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The Pros and Cons of Self Directed IRA Thumbnail

The Pros and Cons of Self Directed IRA


A self directed IRA opens the opportunity to invest in alternative investments that a traditional IRA wouldn't allow. It also gives the account holder more freedom to manage the account. But it's not for the faint of heart.

Keep reading to learn the pros and cons of a self directed IRA.

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Pros and Cons of a Self-Directed IRA

At first glance, most people assume self directed IRAs are better than traditional IRAs because you have more control. However, most people don't realize the pros and, more importantly, the cons of self-directed IRAs.

What Is a Self-Directed IRA?

A self directed IRA is a retirement account with the same contribution limits and tax benefits as a traditional IRA. The main difference is you are responsible for all investment decisions and have access to alternative assets that traditional IRAs don't allow.

Understanding a Self-Directed IRA (SDIRA)

Traditional retirement accounts have a basic investment strategy. They allow you to invest in CDs, mutual funds, stocks, and bonds. SDIRAs allow the same investments; however, you can also invest in other investments, including real estate, cryptocurrency, tax lien certificates, raw land, promissory notes, and water rights, as a few examples.

Difference Between an SDIRA and Other Retirement Accounts

Before self-managing an IRA, it's important to understand your other retirement account options.

Managed and Self-Managed IRA

A managed IRA is managed by a brokerage house that allocates the funds according to your retirement plans. They'll often consider all your retirement account options, including any 401Ks, pensions, or other retirement income.

They'll keep your account balanced, reallocating funds when necessary to continue reaching your goals even when asset balances change.

Traditional vs. Roth Self-Directed IRA

You can have a self directed traditional or Roth IRA. In both cases, your investment decisions go through a broker or the company that handles your transactions.

A traditional IRA uses before-tax funds, and a self directed Roth IRA uses after-tax funds. The difference is primarily when you pay taxes. With a traditional IRA, you pay the taxes when you withdraw the funds, and with a Roth IRA, you pay the taxes before you contribute, but you can withdraw your contributions and earnings tax-free.

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How to Open a Self-Directed IRA?

Despite its name, self directed IRA, you aren't completely on your own managing the account. When you set up a self directed IRA, you need a self directed IRA custodian or trustee. This entity is in charge of administering the account and cannot be a person. According to the IRs, it must be a bank or financial institution.

Opening a self directed IRA account is easy using these steps:

  • Locate a custodian or trustee
  • Identify what you want to invest in
  • Select your broker to carry out the transaction
  • Prompt the custodian or trustee to conduct the transaction

Pros of Self-Directed IRAs

While there are many downsides of the self directed IRA, there are some benefits to consider.

  1. Higher Returns
    Some investments, such as real estate investments, have higher rates of return than stocks or bonds. This can increase your retirement account balance and help you achieve your financial goals faster.
    There's no guarantee alternative assets will perform better than stocks, bonds, or mutual funds, but the potential exists.
  2. Greater Diversification
    You diversify your portfolio further when you can invest in many alternative assets. For example, investing in stocks and bonds doesn't diversify your portfolio much, except for investing in different industries or types of stocks. However, stock market volatility exists in any stock but can be offset by investing in another asset class.
  3. Easy to Set Up and Access
    You don't need special qualifications to learn how to set up a self directed IRA. Anyone with taxable income is eligible. As long as you find self directed IRA custodians, you can open your IRA and invest in assets.
  4. Better Control
    You have control over what you invest in with a self directed IRA. First, however, do your due diligence. You may find other investment opportunities you want to take advantage of, such as real estate investing, limited liability company investing, or other assets.
  5. Asset Protection
    With a self directed IRA, you have more options to protect your assets. Take real estate investing, for example. If you purchase real estate, you can leverage your investment with mortgage financing, improve the property to increase your capital gains, or sell it.
    When you invest in stocks and bonds, you have two options - buy or sell. Unfortunately, this doesn't leave much room for asset protection and puts you at a greater risk of loss.
  6. Tax Advantages
    Any earnings you make on your investments in the retirement account will grow tax deferred. So, for example, if you sell a real estate investment for a profit, you won't pay taxes on the capital gains until you withdraw the funds in retirement unless you have a self directed Roth IRA. That's tax-deferred account growth.

