During his presidential run, Mitt Romney came under scrutiny when it came to light that he had acquired something of a fortune in his self-directed IRA. According to Forbes.com, Romney’s IRA was worth between $20.7 and $101.6 million. How did he acquire such wealth in a qualified plan environment?

The answer lies in the descriptor “self-directed.” Because Romney this had a self-directed IRA (aka SDIRA), he was able to use his IRA to fund venture capital and private equity investments inside his retirement account. When Bain Capital (in which Romney was a founding partner) became highly successful, Romney’s wealth ballooned.

While few people have the ability to turn limited retirement plan contributions into many millions, the financial container Romney used to grow his investments tax-deferred is not reserved for multi-millionaires. Any American can open a self-directed IRA and use it to invest in (almost) anything they wish.

In this article, we outline self-directed IRA pros and cons and the basics of self-directed IRAs, including:

• What is a self-directed IRA?
• What can you invest in within a self-directed IRA?
• What are self-directed IRA pros and cons, advantages and disadvantages?
• Who might benefit from one?
• What is the process and how do you begin it?

Then at the end of this article, we’ll list links to additional resources for further information.

What is a self-directed IRA?

A self-directed IRA is a type of traditional or Roth IRA. It has the same eligibility and contribution rules as other IRAs. The difference with a self-directed IRAs is the type of assets you can own in the account.

Typically, you would hold only stocks, bonds, mutual funds and other investments commonly sold by a bank or brokerage firm in an IRA. By contrast, you can hold almost any investment in a self-directed IRA, such as farmland, interest in a business, precious metals or a mineral rights lease.

Although many people have never heard of self-directed IRAs, they are anything but new. Self-directed IRAs started in 1974 when the Employee Retirement Income Security Act of 1974 (ERISA) ushered them into existence. Roth IRAs were created with the Taxpayer Relief Act of 1997.

They aren’t that well known (even amongst accountants and advisors) because financial institutions offering very limited choices have been the main force behind the proliferation of IRAs. In other words, banks and brokerages offer IRAs filled with the bank CDs, stocks, bonds, or mutual funds they sell. Yet according to TrustEtc.com, “Investing in alternatives to stocks, bonds, and mutual funds has always been allowed by the IRS (see IRS Publication 590).”

What can you invest in?

In the romantic comedy Hitch, Albert Brennaman, an awkward accountant, played by Kevin James, catches the attention of the Allegra Cole, the beautiful heiress played by Amber Valletta. Cole wishes to invest in her friend Maggie’s new fashion business. She receives a dismissive response from the lead advisor who suggests that they put together some “appropriate investments” for her to consider instead.

What happens next is great fun and a turning point in the plot. And while the fictional heiress was not concerned about an IRA, if Allegra Cole had a self-directed IRA, this type of investment could indeed be made inside of it.

Investments that can be made inside of a self-directed IRA include:

• passive interest in business partnerships
• a peer lending portfolio
• real estate or land (although rules and restrictions apply)
• bridge loans and mineral rights leases
• tax liens
• gold or other precious metals
• crypto-currencies
• individual stocks
• life settlement funds (which purchase life insurance policies from seniors who no longer want or need them).

(Note: Just because something is on the list above does not mean we endorse the investment! We invite you to talk with Kim to discuss self-directed IRAs.)

There are a handful of investments that are NOT allowed in a self-directed IRAs, including:

• Life insurance
• Collectibles and antiques
• Certain types of derivative trading
• Property that you or a family member live in, rent, or currently own.

Now, let’s look at self-directed IRA pros and cons.

What are the advantages of a self-directed IRA?

Diversification. The ability to utilize different asset classes is a big advantage of a self-directed IRA. Unfortunately, qualified plans have become almost synonymous with “mutual funds,” leaving most investors at the mercy of stock market downturns.

Leverage your intellectual capital. Do you have unique experience and expertise? The ability to potentially leverage your knowledge and skills can be an important advantage of self-directed IRAs.

Tax advantages. As with other traditional and Roth IRAs, self-directed IRAs (traditional or Roth) will either allow you to:

• defer taxes  in a self-directed traditional IRA, or
• avoid taxes on investment gains when investing with after-tax dollars in a self-directed Roth IRA.

Creditor protection. As with other IRAs, self-directed IRAs can protect assets from creditors under bankruptcy law—often up to one million dollars. However, the protection varies from state-to-state, so be sure to research the rules in your state. 

What are the disadvantages of a self-directed IRA?

