It sounds like semantics – but there are self-directed IRAs and 401(k) plans, and then there are self-directed IRAs and 401(k) plans.
The latter is a unique type of retirement plan, specifically designed to hold alternative investments.
These accounts aren’t for the faint of heart or the novice investor.
But if you have a large investment portfolio, and you’re looking to get the higher returns alternative investments often provide, holding a portion of that portfolio in an alternative self-directed IRA or 401(k) plan may be just what you’re looking for.
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What is a Self-Directed IRA?
A self-directed IRA shouldn’t be confused with the general understanding of “self-directed IRA”.
Discussions of self-directed IRAs usually refer to non-employer-sponsored retirement plans. These can include the various types of IRAs, like traditional, Roth and SEP IRAs, but also solo 401(k) plans.
These are conventional retirement investment accounts where you have direct ownership and control over the account, and are free to choose the account trustee and any investments held in the account.
But with a conventional self-directed IRA or 401(k) plan, you’re limited to certain and investments.
These include individual stocks, bonds, options, mutual funds, exchange traded funds (ETFs), and real estate investment trusts (REITs).
But there’s another type of self-directed IRA or 401(k) that’s similar in that you own the account and decide where to hold it and what to invest in, except the account is specifically designed to accommodate alternative investments.
Alternative investments include those often available only to the very wealthy. In addition, they’re often not in the usual paper form.
Though some are, many others are actually hard assets, like precious metals and even real estate, that are held within your plan.
The general idea of a self-directed IRA is to give you access to virtually any type of investment class not prohibited by the IRS.
These investments carry higher risk than more traditional ones, but also the potential for much greater rewards.
That’s the basic idea behind a self-directed IRA, and the reason why they’re becoming increasingly popular.
You’re not limited to the list of investments offered by a traditional broker. You can even create individual investments to include in your plan.
The typical household name type investment brokers aren’t what you’re looking for here.
Instead, you’ll be looking for a special class of custodians that specializes in alternative self-directed IRA accounts.
How Self-Directed IRAs Work
A self-directed IRA starts with selecting the right custodian.
Such a trustee will understand exactly how the process works, and help you set up the type of plan you want.
But be advised from the outset that alternative self-directed IRA accounts are designed specifically for more sophisticated investors.
If you are a new or intermediate level investor, this type of account won’t be suitable for you.
You’ll start by selecting the custodian based on the type of investing you want to do.
For example, if you want to invest specifically in precious metals – as in holding the metals in your account directly – you’ll want to work with a custodian that specializes in that asset class.
The same is true if you want to use your self-directed IRA primarily to invest in physical real estate.
Most alternative self-directed IRA custodians work with a wide variety of alternative asset classes, but many have specific areas of concentration.
We’ll get into the specific types of alternative asset classes offered by self-directed IRAs in the next section.
Just keep in mind the type of investing you want to do is critical in deciding which custodian to work with.
Executing Investment Transactions
You can set up a self-directed IRA once you send instructions to the trustee on which investments you want to add to your account, and the trustee will then purchase those assets in the name of your account.
This will be done by sending a check or a wire in payment for the asset(s) purchased.
But another way to structure your accounts is to set up a limited liability corporation (LLC), which is owned by the IRA and acts as the investor within the account.
When you set up the account using an LLC, you will also open a bank account specifically for the LLC.
Funds are transferred from the IRA to the self-directed IRA checking account. Once the IRA and the bank checking account are opened, you can invest directly in the assets of your choice simply by writing a check.
Self-Directed IRAs Offer Investments Other IRAs Don’t
This gets to the primary advantage of having an alternative self-directed IRA or 401(k) plan.
While popular investment brokers limit you to conventional paper investments, alternative IRAs offer practically unlimited investment options.
Some of those investments include:
- Precious metals, both coins and bars.
- Real estate, as in individual properties and even raw land held in your account.
- Commercial paper.
- Tax certificates and tax liens.
- Limited partnerships.
- Private stock offerings.
- Private loans and notes.
This is just a sampling of some of the investments you can hold in an alternative self-directed IRA account, that you can’t in a more traditional account.
