Most investors save for retirement using ordinary types of investments, such as stocks, bonds, mutual funds, and exchange-traded funds. But if you really want to ramp up your retirement savings an extra notch, a self-directed IRA could be perfect for you by opening up a whole new universe of potential investments.
Contrary to popular belief, IRAs are allowed to hold a wide variety of different types of investments. Among them are things like real estate, closely held businesses, and special loans and promissory notes. The challenge, though, is finding a company that will allow you to open an IRA and make those investments. Although traditional brokers tend to shy away from IRAs with unusual assets, a select group of institutions actively court investors who want to go the extra mile with tailored IRA investments.
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Why self-directed IRAs are so attractive
The most obvious reason why investors consider a self-directed IRA is that for many people, their IRA is their largest source of potential investment capital. If you've saved in an employer 401(k) plan your entire career, then you could easily have hundreds of thousands of dollars locked up in retirement assets. Rolling that money to an IRA is easy when you leave work, but withdrawing it completely from your account has huge tax consequences. Therefore, being able to use IRA money without creating substantial tax liability is a big advantage that self-directed IRAs have.
In addition, self-directed IRAs allow you to get the tax benefits of a tax-favored retirement account with investments that can have much greater profit potential than a typical stock or fund. Just as venture capitalists often target specific businesses with strong prospects to outpace the crowd, so too can self-directed IRA investors pick and choose the best investments that could help their retirement accounts soar in value.
Real-estate projects are good candidates for self-directed IRAs. Image source: U.S. Navy, Wikimedia Commons.
Specifically, with some types of assets, it's hard to duplicate the potential returns of a particular unique investment. For instance, real-estate investors can use real-estate investment trusts to get general exposure to certain areas of the real-estate market, but REITs tend to move in line with national trends that won't capture the opportunities of a particular piece of property. Similarly, opening a particular franchise restaurant location is a lot different from owning shares of the franchisor.
The challenges of self-directed IRAs
Before you jump into self-directed IRAs, though, you should be aware of their risks. Tax rules surrounding self-directed IRAs are extremely complex, and one misstep can have disastrous consequences.
Source: alamosbasement on Flickr.
Three rules stand out as being particularly problematic. First, self-dealing rules prohibit you from investing IRA assets in a business in which you act as a corporate officer or hold a controlling interest. They also keep you from owning a vacation home that you use for your own personal benefit within an IRA. Second, whenever it's necessary to get financing for the purchase of an IRA investment, it's essential to avoid combining personal assets with IRA assets. And finally, a host of other confusing provisions apply, such as the requirement that IRA investments not generate more than a minimal amount of what's known as unrelated business taxable income.
If you violate these rules, you can jeopardize the entire tax-exempt status of your IRA, potentially making every penny of your retirement account immediately taxable and subject to penalties. So before you jump into a self-directed IRA, you have to get the help you need to understand exactly what you're investing in and whether it will run afoul of any of these provisions.
Be safe with your self-directed IRA
Finally, make sure to do research to ensure that the financial institution you choose to act as IRA custodian has a strong reputation for integrity and doesn't overcharge for its services. Some investors have lost money dealing with disreputable providers, and charges for self-directed IRAs typically run much higher than what you'll pay for a standard brokerage IRA.
For many investors, these added hurdles are enough to convince them not to follow through with a self-directed IRA. If you have the perfect investment and the willingness to embrace risk in order to see it through, then a self-directed IRA could be your best option to take advantage of a golden opportunity.
The article Why You Need a Self-Directed IRA originally appeared on Fool.com.
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