Pros and cons of self-directed IRAs
Cash Flow and Retirement
Traditional bank and investment firm IRAs typically allow you to select from a menu of stocks, bonds and mutual funds. If you’d like more control over how your retirement dollars are invested, you might want to consider a self-directed IRA. Offered by certain financial institutions, self-directed IRAs give you nearly complete control over investment decisions.
Along with greater diversification and potentially higher returns come significant risks and disadvantages. For starters, many alternative investments are more volatile than traditional investments. And you’ll need to conduct your own due diligence and oversee your account’s assets. So before you choose this option, review both the potential risks and rewards.
Many self-directed IRA holders are attracted by the wide array of traditional and alternative investments available. These include real estate, closely
held stock, LLC and partnership interests, options, hedge funds, oil and gas, mineral rights, timber, and even certain precious metals and coins. Those who choose this type of IRA should be knowledgeable and experienced investors willing to research investments and monitor their portfolios closely.
But even if you do most of the investment “work” yourself, you may pay more in expenses than traditional IRA owners. This is because account custodians usually charge annual fees, plus fees for each transaction.
There’s another pitfall of self-directed IRAs: “prohibited transactions.” Under the Employee Retirement Income Security Act (ERISA), dealings are prohibited between an IRA and certain “disqualified persons,” including you, certain members of your family, businesses that you or your family control, and certain advisors. Among other things, a disqualified person can’t:
- Sell property to or buy property from the IRA,
- Provide goods or services to it,
- Lend money or guarantee a loan to it nor pledge its assets as security for a loan,
- Receive compensation from it, or
- Personally use its assets.
If you engage in a prohibited transaction, the consequences generally are severe. Your IRA could lose its tax-advantaged status and its assets will be
deemed to have been distributed to you on the first day of the year in which the prohibited transaction took place. This distribution immediately triggers income taxes and, in many cases, a 10% early withdrawal penalty.
Prohibited transaction rules make it difficult — if not impossible — for you or your family to actively manage a business, real estate or other assets held by your self-directed IRA. Suppose, for example, you invest in rental real estate and perform certain repairs and maintenance yourself. If the IRS finds out, it’ll likely claim that you violated the prohibited transaction rules by providing services to the IRA. So, while a self-directed IRA gives you control over how funds are invested, once you make an investment, you'll need to accept an essentially passive role in it.
There’s another potential risk. Self-directed IRAs can invest in physical assets such as precious metals or coins, but only if they’re in the possession of the IRA custodian. In a recent U.S. Tax Court case, a taxpayer learned this lesson the hard way. The taxpayer set up an LLC within a self-directed IRA and had the LLC purchase gold coins. However, even though the LLC held legal title to the coins, the taxpayer kept the coins in a safe at her
home. The court ruled that, because the taxpayer “had complete, unfettered control over the … coins and was free to use them in any way she chose,” she had received a taxable distribution equal to the value of the coins.
Other investments by a self-directed IRA, although allowed, may generate unrelated business taxable income or unrelated debt-financed income. For example, income earned by the IRA on investments in unincorporated operating companies or debt-financed property may be subject to current taxes because the income is unrelated to the IRA’s tax-exempt purpose (to save for retirement). You’ll need to consider these taxes when selecting investments for a self-directed IRA.
Dicuss your plans
Self-directed IRAs offer owners investment flexibility but also present real risks and a need for careful adherence to regulatory rules. Before opening an account, discuss your plans with your Lenox advisor and accountant.