In fact, you can hold any investment in a self-directed IRA that isn’t prohibited by the IRS. And that list is notoriously short, including mainly collectibles and insurance policies.
But just in case you’re thinking self-directed IRAs are designed only to hold more exotic assets, you can also include more traditional ones.
That includes the usual array of stocks, bonds, funds, and REITs.
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Why Should You Invest through a Self-Directed IRA?
As you can see from the list of investments that can be held in an alternative self-directed IRA or 401(k) plan, there’s a much wider selection of asset classes for you to choose from.
But it’s not just the number of different investments you can hold in your account.
Direct Control Over Your Investing Activities
Many people who open such accounts like the direct control they can maintain over their retirement accounts.
As an account holder, you can choose investments you want to make, and purchase them directly. There’s no need to go through the custodian to make the actual investments for you.
Maybe like many investors, you’ve often wondered if your broker is really getting you the best deal on a certain investment.
For example, you place an order to buy a certain stock at $47 a share, only to find you really pay $48.50.
It naturally leaves you wondering if the broker did all they could to get you the best price. And if they didn’t, was it because there was some financial advantage to them to buy at a higher price?
When you have a self-directed IRA or 401(k) account, those questions are removed.
As the direct investor in any asset, you’ll be able to choose the specific price you want to buy at – or not to proceed if the price goes against you.
What’s more, since many of the investments you’ll make in a self-directed IRA are private deals, you’ll be able to negotiate the price.
That means you won’t be hostage to the price swings in major markets.
Let’s also not forget that a self-directed IRA is in fact an IRA.
Your contributions are generally tax-deductible, and your investment gains are always tax-deferred.
If you’re investing in the type of asset plays likely to turn 10-to-1 gains, rather than plodding 10% annual returns, the tax-sheltered aspect of the self-directed IRA will be a major advantage.
It’ll enable you to completely avoid capital gains tax you’d pay by making the same investment play in a non-retirement account.
As well, you won’t have to concern yourself with short-term versus long-term capital gains.
If you have an opportunity to make a major gain on an investments in under one year, the fact that it takes place in a retirement account means the gain won’t be taxable at ordinary income tax rates.
How to Set Up a Self-Directed IRA?
Once you’ve selected the self-directed IRA account trustee, you’ll open your account.
You can do that either by making an annual contribution of $6,000, or $7,000 if you’re 50 or older, or by transferring funds from another IRA account or an employer-sponsored retirement plan through an IRA rollover.
Your new account custodian will be able to walk you through the entire process. This is important because it’s very different from the process of opening a traditional IRA account.
You’ll need to create an LLC for your IRA, as well as obtain an employer identification number from the IRS.
The trustee will provide assistance with both, as well as create a proprietary operating agreement for the LLC.
Once your account is set up, including the LLC, you can fund your account and begin investing. There’s an entire process involved in the type of direct investing done through an alternative self-directed IRA.
That will include the creation of special documents, including transfer requests, direction of investment letters and banking instructions.
It’s important to understand from the very beginning that unless you’ll be making conventional investments (stocks, bonds, bonds, etc.), it’s likely you’ll be making primarily individual asset purchases.
This may include real estate, precious metals, promissory notes, interests in small businesses, and other individual transactions.
The Risks of Investing Through a Self-Directed IRA
Though the potential to earn above average returns is certainly real with self-directed IRAs, the risks are just as likely.
None of these risks are meant to discourage you from opening an alternative self-directed IRA. But you should be fully aware of the risks involved before moving forward.
By knowing what they are, you can set up ways to mitigate them in your overall portfolio.
Some of the risks you should be aware of include:
You’re on Your Own
One of the advantages to working with traditional investment brokers is that they provide a generous amount of investor support.
This is especially true for larger firms, like Fidelity and Charles Schwab.
Of course, part of the reason they’re able to do this is because of the conventional nature of the investments they offer.
But when you’re working with an alternative self-directed IRA, that broker support won’t be available.
The trustee will certainly help you with matters related to the IRA and its set up. But when it comes to the actual investments, you’ll mostly be on your own.
There may be exceptions where you’re setting up a self-directed IRA with a trustee that specializes in a particular investment, like precious metals or real estate.
