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What Is a Self-Directed IRA?

A Self-Directed IRA is a tax-deferred investment option for those who like a little more control than a regular IRA affords. It’s an approach that comes with higher risk and greater potential rewards than your standard index fund. If you don’t have the time, expertise or inclination to chase high returns, it’s probably not for you. But if you’re intrigued, read on for more about this retirement vehicle. 

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Self-Directed IRA: The Basics

Let’s review the point of a traditional IRA before we explain how a Self-Directed IRA takes that concept and runs with it. A traditional IRA lets you save for retirement with money you can deduct from your taxable income when you file your returns. Usually, people stash their traditional IRA contributions in something dependable like a mutual fund, a target date fund or a few index funds. They want potential for some growth over time, but they don’t want to risk losing all their contributions. So they turn over some money to an IRA provider and let things take their course.

As the name suggests, a Self-Directed IRA gives the account holder more control, plus the option of investing in non-traditional assets. If you’ve always wanted to get into the commodities game, or to invest in private equity and real estate, a Self-Directed IRA could be right for you.

Self-Directed IRA Custodians

Although Self-Directed IRAs come with more control than a typical mutual fund IRA investment, you’ll still need to work with what’s called a “custodian.” For a traditional IRA, your custodian would be a bank or brokerage. They tend to be big companies with recognizable names. A Self-Directed IRA custodian is more likely to be a small firm you’ve never heard of before. You give them your retirement savings (which you can deduct at tax time) and they put your money in some kind of alternative investment vehicle, like real estate or tax lien certificates.

Self-Directed IRA Rules

If you go the Self-Directed IRA route, be sure to follow IRS rules, or you’ll risk losing the tax-deferred benefits of your IRA. In fact, that’s one of the reasons some people avoid this type of IRA. If you think you might have a hard time figuring out and complying with the many regulations surrounding Self-Directed IRAs, you might be better off sticking with a traditional IRA through a brokerage.

A brokerage for a regular IRA would send you a tax statement every year. With a Self-Directed IRA, your tax prep is, well, self-directed. You also have to keep track of what’s allowed under IRS rules. You can’t invest in a rental property that you live in, for example. Plus, some forms of Self-Directed IRA income is taxable. That’s right. You’re not guaranteed 100% tax-deferral as you would be with a traditional IRA.

Self-Directed IRAs are subject to the same rules as traditional IRAs when it comes to early withdrawals. Want to take money out of your Self-Directed IRA before you hit age 59.5? You’ll pay income tax on the money you withdraw, plus a 10% penalty. For this reason it’s a good idea to avoid taking early withdrawals if you can. Keep your money in your IRA until after age 59.5 and you’ll reap the full benefits of these tax-deferred plans. Just don’t forget to start taking Required Minimum Distributions after you hit 70. Running afoul of the IRS is not a good retirement strategy.

Self-Directed IRA Risks

The US Securities and Exchange Commission (SEC) recently issued an investor alert concerning fraud risk in Self-Directed IRAs. According to the SEC report, some Self-Directed IRA custodians misrepresent their custodial duties and deceive investors. They may mislead investors as to the nature of alternative investments like metals and real estate, and promise returns that are uncertain or even impossible. Regulators have sued some Self-Directed IRA custodians for running Ponzi schemes, duping investors into investing in unregulated securities, committing other forms of fraud and using investor funds for living expenses.

If you’re not deterred by these risks, it’s important to do due diligence when shopping for a Self-Directed IRA custodian. Check the licensing and registration of the investors against SEC or state regulatory resources. Be wary of investment promises that sound too good to be true, or sketchy offers and tips from strangers.

Bottom Line

If you’re a real expert in real estate, metals or private equity, using a Self-Directed IRA can let you put your knowledge to work for you and grow your retirement savings. A Self-Directed IRA lets you explore off-the-beaten-path retirement investment areas while still enjoying the tax-deferred growth that makes traditional IRAs so attractive.

However, because Self-Directed IRAs carry more risk, they’re probably best used in combination with another retirement savings vehicle – or not at all, if you’re skittish. You don’t want to have all of your retirement savings evaporate when that shopping mall deal in Pensacola falls through.

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Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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