Saving for retirement in a tax-efficient manner is an important goal of any retirement planning strategy. In the United States, individual retirement accounts (IRAs) are an established tool for pursuing this goal. These arrangements may be structured as traditional plans, where the account is funded with pre-tax dollars and taxed upon distribution, or as Roth plans, where funding comes from after-tax dollars and distributions are tax-free.
U.S. tax codes require an IRA to be a trust or a custodial account created or organized in the United States for the exclusive benefit of an individual or the individual’s beneficiaries. The account must be governed by written instructions and satisfy certain requirements related to contributions, distributions, holdings, and the identity of the trustee or custodian. These requirements and restrictions related to the custodian and an account’s permitted holdings give rise to a special type of IRA: a self-directed IRA (SDIRA).
Individual Retirement Arrangements: Self-Managed vs. Self-Directed
In all IRAs, account owners can choose from investment options allowed by the IRA trust agreement, and to buy and sell those investments at the account owner's discretion, so long as the sale proceeds remain in the account. The constraint to investor choice arises because IRA custodians are allowed to determine the types of assets they will handle within the boundaries established by tax regulations. Most IRA custodians only allow investments in highly liquid, easily valued products such as approved stocks, bonds, mutual funds, ETFs and CDs.
However, certain custodians are willing to administer accounts holding alternate investments and to provide the account owner with significant control to determine or "self-direct" those investments, subject to prohibitions established by tax regulations. The list of alternative investments is expansive, limited only by a handful of IRS prohibitions against illiquid or illegal activities and the willingness of a custodian to administer the holding.
The most frequently cited example of an SDIRA alternative investment is direct ownership of real estate, which might involve rental property or a redevelopment situation. Direct real-estate ownership contrasts publicly traded REIT investments, as the latter is usually available through more traditional IRA accounts. Other common examples include small-business stock, LLC interests, precious metals, mortgages, partnerships, private equity, and tax liens.
Advantages and Disadvantages of a Self-Directed IRA
The advantages associated with an SDIRA relate to an account owner’s ability to use alternative investments to achieve alpha in a tax-advantaged manner. Disadvantages include the higher risk levels associated with alternative investments, as well as the compliance costs and compliance risks specific to an SDIRA. Success in an SDIRA ultimately depends on the account owner having unique knowledge or expertise designed to capture returns that, after adjusting for risk, exceed market returns.
Regulatory Requirements and Pitfalls
An overarching theme in SDIRA regulation is that self-dealing, where the IRA owner or other designated individuals use the account for personal benefit or in a way that circumvents the intent of the tax law, is prohibited. Key elements of SDIRA regulation and compliance are the identification of disqualified people and the types of transactions these people may not initiate with the account. The consequences of violating prohibited transaction rules can be severe, including having the IRS declare the entire IRA as taxable at its market as of the beginning of the year in which the prohibited transaction occurred, exposing the taxpayer to paying previously deferred taxes and a 10% early withdrawal penalty.
In addition to the IRA owner, the IRS identifies a "disqualified person" as anyone controlling the assets, receipts, disbursements, and investments, or those who can influence investment decisions. This list includes IRA account fiduciaries, the IRA owner’s spouse, lineal descendants and spouses of lineal descendants.
Specific examples of prohibited transactions are too numerous to list, but there are certain general principles. Among these principles, the IRA cannot be used to buy stock or other assets from a disqualified person, lease assets from or to a disqualified person, buy stock in a corporation in which a disqualified person has a controlling interest, or lend to or borrow from a disqualified person.