Retirement savings provide financial security and prepare you for reduced income during the latter stage of life. People who accumulate savings at a faster pace can retire sooner, or work fewer hours, to maintain a better work-life balance. A self-directed IRA is one resource that can shorten the path to retirement and remove financial stress from the later years of life. This article will explore how self-directed IRAs work and how you can use them to build wealth.
What Is a Self-Directed IRA?
A self-directed IRA is an individual retirement account that provides tax advantages and can grow your portfolio value. Investors can contribute to their retirement accounts each year in equal or lesser amounts than the contribution limit. The IRS adjusts contribution limits each year.
How Does a Self-Directed IRA Work?
Individuals utilizing these accounts can purchase investments in various asset classes. Contributions to a Traditional IRA are made pre-tax, allowing you to build wealth while deferring taxes. You will owe taxes on withdrawals taken at retirement age. However, most people are in a lower tax bracket after they retire, thus allowing you to keep more of your funds. The IRS also expands tax brackets over time due to inflation and other factors, which may result in additional savings.
Traditional IRA vs. Self-Directed IRA
Traditional and self-directed IRAs have the same contribution limits and tax deferral model. However, unlike traditional IRAs, self-directed IRAs give investors more flexibility with the types of assets they can invest in. Traditional IRAs typically can only hold stocks, mutual funds, bonds and other publicly traded assets. Self-directed IRAs can store real estate, crypto, and other alternative assets as well. This path allows investors to diversify their portfolios without being limited to a few asset classes.
What Can You Invest in a Self-Directed IRA?
Investors have access to many opportunities when they open a self-directed individual retirement account. Below are some of the assets you can buy in your self-directed IRA.
Real Estate
Real estate is a great asset that offers tax advantages, cash flow, appreciation, and other advantages. You can use your self-directed IRA to invest in real estate, but there are a few rules to keep in mind.
You and certain other disqualified persons cannot live in a property owned by your retirement account. Nor can you act as the property manager and collect the rent yourself. Rental income must either be sent directly to a property manager or the IRA custodian. In addition, if the IRA does not have sufficient cash to purchase the property, the IRA will need to take out a non-recourse loan which can be difficult and time-consuming. There are additional rules and considerations when using a retirement account to invest in real estate. You should perform research and become familiar with everything entailed before investing in real estate with your IRA.
Private Equity
Most investors focus on public markets, such as stocks and bonds. Private equity offers many choices that typically do not correlate with the stock market. In addition, private equity assets can generate higher returns than stocks and act as hedges during market corrections.
Precious Metals
Precious metals have a limited supply and act as an inflation hedge. These metals are essential for society; gold, silver, and other precious metals are used in critical technology and as resources. You can invest in these physical assets with your self-directed IRA. A depository will hold the asset for you in exchange for a storage fee.
Cryptocurrency
Cryptocurrencies have outperformed the stock market since Bitcoin launched in 2009. Some self-directed IRAs let you trade cryptocurrencies and will store them on your behalf. The best crypto IRAs have insurance policies that add extra layers of protection and secure your crypto in a cold wallet. Investors don’t need their own digital wallet to get started, nor can you move existing non-custodial crypto holdings to your IRA. Instead, investors can sell existing crypto, move the cash to their IRA, then buy crypto with the IRA funds.
Advantages of a Self-Directed IRA
Self-directed IRAs have many perks that make them worthwhile resources for people saving for retirement.
- Tax-deferred contributions: Each contribution to your self-directed Traditional IRA is pre-tax, and may be deductible if you meet the requirements, thus lowering your tax bill. Tax savings make it easier to invest each month. The IRS sets maximum contribution limits each year. Investors can contribute up to $6,500 in 2023; if you are 50 years or older, you can contribute an additional $1,000 to your IRA.
- Portfolio diversification: Self-directed IRA holders aren’t limited to public markets. They can also buy alternative assets like real estate and crypto. Spreading your funds across more asset classes will help create a diversified portfolio.
- Capitalize on a lower income bracket: You will owe taxes when you distribute funds at retirement age. However, most people will be in a lower tax bracket after they retire, so they pay fewer taxes. The IRS adjusts income brackets each year, which can impact investors favorably.
- Less correlation with the stock market: Alternative assets tend to be less correlated with the stock market. Real estate, precious metals, crypto, and other alternatives have their own catalysts and do not depend on the stock market by default. Some of these assets can become valuable hedges that provide cushion during stock market corrections.
Disadvantages of a Self-Directed IRA
While self-directed IRAs have significant advantages, investors should keep the disadvantages in mind. Every type of retirement account has strengths and weaknesses, including self-directed IRAs.
- Fees: Self-directed IRAs usually have higher fees than Traditional IRAs, especially for assets that require storage or other types of special treatment. These fees can be worth the extra expense if they enable access to assets that can better position you to reach retirement goals.
- Taxes on withdrawals: Tax-deferred accounts don’t completely avoid taxation. Instead, you will pay income taxes on your distributions. While there are ways to minimize this, it can catch some investors by surprise.
- Penalty tax if you withdraw funds too early: Self-directed IRA holders can be penalized for withdrawing funds too early. You must be 59 ½ years or older to withdraw funds. Younger IRA holders can withdraw funds earlier for eligible expenses without incurring the 10% penalty, such as higher education and qualifying medical bills. You must start withdrawing funds when you turn 73.
- Extra work: Self-directed IRAs require more work than Traditional IRAs since you have to find a broker or custodian that meets your needs. Having more assets to choose from also means more research and homework across a wider range of assets. Some investors enjoy this process in order to find compelling opportunities, but it’s not for everyone.
Rules and Regulations on Self-Directed IRA
Self-directed IRAs provide more flexibility than other IRAs, but you should keep important rules and regulations in mind. For example, the IRS requires cash flow from assets be deposited into your IRA instead of a personal account. Transactions with family, relatives and other people with your IRA funds are also not allowed. Consult a professional if you are unsure about a particular transaction violating these rules.
