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Self-Directed IRA vs. Traditional IRA


Understanding the difference between a self-directed IRA and a traditional IRA can help you decide how and where to invest your retirement savings. A traditional IRA is a popular choice for many investors, offering tax-deferred growth on contributions made with pre-tax dollars. This means you don’t pay taxes on your investments until you withdraw them in retirement, potentially lowering your current taxable income. On the other hand, a self-directed IRA offers the same tax advantages but with significantly more flexibility in investment choices. Choosing between the two depends on your investment preferences and risk tolerance.

A financial advisor can help you decide between contributing to a self-directed IRA or traditional IRA. Connect with a fiduciary financial advisor today.

What Is a Self-Directed IRA?

A self-directed IRA (SDIRA) gives investors more control over their investment choices compared to traditional IRAs. While traditional IRAs typically limit investments to stocks, bonds, exchange-traded funds (ETFs) and mutual funds, SDIRAs permit a wider variety of assets, such as real estate, private equity, precious metals and even cryptocurrencies. This greater flexibility is particularly appealing to savvy investors who want to diversify their portfolios and take advantage of alternative investments.

The primary advantage of a self-directed IRA lies in its ability to accommodate non-traditional investments, providing a unique opportunity to capitalize on market niches that are not accessible through standard IRAs. Investors can purchase rental properties, invest in startups, or even buy tax liens.

However, with this expanded range of options comes an increased need for diligence and expertise. Investors must ensure that their chosen assets comply with IRS regulations, which prohibit certain transactions and investments, such as collectibles or personal property.

Opening and Managing a Self-Directed IRA

Opening and managing a self-directed IRA requires working with a custodian or trustee who specializes in these types of accounts. The custodian’s role is to handle the administrative tasks and ensure that the account complies with all IRS requirements. However, the investor is responsible for making the investment decisions and conducting thorough research to mitigate risks. 

While a self-directed IRA offers substantial growth potential and diversification benefits, it also demands a higher level of involvement and knowledge compared to traditional IRAs. For those willing to take on the challenge, a self-directed IRA can be a powerful tool in building a robust retirement portfolio.

How a Traditional IRA Works

A traditional IRA is a retirement savings plan that offers tax advantages. IRA contributions are usually made with pre-tax dollars, which can lower your taxable income for the year of the contribution. This upfront tax break can be especially beneficial for individuals in higher tax brackets. The funds in the account grow tax-deferred, so you don’t pay taxes on the earnings until you withdraw them in retirement. This deferral allows the investments to potentially grow faster compared to those in a taxable account.

Withdrawals from a traditional IRA are subject to income tax at the rate applicable in the year of the withdrawal. Generally, these withdrawals can begin without penalty at age 59 ½. However, if funds are taken out before this age, they may be subject to both income tax and a 10% early withdrawal penalty. 

There are certain circumstances that let you withdraw from your IRA without penalty such as first-time home purchases (up to $10,000), qualified education expenses or medical bills. This structure encourages individuals to save consistently for retirement while benefiting from the tax advantages.

Opening and Managing a Traditional IRA

Traditional IRAs are relatively straightforward to manage. You can open an account through various financial institutions, including banks, brokerage firms and mutual fund companies. These institutions often offer a wide range of investment options, such as stocks, bonds and mutual funds. The flexibility in choosing investments allows you to tailor your portfolio according to your risk tolerance and retirement goals. 

Additionally, many financial institutions provide tools and resources to help you make informed decisions. For those seeking professional guidance, working with a financial advisor can further optimize the benefits of a traditional IRA, ensuring your retirement savings strategy aligns with your long-term objectives.

Differences of Self-Directed and Traditional IRAs

A self-directed IRA gives you access to non-traditional investments, like tax liens.

Understanding the differences in self-directed IRAs (SDIRAs) vs. traditional IRAs is essential for making informed decisions about your retirement savings strategy. Both account types offer tax advantages and can be powerful tools for building your retirement nest egg. However, they differ significantly in terms of investment options, management requirements and potential risks.

Investment Options

Traditional IRAs typically allow investments in stocks, bonds and investment funds. This limited range suits those looking for a more straightforward investment approach. In contrast, SDIRAs offer a broader spectrum of investments, including real estate, private equity and precious metals, appealing to investors seeking greater diversification and alternative investments.

Control and Flexibility

SDIRAs provide greater control and flexibility, enabling investors to direct their retirement funds into niche markets and alternative assets. Traditional IRAs, while easier to manage, restrict investors to more conventional asset classes, which can limit growth potential for those with specialized knowledge.

Management and Custodians

Managing a traditional IRA is relatively simple, often requiring minimal involvement beyond selecting investments from a pre-defined list offered by financial institutions. On the other hand, SDIRAs demand more active management and a custodian who specializes in these accounts, ensuring compliance with IRS regulations.

Risk and Expertise

Investing through a traditional IRA is generally less risky due to the familiar and regulated nature of the investment options. SDIRAs, however, come with higher risk due to the complexity and potential volatility of alternative investments. This requires investors to have or seek out significant expertise and conduct thorough due diligence.

Cost and Fees

Traditional IRAs usually have lower fees, with many institutions offering no-fee accounts. SDIRAs often incur higher costs due to the specialized management and custodial services required, along with potential transaction fees for unconventional investments.

Bottom Line

A man who's still saving for retirement looks over his self-directed IRA balance on his laptop.

Deciding between a self-directed IRA vs. a traditional IRA ultimately depends on your investment goals, risk tolerance and level of financial expertise. A traditional IRA offers simplicity and ease of management with a focus on conventional assets, making it suitable for those preferring a straightforward approach. In contrast, a self-directed IRA provides greater flexibility and control, allowing for a diversified portfolio that includes alternative investments, but it requires more active management and due diligence. 

Both account types offer significant tax advantages that can help grow your retirement savings. By understanding the distinct features of each, you can make an informed decision that supports your financial future.

Retirement Planning Tips

  • If you have money invested in a tax-deferred retirement account like a traditional IRA or 401(k), you’ll need to start taking annual withdrawals known as required minimum distributions (RMDs) at age 73 (75 for people born in 1960 or later). Failing to take these mandatory withdrawals – or not withdrawing the correct amount – can trigger a 25% tax penalty on the amount that should have been distributed but wasn’t. Luckily, SmartAsset has an RMD calculator designed to help you estimate how much your first RMD will be and when it’s due by.
  • A financial advisor can help you make decisions surrounding Social Security, RMDs and retirement income. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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