What are potential downsides of a Self-directed Retirement Account? David Moore with IRA Advantage answers this common investor question with tips on how to avoid investment missteps and make this powerful investment tool work for you:
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What Are the Downsides to a Self-Directed Retirement Account?
The only true downside I see to a self-directed IRA is that you don’t have a safety net to prevent you from participating in a prohibited transaction. With a Wall Street IRA, you’re going to work with a financial advisor and you could make a bad investment, but you’re not going to have the opportunity to commit a prohibited transaction. But self-directed retirement accounts typically don’t have any safety net. If you’ve got a basic self-directed IRA, you’re going to work with a custodian, submit an Investment Authorization to the custodian along with a Prohibited Transaction form, and you’re going to give them information.
With a checkbook IRA, you truly have the power of the pen. If you want to do something incorrectly, you can do that. A solo 401k plan, self-trustee, works the same way. You’ve got the power of the pen to make an investment, so you’ve got to be diligent every time you write a check. You have to understand whether it’s truly for an investment and that the uses of these investments don’t fall outside and allow you to commit a prohibited transaction.
Keep in mind that sweat equity is not okay with a checkbook IRA or solo 401K on a rental house, for example. You could do the administrative functions of management, but you shouldn’t go out and get dirty on it. Don’t take your paintbrush out. Don’t swing a hammer. None of that is okay.
With a Wall Street IRA, the worst you can do is make a bad investment. With a checkbook IRA or solo 401K, you can commit a prohibited transaction, so you have to be diligent to avoid that.
A lot of the other objections I hear about self-directed IRAs are really moot points. For example, some people ask why you would want to take your IRA and go out and buy real estate when you lose the long-term capital gains tax treatment of that investment. That’s true, but anything you buy with a retirement account won’t have that long-term capital gains tax treatment anyway. It doesn’t matter if you’re going to self-direct into real estate, notes, or whatever it might be, versus keeping it on Wall Street.
Another fallacy about self-directed IRAs is that you can’t leverage. Why would you take IRA money when you can’t leverage it to go buy real estate or other things? That’s not true. You’ve just got to have non-recourse IRA or 401K compliant debt and that will allow it to be used.
Keep in mind that with IRAs any income or gain attributable to other people’s money is going to trigger some tax exposure, so you need to make sure you’re working with tax people that are going to take care of it.
Understand that when you are self-directing accounts, it’s not an all or nothing proposition. Any financial advisor will tell you this: diversify, diversify, diversify. I want to clarify, we don’t sell investments or give investment advice, but that’s obviously good advice. With that in mind, if we’re talking about IRAs, it’s important that you keep what you want to use on Wall Street in that Wall Street account and move only what you want to use in the self-directed account into that. Therefore, if you commit a prohibited transaction on the self-directed component, all the Wall Street investments are isolated from it; as opposed to creating a checkbook IRA, moving all the money in the LLC account, opening a trading account in the LLC account, and then that’s encumbered with everything else you’ve got going on. I think that’s really important to understand. Keep that diversification there, and keep it segregated so it’s protected.
Other than that, I don’t see any downsides to self-directed IRAs, but I see a lot of upsides. I’ve seen a lot of successful investments that our clients have made through the years, and they’ve been very happy with their choices.
Wall Street can be turbulent, but a lot of times people complain about the lack of liquidity with real estate. Of course, the lack of liquidity typically is going to stabilize investments a bit. You don’t have people buying and selling on the news all the time. And, what’s the general rule about doing that? Don’t.
IRAs are a popular method of investment for retirement. But, as David notes, you need to focus on your investment goals and decide just what you want. His best advice is to pick up the phone and give us a call: 503-619-0223.