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Cons Of Self-Directed IRAs

We discussed the benefits of having a self directed IRA, now let's look at the downsides.

  1. Prohibited Transactions
    Not all transactions are allowed in a self directed IRA. If you don't follow the self directed IRA rules, you could wind up paying the penalty or owing taxes. There may even be legal issues if you sell assets to your IRA or borrow from it.
  2. Losses
    Self-managing your IRA means you make the investing decisions, which can be scary. If you don't know what you're doing, you could easily make a mistake and ruin your investment strategy.
    You must do your research and know exactly what the investment requires and its risk level. If you avoid your due diligence and invest in a bad investment, you could lose everything or not reach your retirement goals.
  3. Fees
    Self directed investments typically have a lot of fees, but most investors don't realize it until it's too late. Like any retirement savings account, it depends on your chosen investments and the brokerage overseeing them.
    Not paying attention to fees can ruin your investment strategy, making you fall short in retirement.
  4. Not Liquid
    If you have a financial situation, you may not liquidate your self directed IRA. This could leave you in financial trouble because you don't have the funds available to manage the emergency in front of you.
    If you have an emergency, you might invest less in your self directed retirement account, which could lead to not meeting your financial goals for retirement.
  5. Due Diligence
    Self directed IRAs means you are in charge of all decisions. You don't have anyone guiding you or giving you options from a set amount of pre-determined investments to fit within your risk tolerance and goal timeline.
    If you don't do your due diligence, you could make an investment mistake that could cost you your retirement savings.
  6. Lack of Transparency
    Alternative assets typically don't have a lot of transparency, or at least as much as typical investments. Moreover, because the Securities and Exchange Commission doesn't monitor them, the prices can be inflated, making them seem more valuable than they are.
    If you're investing in crowdfunding or group investments, there often isn't enough transparency regarding the exit strategy. For example, what happens if one investor wants out, but the others aren't ready?
  7. Fraud
    Fraud is rampant in the financial industry, especially in self directed IRAs. For example, some fraudsters claim an IRA custodian vetted and approved an investment to get more people to invest in it when there isn't such a thing.
    Custodians don't vet investments or determine their riskiness. This claim can lead you right into the arms of a fraudster.
  8. Concentrated Portfolios
    As much as people who promote the self directed IRA versus a traditional retirement account say they do it for diversification, there is usually less diversification. For example, for exampel, if you focus on the real estate market and fill your portfolio with real estate investments, you aren't diversifying; you're concentrating all your assets in one market.
  9. Lost Tax Breaks
    If you use a real estate investment to complete your IRA, you lose the tax benefits of real estate investing. Since the IRA owns the real estate, not you, and the IRA doesn't pay taxes; there aren't any benefits of owning the real estate in the retirement account.
  10. Regulation
    If you don't handle the self directed IRA properly, it could be disqualified as a retirement account, leaving you with tax liabilities and no retirement savings.

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Self-Directed IRA Accounts FAQ

There are many pros and cons of a self directed IRA, and here are some of the most common questions people have about them.

What Can You Invest In?

You can invest in almost any asset, including alternative assets that regular IRA accounts cannot invest in. This includes real estate investing, commodities, tax liens, and LLC company investing.

Can a Self-Directed IRA Hold a Mortgage?

It's usually challenging to get a mortgage for property an IRA purchases. This is because most lenders require IRA purchases to be in all cash.

How Can I Invest in Real Estate?

You can invest directly in the real estate market by purchasing real estate, such as a single-family or multi-family home, or in crowdfunded assets, such as real estate investment trusts.

Self-Direct Retirement Plan - The Bottom Line

Should you invest in a self directed IRA? After looking at the pros and cons of self directed IRA, it's plain to see that a traditional retirement account is a safer and often more profitable choice. Always connect with your financial advisor before making any financial decisions, especially regarding retirement savings.