Self-directed IRAs have been on the rise. As opposed to traditional IRAs, a self-directed IRA allows an individual to have complete control when it comes to selecting and directing investments in an IRA (Individual Retirement Account).
Growth of Self-Directed IRAs
While self-directed IRAs have been permitted since 1975, they have seen increasing use in recent years by investors interested in allocating to alternative assets. The SEC estimates that nearly 2% of all IRAs are self-directed, with assets estimated at $100 billion. Millennium Trust Co., one of the largest custodians of self-directed IRAs, saw a 732% dollar increase in its self-directed IRA assets in 8 years, handling $733 million in assets in 2005 to $6.1 billion in 2013. Another well-known self-directed IRA custodian, Pensco Trust, experienced a 587% dollar increase in 5 years, handling $1.5 billion to $10.3 billion in five years. Below are some key benefits of using self-directed IRAs that provide insight into their growth.
Four Benefits of Using Self-Directed IRAs
1. Those with self-directed IRAs are not limited to traditional investment options.
IRAs are typically limited to a small universe of traditional investment options such as stocks, bonds, and mutual funds. Self-directed IRAs, on the other hand, provide the option to invest in alternative investments such as:
- Real estate
- Private equity
- Foreign currencies
- Foreign property
- Privately-held businesses
- Precious metals (i.e. gold)
- And more
2. Having a self-directed IRA allows investors to invest in alternative investments, providing greater portfolio diversification and a way to protect themselves against market volatility.
Widely considered a sound investment strategy, diversifying an investment portfolio with illiquid alternatives can have the positive effect of mitigating market volatility. Traditional investments such as stocks and bonds are often correlated to market trends and thus exposed to market risk. Therefore, investors typically look for portfolio diversification by including alternative investments (known to display low correlation to traditional investments). Beyond portfolio diversification, alternative investments have the potential to enhance a portfolio’s risk return profile.
While the benefits are great, it’s also important to note that alternative investments typically have a longer lock-up period and are less liquid than traditional investments. Investors should consider their risk profiles and need for liquidity when reviewing alternative investment opportunities.
3. Investors have more control and influence in investment decisions and portfolio allocation.
Traditional IRAs typically depend on third parties to make investment decisions on their behalf. Want to invest in gold, timber, or a startup company? The choice is 100% up to the account holder of a self-directed IRA. With this freedom comes more responsibility, however. While we’ll dig deeper into the challenges of having a self-directed IRA a little later, investors who are knowledgeable and understand exactly what they are investing would benefit most from opening self-directed IRAs. For instance, those very familiar with real estate would be able to leverage their knowledge by investing in property via their self-directed IRA.
4. Tax Benefits
Traditional IRAs offer tax-deferred growth, allowing account holders to pay taxes on their investment gains only when the retirement money is withdrawn. Furthermore, Roth IRAs offer tax-free growth so the account holder does not owe any tax when withdrawing retirement funds. These same tax benefits apply to self-directed IRAs. Any income generated from alternative investments goes directly into the retirement account on the same tax-free to tax-deferred basis as a traditional IRA.
Challenges of Having a Self-Directed IRA
1. Investors/account holders are responsible for performing their own due diligence
It’s important to know what custodians will and will not do for self-directed IRA accounts. Custodians will typically receive, document, and report all deposits into a self-directed IRA account, as well as send funds to invest and receive income from investments. In regards to the IRS, custodians typically help with recordkeeping required by the IRS and help handle the reporting of investment activity. A custodian will hold assets and administer the account, but they will not help analyze and choose investments. As such, custodians are not responsible for conducting due diligence for a self-directed IRA. The account holder/investor will be 100% responsible for selecting and performing due diligence on investment opportunities.
2. Limited to certain types of alternative investments
While a self-directed IRA provides investors a wider range of investment options compared to a traditional IRA, there are certain investments prohibited from being included in a self-directed IRA. Some of the prohibited investments include:
- Collectibles such as artwork, coins, stamps, rugs, and other personal property
- S-corp shares
- Insurance contracts
- For a list of other prohibited IRA transactions, visit here.
While there are many benefits and potential upsides associated with opening up a self-directed IRA account, it may not be for everyone. Who would make a good account holder of a self-directed IRA? Someone with experience, knowledge, and expertise in investing in the asset class they would like to put towards their account. For those that fit this bill, self-directed IRAs provide great potential and upside when it comes to saving and investing for retirement. Furthermore, as online technology platforms such as DarcMatter provide investors with greater access to alternative investment opportunities, investors can leverage these tools in tandem to better source deals and allocate their funds.
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