How to Determine If a Self-Directed IRA Is Right for You
The world of investing is changing. What with market volatility, decreased returns, and longer life expectancy, traditional investments like stocks and bonds may no longer be enough to help you build the retirement nest egg you need. Retirees are also finding that Social Security, even when paired with 401(k) or IRA savings, simply isn’t enough to sustain them through retirement.
Therefore, it’s likely that pre-retirees and future-thinking young professionals need to get creative with their retirement savings plans and consider investing in nontraditional assets.
Investing in nontraditional assets like real estate is increasing in popularity, so many investors are already familiar with the process and benefits of investing outside Wall Street. Additionally, real estate and many other nontraditional assets may provide better returns over the long term than most traditional assets. They can also offer more options for income cash flow.
Contrary to popular belief, you can invest retirement savings in nontraditional assets without sacrificing the tax benefits you’re accustomed to when you invest in stocks, bonds, and mutual funds through regular retirement accounts.
You can do this by investing in a self-directed IRA (SD-IRA).
Of course, SD-IRAs aren’t for everyone. SD-IRAs often require more research and oversight from you, the investor, than regular IRAs. SD-IRAs are also subject to complex regulations, which can be daunting to some investors.
However, the benefits of an SD-IRA to diversify your portfolio and potentially generate higher returns on your investments cannot be overstated. To learn more, keep reading to determine if an SD-IRA is right for you and your goals.
What Is a Self-Directed IRA?
Regular IRAs and 401(k)s (whether Roth or traditional) only allow investments in certain types of asset classes – stocks, bonds, mutual funds, and the like. An SD-IRA, on the other hand, allows you to invest in nontraditional assets, such as real estate and private equity, while retaining the tax benefits inherent to regular retirement accounts.
This is because the institutions that hold regular IRAs manage such a high volume of accounts that they are not able to provide the regulatory oversight required to invest in nontraditional assets.
An SD-IRA allows you to choose from the entire spectrum of investment assets available to you: residential and commercial real estate, private equity, hedge funds, precious metals, cryptocurrencies, venture capital, peer-to-peer lending, and more.
(In fact, it’s actually easier to list options you’re not allowed to invest in with an SD-IRA, which include life insurance policies, collectibles, and real estate properties you already own.)
How a Self-Directed IRA is Different From a Regular IRA
Besides offering a much wider range of investment options, SD-IRAs differ from regular IRAs in other ways. Most notably, an SD-IRA is truly self-directed.
You must do all the research on the assets you’re looking to invest in, and you must actively search for investment opportunities. Unlike the wide array of options curated for you by regular IRA and 401(k) administrators, there’s no database to choose your investments from.
With that being said, your SD-IRA still needs to be held by an administrator (also known as a custodian), but the role this administrator plays is much different than the role a traditional financial institution plays.
An SD-IRA custodian administers your plan and acquires the assets you direct them to purchase, but they do not research or manage your account for you. Instead, they’re essentially the compliance experts that help you adhere to IRS regulations for these types of investments.
What Do You Plan to Invest in?
To determine whether an SD-IRA is right for you, you first need to be clear on what you plan to invest in.
For example, if you’re a current real estate or venture capital investor using after-tax dollars to purchase your investments, it may be time to consider an SD-IRA. When you’re already familiar with a particular nontraditional asset class, an SD-IRA can be a logical next step to continue growing your portfolio and preparing for retirement.
If, on the other hand, you are only comfortable (and indeed, content) with investing in stocks, bonds, mutual funds, and ETFs to build your retirement nest egg, you may have no reason to consider an SD-IRA.
Advantages of a Self-Directed IRA
For those who are planning to grow their wealth with nontraditional assets, SD-IRAs pose a number of advantages, not the least of which are the tax benefits described above, as well as the expanded freedom to choose from a wider array of investment options.
SD-IRAs may also help you to grow your retirement wealth faster, as many nontraditional investments can provide higher returns than stocks and bonds, offset your portfolio against market volatility, and generate more consistent cash flow on a monthly or quarterly basis.
Additionally, the option to invest in assets outside of Wall Street allows for greater diversification opportunities. In fact, many investors with an SD-IRA still invest in stocks and bonds, just not exclusively. Many nontraditional assets are less volatile than the stock markets, although they may still carry high risk.
Disadvantages of a Self-Directed IRA
But SD-IRAs certainly aren’t for every investor, and they can pose risks for inexperienced and experienced investors alike.
The rules governing SD-IRAs – known as prohibited transactions – are complex. Failing to adhere to these rules can cost a significant amount in penalties to the IRS – sometimes amounting to more than the original cost of the investment itself!
But with a good SD-IRA custodian, you don’t have to worry as much about not following rules you don’t know about.
And even though SD-IRAs offer more opportunities for diversification, investors with an SD-IRA risk being underdiversified if they only use an SD-IRA, especially one which only holds a few expensive assets that fall within the same asset class. For example, an SD-IRA that only holds three rental properties and nothing else may be considered underdiversified.
Finally, many nontraditional assets held in SD-IRAs are illiquid compared to stocks, bonds, mutual funds, and ETFs. While illiquid investments can typically be planned for, some investors may find themselves in a bind if they face an unexpected emergency. And unfortunately, the thing about most emergencies is just that – they’re usually unexpected.
How Chicago Trust Administration Services Can Help
Despite these risks, an SD-IRA can still make sense for many investors, especially as many of the disadvantages above can be planned for and mitigated when you partner with the right custodian. At Chicago Trust Administration Services, we’ve been helping investors self-direct their futures for seventeen years.
If you’re still wondering whether an SD-IRA is right for you, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com. We look forward to sitting down with you to discuss your options.