But given the very wide range of potential investments you can make, most of your investing activity will be unsupported by the custodian.
You’ll have to know exactly what it is you’re investing in, how to do it, and what the potential risks are associated with that asset class.
Lack of Third-Party Information Sources
If you’re investing in stocks or funds, there’s usually an abundance of information available about those investments.
Most of it can even be had for free. But since the investments you’ll hold in an alternative self-directed IRA are unique, there may be no third-party information available at all.
All of the metrics that are widely available for common investments, like price-earnings ratios, expense ratios, book value, credit ratings, market sentiment, and a host of other factors, will not be readily available for the types of investments you’ll be making.
You’ll Need to Conduct Your Own Investment Research
Once again, unless you’re working with a custodian that specializes in the asset class you’re investing in, you’ll be responsible to gather your own information.
That will include conducting your own research and due diligence on any asset class or specific investment you plan to make.
This effort will be complicated by the fact that some of the investments you make will be of the stand-alone variety.
For example, if you plan to hold a piece of real estate in your IRA, it’s a unique investment.
You’ll need to do a thorough investigation of the market area where the property is located, as well as the specifics of the property itself.
Lack of Liquidity
Common paper investments can be bought and sold with a few mouse clicks on your computer.
But if your self-directed IRA is holding a piece of raw land or rental property, liquidating your investment will be a long and complicated process.
For that reason, any funds you hold and an alternative self-directed IRA should be money you can afford to lose.
You should never invest with funds you may need for living expenses or an emergency. The liquidation process just doesn’t work that quickly.
Difficulty in Diversifying
Many of the assets you’ll be holding in an alternative self-directed IRA will be both unique and have a high value.
Once again, real estate is a prime example. If you’re going to hold a $200,000 rental property in your account, it will be very difficult to diversify with several properties.
It may even be possible that you’ll set up an alternative self-directed IRA for a single asset class, like real estate, tax liens, or private loans.
That being the case, you may have an account that is 100% invested in a single asset class.
You may be diversified within that class, but your account may hold no other classes of any meaningful value.
If you do set up a plan for a single asset class, be sure you have unrelated asset classes held in other investment and retirement accounts.
The High Risk that is Inherent in High Reward/High Risk Investments
The major attraction of alternative investments is usually hitting an investment home run.
That may cause you to focus primarily on the high reward potential of the investments.
But because of that potential for high rewards, alternative assets also carry high risks. In fact, alternative investments are often more about speculation than true investing.
Even if you’re aware of that from the very beginning, there’s another serious threat that’s difficult to insulate yourself from, and that’s investment fraud.
The lack of third-party oversight or verification of many alternative investments makes them fertile ground for shady operators.
In the pursuit of high rewards, it’s easy to get swept up into an investment that seems so promising on the surface, but is actually a subterfuge for fraudulent dealings.
Because of their unique nature, alternative self-directed IRA accounts charge higher fees than standard accounts. But that’s just the beginning.
It’s likely you’ll incur higher transaction costs in both buying and selling the alternative investments you’re holding in your account.
A good example is real estate transaction fees. Though you may be able to get the seller to pay these on purchase, the roles will reverse when you sell the property.
Not only will you need to pay a real estate commission, but also any real estate transfer taxes and other seller closing costs.
You may even need to pay part or all the buyer’s closing costs to make the sale happen in the first place.
This is very unlike the current trend in traditional brokerage accounts toward zero trading commissions.
When investing through an alternative self-directed IRA, fees will represent a significant factor in your return on investment on any asset you buy or sell.
We probably should have covered this risk first, because it’s the investment equivalent of a nuclear disaster.
If you commit one of the infractions that violate the prohibited transactions list from the IRS the penalties are severe.
First and foremost, the IRS revokes the tax-sheltered status of the IRA account retroactive to January 1 of the year in which the prohibited transaction took place.
That means 100% of the value of the accounts on January 1 will automatically become a distribution. It will then be subject to ordinary income tax, plus an early withdrawal penalty.
If the assets in the account are not liquid, such as real estate, you may need to pay the taxes and penalties out of other accounts.
Generally, a prohibited transaction is any in which you use the IRA account for some sort of personal benefit. Examples include:
- Borrowing money from the IRA.
