A self-directed IRA (SDIRA) can help investors planning for retirement access a variety of alternative investments. As you explore your retirement saving options, it is a good idea to consider setting up this account if it fits your needs.
Ready to learn more about self-directed IRAs? Let's take a closer look at how they work, how to set up a self-directed IRA, and what the best self-directed IRA might be for you!
What is a Self-directed IRA? (Self directed IRA definition)
If you are exploring your retirement savings vehicles, you have likely encountered the traditional IRA and Roth IRA as tax-advantaged options. Well, a self-directed IRA is a type of individual retirement account, which is governed by the same IRS rules as a traditional IRA and Roth IRA. And like other IRAs, the contributions made to this investment vehicle enjoy tax advantages.
Can a traditional IRA be self directed?
The answer is yes, but there are some differences. Unlike other IRAs, a self-directed IRA can unlock access to alternative investments that are typically not available within an IRA. These alternative investments are the major differentiator between SDIRAs and other IRAs.
Generally, IRAs have limited investment options. For instance, stocks, bonds, mutual funds, ETFs, and certificates of deposit. While these types of investments are useful ways to build wealth, there are investors who want to have more options.
That’s where a self-directed IRA comes in. With an SDIRA, you can access much broader investment categories that a traditional brokerage does not have the expertise to offer. You'll need to choose a provider that offers expertise in alternative investment types. For instance, real estate, limited partnerships, commodities, precious metals, livestock, cryptocurrency, and more.
Advantages of a self-directed IRA
With a self-directed IRA, you gain more power and control over your investment options and choices. Instead of facing limited options, you can take control and choose the investments that make sense to you.
Additionally, you may also choose to tap into investments that tie into causes or companies that are meaningful to you. As a result of doing this, you can create broader diversification in your portfolio.
You will, however, face greater responsibility for your investment choices. Typically, self-directed IRA investors have more risks built into their portfolios. Therefore as an investor with this vehicle, it's important to understand your risk tolerance. You also need to ensure you do your research to protect yourself against fraud.
Choosing the best self directed IRA and how to set up a self-directed IRA
Now that you know a little bit more about what a self-directed IRA is let’s explore how to set up a self-directed IRA.
Choosing the best self-directed IRA provider
As mentioned earlier, most traditional banks and brokerage firms do not offer SDIRA accounts. However, you can open an account with a company that has the expertise and specializes in SDIRAs.
Some of the bestself directed IRA providers include:
Keep in mind that when it comes to determining the best self directed IRA for you, it's important that you do your research.
The funding process
Once you open the account, you can add funds from your preferred account. You can take action on funding your account in three ways:
Of course, you can open an SDIRA and start making contributions directly into the new account. You can make direct contributions via check deposits, automatic, or via one-time bank transfers.
With either a Roth IRA or a traditional IRA, you will have to take note of any contribution limits established by the IRS, even if you choose the self-directed IRA option. As of 2021, you are able to contribute up to $6,000 per year into a traditional or Roth IRA, either of which can be self-directed.
If you choose to work with a traditional IRA, you won’t have to deal with any income restrictions. If you choose a Roth IRA, there are income limits to be aware of along the way.
For 2021, married couples filing jointly are able to contribute up to $6,000 to a Roth IRA if they have an Adjusted Gross Income of $198,000 or less.
On the other hand, if you are a married couple filing jointly that earns over $208,000, you will be unable to contribute to a Roth IRA.
Do you have a different kind of retirement account, such as a 401(k) or 403(b)? You can roll these funds over into a newly opened SDIRA through a direct or indirect rollover.
In a direct rollover, no funds will need to be withheld for taxes. In an indirect rollover, you will receive the funds through a check or wire transfer that will require you to pay a distribution fee of 10% to 20% and then deposit the funds into your new SDIRA within 60 days.
Transfers from an existing IRA
Already have an IRA set up at another institution? You can transfer the funds into the same type of retirement account. For example, if you have a traditional IRA at another institution, you can transfer your funds into a Traditional SDIRA and reinvest the money. The same would apply to Roth IRAs as well.
The investing process
When you open up a self-directed IRA, your SDIRA provider will act as a recordkeeper for your account. That said, you have to power and control to make investments within your IRA that fit within your investment goals. Once you open and fund your account, you will have the ability to choose your investments.
It's very important that you research every investment before you make it since SDIRA providers do not offer investment advice or financial guidance. A financial advisor can help if you need specific investment, tax, or other financial guidance.
Once you've decided what investments will work best for your portfolio, you can make your investments in your SDIRA account.
Example of a self-directed IRA
Now let's get into an example of how a self-directed IRA works. Let’s say that you open a self-directed IRA account. Making this choice allows you to invest in a wide range of assets that most retirement funds typically won’t allow. These assets include:
- Private equity, private placements, LLCs, Limited Partnerships, joint ventures, startups
- REITs, residential real estate, commercial real estate, mortgage notes
- Microloans, oil investments, livestock
- Hedge funds, precious metals, and more.
Throughout the process, you will be responsible for choosing the appropriate investments for your situation. Additionally, as the record keeper, your SDIRA account provider will keep track of the types of investments you make.
That being said, it's important to keep in mind that you can’t invest in insurance, collectibles, and S-corporations.
Rules and regulations
Based on regulations from the U.S. government, individual retirement accounts must be overseen by a financial institution. With other types of IRAs, the overseeing financial institution often limits the types of investments the account owner can make through the account.
However, with a self-directed IRA, the overseeing financial institution opens up the possible types of investments for the account owner. Instead of being limited to particular asset classes, most account owners are able to make a wide range of untraditional investments within their IRA.
As you build your investments, you will need to stay vigilant to prevent any prohibited transactions. The IRS defines a prohibited transaction as the improper use of your IRA by you or a disqualified person.
An example of a prohibited transaction includes the sale, exchange, or lease of property between your IRA and a disqualified person. In addition, an example of disqualified persons includes family members, beneficiaries of the IRA, or anyone involved in the administration of your IRA.
Who can benefit most from a self-directed IRA?
A self-directed IRA offers a great opportunity to take control of your retirement investment strategy. In most cases, experienced investors will benefit most from this account. With the right knowledge in place, experienced investors are in a unique position to capitalize on the benefits of a self-directed IRA.
In other words, if you aren’t an experienced investor or want to preserve a more liquid portfolio, then the alternative investment opportunities of a self-directed IRA may not be the best choice for you.
In conclusion: A self-directed IRA can be a great choice
By doing your research, assessing your risk tolerance, and choosing the right provider, a self-directed IRA can be a great choice. Before you dive in, however, it's important that you understand how investing really works.