5 Questions to Ask Before Starting a Self-Directed IRA

If you want greater control over your retirement savings and the freedom to invest beyond traditional stocks and bonds, a Self-Directed IRA (SDIRA) can offer an exciting opportunity. With a SDIRA, you can diversify your portfolio with alternative assets like real estate and other options. But before taking the leap, it’s crucial to ask the right questions to ensure a SDIRA is the right fit for your retirement goals.

1. Which types of assets can I invest in through a SDIRA?

A Self-Directed IRA allows you to invest in a variety of alternative assets, including:

• Real estate
• Precious metals
• Private Equity (LLCs/LPs)
• Private Stock
• Crowdfunded assets
• Promissory Notes (Individual or Entity Loans)
• Traditional stocks, bonds, and mutual funds

The IRS prohibits SDIRA investments in life insurance, S-corporations, and collectibles, which include antiques, stamps, most coins, and more. Refer to IRS guidance for a complete list of prohibited investments.

Prohibited investments include what the IRS defines as “collectibles,” which include art, antiques, stamps, most coins, and more. Investing in life insurance policies and S-Corporations is also prohibited. In addition, potential investors should be aware of IRS prohibited transaction rules, which can result in negative tax consequences and potentially disqualify the SDIRA.

2. Which type of SDIRA is most appropriate for my retirement needs?

Just like with a regular IRA, you can choose between Traditional and Roth when selecting the SDIRA that’s right for you.

• Self-Directed Traditional IRA: Contributions are generally made with pre-tax dollars, potentially reducing your taxable income for the year of the contribution, subject to IRS limitations. Your investments can grow tax deferred, but you will pay ordinary income tax on the withdrawals. Refer to IRS Publication 590-A for limitations on IRA contributions and deductibility.
• Self-Directed Roth IRA: Contributions are made with after-tax dollars, contributions and earnings grow tax-free, and withdrawals are also tax free after age 59 ½ and five years from account opening, subject to IRS rules regarding Roth IRAs.

You will also need to choose how to structure your Self-Directed IRA:

All Self-Directed IRAs (SDIRAs) must be held with an IRS-approved IRA custodian. These custodians do not offer investment advice or sell investments. Instead, they provide administrative and custodial services — such as executing transactions, maintaining records, and ensuring compliance with IRS requirements — based solely on the direction of the account owner.

There are two common ways SDIRAs are structured:

• Custodian-Directed SDIRA: This is the most common approach. The IRA custodian holds your SDIRA assets and executes transactions at your direction. You select and direct all investments, and the custodian carries out your instructions, such as purchasing or selling assets, processing income, or paying fees. This structure is suitable for investors who prefer to work through a custodian for all transactions and asset management.
• Checkbook Control SDIRA (also known as an IRA LLC): This strategy involves setting up a Limited Liability Company (LLC) that is owned by your SDIRA. You, as the SDIRA owner, act as the manager of the LLC. Once the custodian funds the LLC from your SDIRA, you can write checks and make investment decisions directly from the LLC account without going through the custodian for each transaction. While this option offers greater control and speed in managing investments, it also introduces additional complexity and responsibility. Importantly, you are still required to have a custodian for the SDIRA itself, and all activities must comply with IRS rules.

Before pursuing a Checkbook Control structure, it’s strongly recommended to consult a qualified legal or tax advisor to ensure the setup and ongoing operation meet all regulatory requirements.

3. Which IRS rules and regulations should I be aware of?

When opening a Self-Directed IRA (SDIRA), understanding IRS rules and regulations is critical to avoiding mistakes that could jeopardize your account. A prohibited transaction can bring into question the tax-deferred status of your self-directed account, potentially resulting in the disqualification of your IRA or other account, and severe tax consequences. The IRS defines a prohibited transaction as follows:

“Generally, a prohibited transaction is any improper use of your IRA account or annuity by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of lineal descendant).”

IRS Publication 590 states that, in addition to prohibited investments, the IRS prohibits certain transactions within IRAs. Prohibited transactions include investments with disqualified individuals (as defined by IRC 4975), “self-dealing,” and receiving indirect benefits.

Permitted Investments

The IRS does not provide guidance on what is permitted but dictates only what is NOT permitted. Examples of prohibited IRA investments include collectibles (such as artwork, stamps, rugs, antiques, and gems), certain coins, and life insurance. See IRS Publication 590 for more information about prohibited investments.

4. What are the advantages and disadvantages of a SDIRA?

Adding a SDIRA to your retirement savings mix is most appropriate for seasoned investors who enjoy being actively involved in choosing investments and tracking the performance of their portfolio, as the name suggests.

Here are some pros and cons to consider:

Potentials Advantages of SDIRAs:

• More control over your investments: Unlike a regular IRA, you’re not limited to traditional financial instruments like stocks, bonds, and mutual funds. Opening a SDIRA allows investors who are well-versed in a specific industry or asset type, to use retirement funds to invest in these assets.
• Diversification potential: By investing in a SDIRA you can create a more diversified portfolio and potentially reduce risk by expanding investment options beyond stocks and bonds.
• Potential for higher returns: A SDIRA allows you to invest your retirement funds in alternative assets, which offer the potential for enhanced yield and returns compared with traditional investments. With an SDIRA, you may be able invest in companies before they go public, if you are an accredited investor.
• Tax Advantages: In a SDIRA, investors can choose their investments and build a portfolio while still receiving the same tax breaks found in traditional or Roth IRAs. Refer to IRS Publication 590-A for IRA rules.

Potential Disadvantages of SDIRAs:

SDIRAs may not be suitable for everyone. SDIRA accountholders are responsible for managing their own investments and for ensuring they remain tax compliant, and the fees for these accounts may be higher than for traditional IRAs. Individuals considering SDIRAs are therefore encouraged to seek independent professional advice.

5. Which type of IRA Custodian should I engage with for my SDIRA?

When choosing a SDIRA custodian, you should focus on reputation, experience, investment options, and customer service, along with ensuring the custodian is state or federally regulated. It is very important to use a custodian that is experienced handling the type(s) of investments you plan on including in your SDIRA to help guide you through the investment process.