- Selling property to the IRA that you own personally.
- Pledging IRA assets as collateral for a loan.
- Using IRA property for personal use.
The prohibited transaction regulations are particularly severe when it comes to real estate investing.
For example, if you or a family member live in the property for even one day, it’s considered personal use, and a prohibited transaction. That’s all it would take to vaporize your self-directed IRA for good.
Moral of the story: Know exactly the risks you’re taking on with an alternative self-directed IRA, or don’t open one.
It’s strongly recommended that you have representation from both an attorney and a CPA who are well-versed in alternative self-directed IRA accounts, to advise you along the way.
There Are Self-Directed 401(k)s Too
For the most part, the same rules that apply to alternative self-directed IRAs also apply to self-directed 401(k) accounts.
The main difference is the availability of 401(k) plans for alternative investments.
Though it’s possible some employers offer an alternative self-directed 401(k) plan option, the vast majority don’t.
If your employer doesn’t offer an alternative self-directed option, you can still open an alternative self-directed IRA.
But if you’re self-employed, you can set up a solo 401(k) plan, that can be held as an alternative self-directed 401(k).
Unfortunately, there aren’t as many account custodians that will handle a self-directed 401(k) as there are self-directed IRAs, at least the type for alternative investments.
But if you do find one, there are certain advantages.
First, 401(k) plans offer much more generous contribution limits than IRAs. You can contribute up to $19,000 per year, or $25,000 per year if you’re 50 or older.
And that’s just your employee contribution. But since you’re self-employed, you’re also the employer in the arrangement, and can make a matching contribution equal to as much as 25% of your net income.
Under a best-case scenario, you can contribute as much as $56,000 to a 401(k) plan for 2019.
Once again, be aware that all the limitations that apply to alternative self-directed IRAs also affect alternative self-directed 401(k) plans.
Pros & Cons
- Unlimited investment options.
- Complete control over the investment process.
- You can hold assets in an alternative self-directed IRA or 401(k) plan that would not be permitted in a conventional retirement plan.
- Potential for huge investment gains.
- Those huge investment gains will get the benefit of tax-deferred status.
- An opportunity to diversify your investment portfolio away from the limited list of assets offered by traditional investment brokers and retirement plans.
- Alternative self-directed IRA and 401(k) accounts are available for both traditional and Roth plans.
- Alternative self-directed accounts involve an unusually high level of risk.
- This is an investment vehicle for sophisticated investors only.
- The number of plan custodians is fairly limited, and doesn’t include well-known brokers.
- You’ll be responsible for choosing and managing your own investments.
- Investment fees are higher than they are in traditional accounts.
- If you engage in a prohibited transaction the tax consequences can be severe.
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Should You Invest in a Self-Directed IRA or 401(k)?
If you’re a new or intermediate level investor, and particularly if you have a small portfolio, alternative self-directed IRAs and 401(k)s should be avoided.
But if you’re a well experienced and knowledgeable investor, who has a keen interest in high reward type investments (despite the equally high risks), and a large portfolio of other assets, self-directed IRAs and 401(k)s may be a good idea.
It’s an excellent way to move into alternative investments, giving your portfolio a higher level of diversification, as well as tax deferral on the large gains you may reap from the accounts.
But we have to emphasize the importance of having only a small amount of your portfolio – maybe no more than 10% – invested in a self-directed IRA or 401(k) account.
You’ll mostly be speculating in this type of account, so you’ll need to have more traditional investments held in conventional investment and retirement plans.
The small percentage you have invested in a self-directed IRA or 401(k) plan may be just enough to significantly increase the overall return on your portfolio, without putting you at substantial risk if the investments go against you.
And though it’s already been mentioned in this guide, we strongly recommend you engage the services of both an attorney and a CPA who are well-versed in self-directed IRA and 401(k) plans.
These are unique accounts, and you’ll need professional help to avoid the taxes and penalties that come from prohibited transactions.
Self-directed IRAs and 401(k)s can provide very lucrative returns. But you’ll need to be fully aware of the risks, and make every effort possible to minimize them.
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Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He and his wife are “empty nesters” living in New Hampshire.