.
However, there may be a better way to invest in real estate without all of the hassle.
Real Estate Crowdfunding for Self-Directed IRAs
One way you can invest in real estate is through crowdfunding. Real estate crowdfunding sits in between direct property ownership/management and passive RE investments like REITs. While you will be involved in choosing which asset(s) to invest in, you will not be responsible for the day-to-day management or maintenance of the property. Plus, with RE crowdfunding, you can invest in a diversified portfolio of commercial properties, multifamily buildings, single-family homes, and more - all while taking maximum advantage of the tax benefits of a Self-Directed IRA.
Self-Directed IRAs offer the same tax benefits as a standard IRA, with the added ability to control your financial future by investing in alternative asset classes like real estate. If you want to take advantage of the long-term potential of RE, an SDIRA might be for you.