The Pros and Cons of Using a Self-Directed IRA
In this segment from theMotley Fool Answerspodcast,Alison Southwick and Robert Brokamp welcome Sean Gates to the show as they answer listener questions.
Dan asks about the complexities of investing in a business via the tax-advantaged vehicle of a self-directed IRA. The rules are not simple, the expenses are higher than a normal IRA, and it can be hard to take your profits, but that said, there are some very good reasons to consider it.
A full transcript follows the video.
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Alison Southwick:OK. The next question comes from Dan. Dan writes: "My wife and I are 36 and 37, and currently set aside money in both our Roth IRAs and 401(k)s. I'm interested in investing in a business idea with some friends (commercial real estate), but it is four to five years off. I'll need some seed money for the investment, but I don't want to miss out on socking away money in either my 401(k) or Roth. I know I can withdraw my Roth contribution (I meet the five-year rule) but would a self-directed IRA be a viable option? What do I need to know about a self-directed IRA and is there a reputable firm equivalent to Vanguard in that space?"
Robert Brokamp:A couple of things about this. First of all, as he points out, the money you put into a Roth IRA you can actually take out tax-and-penalty free anytime, and for that you don't even have to worry about the so-called five-year rule for the Roth. So he can put that money in and take it out anytime he wants.
Now he has used a term called the "self-directed" IRA. A lot of people think if they have their own IRA and they're just picking their own stocks and bonds, or whatever, that's self-directed. In a sense, it is, but that's actually an actual term related to a special type of IRA that allows you to invest in other things like real estate. Some businesses. All kinds of crazy stuff.
And the average broker, like Vanguard, doesn't allow you to do it, so you have to go find a specific type of custodian that usually has higher expenses, and there are a lot of rules about it. Like you can't use this money to buy a vacation house that you eventually stay in. You have to invest in some sort of business that you don't have any personal use of. Now Sean, in your history of being a financial advisor, you actually have dealt with this.
Sean Gates:Yes. I've run into this a couple of times, and it's usually people who come to a financial advisor and say, "Hey I got into this investment idea and now I don't know how to get out of it." They're stuck, because a self-directed IRA, like Bro said, limits you to only a few organizations. Equity Trust is one. I think that Millennium Trust is another. It's usually trust companies. They do the annual reporting for you, but that's about it. So there's a whole other stack of documents and compliance that you need to keep up on, and it's not always clear whether the trust company is doing that for you.
Southwick:It sounds messy.
Gates:It's pretty messy. And then, in this case, if you go into a limited liability corporation or I've seen equestrian (like people invest in horses for horse racing), you can pretty much do anything you want.
Brokamp:I've seen people buy interests in parking lot meters and things like that.
Southwick:OK.
Gates:You can invest in all sorts of wonky things, and it's just when you then need to go utilize that money, it's very difficult to get it back out. You don't know when the term ends, or how you get back out of horses, or this business, if this doesn't succeed.
Southwick:Do you really have to sell the horse in addition to getting out of it?
Brokamp:Right. Piece by piece, sell the horse.
Southwick:Wow.
Gates:You just end up, for the rest of your days, riding the horse in horse races. It's crazy.
Brokamp:Actually, not really. You actually can't do that, because that's personal use, and if you use the thing you invested in, then it could be considered distribution and then you pay taxes and penalties. So there are lots of rules around it.
Philosophically, I think it's a great idea. Especially if you have, already, other big accounts that have stocks and bonds, this is a way to diversify your portfolio. You just have to be very careful about it, and generally these things are not very liquid.
Gates:Yup. And we don't want to make it sound like it's all bad because, as Bro said, the diversification element is great and you can find some pretty sweet deals that you can't otherwise get. The stock market might get you 7% to 8%. Some private deals could get you 20% to 25%. I'm not trying to say that all do, but if you marry up with the right partner, it could be a great investment.
Brokamp:So to answer Dan, I would say your best bet is actually to put the money in the Roth with the idea of taking out the contributions. That's probably going to be an easier thing to do, but definitely look into self-directed IRAs and it might be suitable for you.
Gates:Yeah.
Southwick:I just realized I am not diversified at all into racing ponies.
Brokamp:You've got a next episode.
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