Self-directed IRAs were created back in 1974 by the Employee Retirement Income Securities Act, or ERISA as it is more commonly known. They have become increasingly popular in recent years as more people want to take more control over how their IRA funds can be invested.
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Investors establish self-directed IRAs with a specialized custodian or trust bank, instead of a traditional bank or brokerage firm. This custodian is only responsible for administrative tasks like handling paperwork and providing annual valuations — not for identifying and recommending specific types of IRA investments.
Going outside the Box with IRA Investments
With a self-directed IRA, you can invest your retirement money in a wide variety of different kinds of alternative investments beyond just the usual stocks, bonds and mutual funds. These include real estate, private loans, tax liens, hedge funds, commodities and even racehorses. Art, collectibles, life insurance and tangible personal property — like a yacht, for example, unless it is used as part of a charter business — are among the few types of investments that cannot be purchased with a self-directed IRA.
Unfortunately, many people who open self-directed IRAs are not taking full advantage of their potential to go “outside the box” when it comes to their retirement investments. Instead, they are simply choosing the same kinds of stocks, bonds and mutual funds that are available to anyone who owns a normal IRA.
Investing in real estate, for example, can be one of the best ways to take advantage of the tax benefits of an IRA. Consider a rental home, for example. If you bought a home for $100,000 with self-directed IRA funds and netted $500 per month — or $6,000 per year — in rental income after expenses, this profit could be tax-deferred if you have a traditional IRA or tax-free if you have a Roth IRA. Your net profit upon selling the home would also be tax-deferred or tax-free.
The same concept applies to flipping real estate. If you bought a home for $100,000 with self-directed IRA funds, spent $50,000 on repairs and upgrades and then sold the home for $200,000, your $40,000 profit (after $10,000 in selling expenses) would be tax-deferred or tax-free if held in a traditional or Roth self-directed IRA. Profits on such a transaction conducted outside of a self-directed IRA would be subject to short-term capital gains taxes at ordinary income tax rates.
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More Creativity, More Risk
This is just one example of how you can get creative with investments held within a self-directed IRA. You should keep in mind, however, that self-directed IRAs can be riskier than normal IRAs can, since the investments are less traditional and you may not receive the kind of investment advice from an advisor or broker that you would with a normal IRA. However, if you want to go outside the box a little bit with your retirement investments, you might want to look closely at the benefits and drawbacks of a self-directed IRA. If you do, be sure to take full advantage of the flexibility and potential creativity a self-directed IRA will offer you.