Interested in a Self-Directed IRA? You Better Know Your Stuff

Self-directed IRAs have been around for years, but they’ve been gaining popularity recently among do-it-yourself investors looking to expand beyond stocks, bonds and treasuries.

But experts warn these retirement accounts aren’t for everyone. There are a host of pitfalls associated with self-directed IRAs that could end up costing you money if you aren’t careful.

“If you have complete confidence that you have the time, energy and understanding to run an account then it gives you some direction which you may not have with traditional stocks, bonds and mutual funds,” says Andy Smith, certified financial planner at The Mutual Fund Store. “The problems we’ve seen seem to outweigh the benefits.”

When it comes to self-directed IRAs there are two types: self-managed and self-directed.

Self-managed IRAs are offered by big brokerages and online trading firms like E*Trade and Charles Schwab and let you choose the stocks, bonds, mutual funds and treasuries to invest in. This type tends to provide you more control of your retirement savings beyond choosing the type of mutual fund.

A self-directed IRA involves a custodian holding your money in the account and makes investments in things like real estate, private placements and metals for you based on your directive. Self-directed accounts put more responsible on you, meaning you have to understand all the rules governing any particular investment and the tax implications. Not to mention you’ll have to do your own due diligence when choosing investments.

While self-directed IRAs can earn a bigger profit than a mutual fund because you can choose among a wider range of investments, they come with great risk, says Clarence Kehoe, executive partner in accounting firm Anchin, Block & Anchin.  “With custodians, they will hold your assets for you but they are not responsible for any tax consequences out there,” he says. “You are not getting any instructions or guidance.”

In addition to being on your own, Smith says investors often get in trouble over the self-dealing rules for real estate and other investments. In order for investors to get the tax benefits of a self-directed IRA or Roth IRA they are prohibited from buying an investment from or selling an investment to a disqualified person: spouses, parents, themselves as the owner of the IRA, etc.

For instance, you can’t use money from your self-directed IRA to buy a rental property for your own personal use.  “Renting the property to yourself is a prohibited transaction. All the tax benefits you set yourself up for will all of sudden go away,” says Smith, noting in one recent case an investment had to be unwound because there was compensation directly paid to the holder of the IRA account.

If you invest in a traditional IRA, the money grows tax deferred and with a Roth IRA tax free but that could quickly change with a self-directed IRA if you unwittingly invest in something that generates more than passive income.

For instance, if you invest in a manufacturing business that is generating income and it’s paid out to you in a form other than a dividend, it has to be recognized as income and taxed accordingly, says Kehoe.  “If it gets missed six years or 10 years later it comes up that you had unrelated business taxable income or UBTI you should have been paying taxes on you’ll get hit with tax, penalties and interest,” he says. “A lot of people step into these things not really knowing the rules and they miss this stuff.”

There’s also tax implications if a self-directed IRA account holder makes an investment and there is debt associated with it, says Kehoe.  It’s common for real estate investors to put down a percentage to buy the rental property and then borrow the rest from a bank. Because there is debt finance involved, some of the investment income could be taxable.  He notes that for older people who hit 70 and a half and are required to take annual distributions, they may have a hard time determining the value of their investments if it’s not stocks and bonds. Valuing may not only cost the investor some money if they need to get an appraisal done on the rental property or a valuation on the business they invested in, but it could mean tax penalties if they improperly value the investment and take the wrong annually required minimum distribution.

At the end of the day, there are risks and rewards associated with self-directed IRAs granted you’ve done all your homework and know what you are getting into. According to Hubert Bromma , CEO of Entrust Group, a self-directed IRA custodian company, real estate and private placements are the most popular areas investors are putting their money to work, but precious metals are also gaining steam.

“Anybody who thinks their money will grow and they don’t have to do anything or doesn’t know anything about investments, this doesn’t make sense for them,” says Bromma. “It does make sense for somebody who is involved and understands the investment they choose.”