What is Self-Directed IRA
Self-Directed Individual Retirement Arrangement (IRA) are gaining popularity and is the right choice for those investors who want to leverage their understanding and knowledge of an industry or an asset class to maximize returns from their investments.
Types of IRA
There are several types of IRA, and the one that is ideal
for you would depend on your employment and tax status. But whatever type of IRA you may chose to invest, it can be set up as self-directed IRAs.
* Traditional Individual retirement account –
A Traditional IRA is a tax-advantaged savings account. It typically involves depositing IRA money with a bank or brokerage, which would act as the custodian of the account an
d also controls where the money is invested. The array of investment options in a traditional IRA is generally limited to stocks, mutual funds and CD’s. The main advantage of a Traditional IRA is that contributions are often tax-deductible. However the decision whether to invest in a Traditional IRA or not would weigh on your current tax slab and the expected tax slab at the time of retirement. If you currently fall in a higher tax slab and you expect to be in a lower tax slab at retirement, traditional IRA is the one for you. Another important advantage of Traditional IRA is that at any point in time it can be
converted to a Roth IRA.
* Roth IRA –
Contrary to what we have in Traditional IRA, contributions in a Roth IRA are not exempt from tax, while withdrawal from a Roth IRA is exempt from tax. As compared to other tax advantaged IRAs, a Roth IRA has lesser restrictions on the kind of investments that can be made. Again in case of a Roth IRA, withdrawals can be done anytime after the completion of seasoning period which is generally five years, which is not the case in Traditional IRA. Early withdrawals from a Traditional IRA would attract tax and penalties.
* SEP-IRA-
An SEP-IRA is a Simplified Employee Pension Individual Retirement Arrangement and is very similar to the Traditional IRA, but is labeled as a SEP IRA as it is generally adopted by employers for the purpose of providing pension benefits to the business owners and the employees. The contribution made by the employer on behalf of the employee is tax deductible for the employer. The employee as well is not required to pay tax on the contributions made by the employer on his behalf. Some reasons why employers chose a SEP IRA over a traditional IRA is because of the lower eligibility requirements and the freedom to skip contributions in those years, when the business is not doing well enough.
* Rollover IRA –
A rollover IRA is established with a purpose to accept money transferred or “rolled over” from another qualified retirement account, which in most cases is an employer-sponsored plan such as a 401(k) or 403(b). You may also roll over your funds from one IRA to another IRA. The primary purpose of roll-over is to avoid huge taxes and penalty that are applicable on premature fund withdrawals. The applicable taxes and penalties can wipe off about 45% of your investments. Typically when people change their jobs, they wish to cash out of their existing retirement account but since cashing out would involve payment of hefty taxes and penalties, it is preferred to roll over the funds from employer sponsored pension account to a traditional IRA and such a transfer of funds would not attract any tax. There are certain rules to be followed while executing a roll over and one should be mindful of the same.
* Simple IRA –
Like an SEP IRA, a SIMPLE IRA plan (Savings Incentive Match Plan for Employees) is employer sponsored, but unlike SEP IRA where employer is the 100% contributor to the plan, employees as well contribute to the SIMPLE IRA. Only organizations with 100 or fewer employees are eligible for initiating a SIMPLE IRA.
Who should invest in Self-Directed IRA?
Self-directed IRA give you active control of your investments, over and above the benefits of tax free profits and tax deductions associated with a traditional IRA. So only if you have conviction in your ability as a person to leverage your knowledge for maximizing the profit of your IRAs investment, then you should certainly opt in for a self-directed IRA. Besides self-directed IRAs also allows you a wider array of investment options. In a self-directed IRA, you may also invest in rental property, foreclosure property, if the custodian allows for the same.
Setting up a self-directed IRA account
A self-directed IRA can be established either as a Self-Directed IRA Limited Liability Company or a Solo 401k or Business Funding Plan/Self-Directed 401k or by utilizing an approved Self-Directed IRA custodian.
In case of Self-Directed IRA LLC, you can establish it in the state of your choice and the cost of doing so can be anything $25 to $1,000. Under this format, the IRA as the owner of the LLC will carry out business on behalf of the IRA. Once this is done, get an account with a custodian, which would allow for self-directed IRAs and then open a bank account in the name of the LLC in order to carry out receive and pay money related to the self-directed IRA.
Self-Directed IRA Investment Options –
The best thing about a self-directed IRA is the range of investments options you have. Some of the best IRA investments options available are real estate (income generating rental properties, commercial buildings), private placement, traditional investments like stocks, bonds, CDs, notes and precious metals.
Pros and Cons of Self-Directed IRA
The main advantages of a self-directed IRA is that you have control over your investment, you can leverage your understanding about a particular asset/industry to maximize returns, and the range of options that you have while selecting your investments. As you have a wider range of asset class to invest in, it helps in properly diversifying.
The obvious con of investing in a self-directed IRA is that you may mess up, if you are not very well aware about the rules of investing. The other con of self-directed IRA is the higher fees charged by the custodian.
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