Risk. Just as a self-directed IRA allows you to invest in nearly anything, it also allows an investor a wide range of risk. For instance, putting money into Bitcoin, other cryptocurrencies, or ICOs (initial coin offerings) is extremely risky business. It is not, however, prohibited in a self-directed IRA.

Unfortunately, self-directed IRAs can be used as a stamp of legitimacy on questionable schemes. If you are told the IRA custodian has “vetted” or “approved” of the underlying investment, that could actually be a warning sign. As the SEC notes, custodians generally don’t evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.” That it is your job—so do your due diligence and keep track of your balances.

Fees. You will typically pay additional fees to open and maintain a self-directed IRA. This is because IRA custodians do not earn fees for assets under management as a brokerage firm would.

These fees might be a disadvantage for someone with a very modest IRA, as it represents a larger percentage of the investment. For larger IRA balances, the fees are well worth the advantages and opportunities.

For instance: $500 would represent five percent of a $10k IRA balance. If you wanted to invest in peer lending just a few thousand dollars, it would be more efficient to do so outside of an IRA. With a $100k IRA balance, the fee could be well worth the opportunity. By investing in non-correlated assets in a self-directed IRA, you can balance your portfolio and protect yourself from stock market volatility.

Of course, the unique investments you choose to put in a self-directed IRA may also have additional fees. While fees should always be considered, it is important to consider the big picture, the risk profile, and the “net” profits of potential alternative investments.

Time. It may take more time or effort to explore your options, educate yourself or use your expertise with a self-directed IRA. On the other hand, while defaulting to hands-free “automatic” investment options such as target date funds may be easier, that does not make them better!

Rules. You may encounter restrictions within a self-directed IRA. For instance, if you use your IRA to purchase real estate, you cannot use the property yourself—not even intermittently. You cannot live there, stay there, or rent office space to yourself there. There’s a strict “no self-dealing” rule that will even prevent you (for instance), from making your own repairs, because now you’ve “furnished services” to the asset owned by the IRA. That can turn into a big problem if the IRS finds out!

Financing a property is also more complicated. Typically a non-recourse loan is required, also a larger down payment than if you were purchasing property as an individual. And remember—any profits generated are now also part of your IRA and subject to qualified plan rules and restrictions.

Who can best benefit from a self-directed IRA?

A self-directed IRA is ideal for an investor who has knowledge or expertise in a particular field or investment and enjoys having greater involvement with their investments. A self-directed IRA is also desirable for anyone invested primarily stocks and bonds who understands the advantage of asset allocation and diversification.

A self-directed IRA is especially attractive to investors who have built up lump sums of $50k or more and/or accredited investors. While almost anyone can utilize a self-directed IRA,  accredited investors (those with a net worth of $1 million or income of $200k, or $300k for joint income) have access to a wider range of investments.

What is the process for beginning a self-directed IRA?

Many investors start the process by researching IRA custodians. However, this is the wrong place to begin! That’s because many IRA custodians work with a limited number or type of investments. Too many people choose a custodian first then discover that custodian doesn’t deal with the investment they want!

First, you want to understand and select the investments you wish to hold in your self-directed IRA. Research the pros and cons. Find out investment minimums and investor requirements, if any. Understand any specific rules that may affect your flexibility or control with that investment. Know what your investment “exit strategy” will be. Be aware if there are issues with taxation, such as Unrelated Business Income Tax (UBIT) that might make certain investments problematic.

(Booking a complimentary call with Kim Butler can be a great way to get some of these questions answered, but always do your own due diligence as well.)

How can you learn more about self-directed IRAs?

We have several resources listed below that can help you better understand different aspects of self-directed IRAs. Additionally, by contacting us directly, we can give you more detailed information about the process and investments that can be held in an IRA.

From The Prosperity Podcast:

“Self-directed IRAs: The Lesser-Known IRA”

“Learning More About Self-Directed IRAs”

Articles from the Prosperity Blog:

“The Best Investments for Your Retirement Account”

“The Self-Directed IRA: Alternative Investments for Your Retirement Account”

“5 Assets that Don’t Belong in your Retirement Account”

Book a call with Kim Butler.

Want to find out more about opening a self-directed IRA? We invite you to schedule a call. In addition to being a best-selling financial author, Kim Butler has been named an Investopedia Top 100 advisor three years in a row. Partners for Prosperity specializes in alternative solutions and we are here to help!

Alternately, if you have a quick question, you can leave a comment or send us an email. We look forward to serving you!