There are several types of Individual Retirement Accounts (IRAs), but they all have one thing in common: By Internal Revenue Service (IRS) decree, they must be in the possession of a custodian. Basically, an IRA custodian is a financial institution that holds your account's investments for safekeeping and sees to it that all IRS and government regulations are adhered to at all times.
Custodians aren't hard to find. But to find the right one for you, you first have to decide what sort of IRA you need, and what sort of investments you wish to make with it.
Traditional vs. Roth
Both allow the money within the accounts to grow free of income tax. The basic difference is that with a traditional IRA, you get a tax deduction for the contributions you make the year you make them, deferring any tax payments until you starting withdrawing funds years later. In other words, this type of IRA is tax-deferred. With a Roth, there is no tax break on the sums you invest; but then, no taxes are owed when you take the money out at retirement. In addition, there are no taxes owed on earnings in most cases.
(There’s more to it than that, of course. To learn more about the differences, see: Roth IRA Vs. Traditional IRA.)
With both Traditional and Roth IRAs, you can opt to have the account managed (that is, the custodian makes most of the investment decisions) or self-directed. A self-directed IRA is an IRA in which you choose the funding methods and instruments – and one that allows for expanded investment options.
Technically, any IRA in which you make all of the investment decisions is “self-directed.” In the financial services industry, however, a self-directed IRA typically means an IRA in which the custodian allows you to invest outside the more traditional world of stocks, bonds and mutual funds. For example, you can invest in real estate, either through a real estate investment trust (REIT) or in actual physical property. Other options include a closely held business, precious metals and even private mortgages.
(For more details, see: What are the differences between a self-directed IRA and a traditional IRA?)
Choosing a Custodian
If you are going the managed IRA route, a number of different financial institutions are available to serve as custodians, once you've established your account with them.
- A bank is an option if you want to enjoy the FDIC-insured security of CDs or money market funds within an IRA. In general, however, banks don’t get particularly high marks for IRAs because most do not offer many investment options outside of the aforementioned vehicles. Those that do offer broker-type services often charge higher fees than brokerages.
- An insurance company often sells flexible premium annuities as its basic IRA. They can be either fixed or variable and offer account value protection, death benefit options and automatic account management.
- A mutual fund company allows you to invest in mutual funds or exchange-traded funds (ETFs) offered by the firm.
- A brokerage could be your IRA entity of choice, if you like the idea of investing in individual stocks or bonds, as well as mutual funds or ETFs.
- A relatively new entity, robo-advisors (also known as Automated Investment Services) are an online service that provides automated, algorithm-based portfolio management advice. Obviously, this holds down costs, fees and other expenses that can eat into the IRA's rate of return.
Special Concerns for the Self-Directed
If you decide to go the self-directed route, things can get more complex. There are three types of providers for self-directed IRAs: custodians, administrators and facilitators. Of the three, custodians alone are directly approved by the IRS and authorized to hold assets. Administrators and facilitators act as intermediaries between you and a partner custodian that actually holds the assets. Therefore, if you intend to open a self-directed IRA, it’s best to stick with a true custodian.
When it comes to custodians for self-directed IRAs, all the aforementioned institutions theoretically could serve. But if you're intrigued by any of the nontraditional investments open to self-directed IRAs, you need to be especially careful in your choice of custodian. It’s far too easy to violate IRS rules and regulations, and the penalties for doing so can be severe. You'll want a custodian that's aware of the types of holdings the IRS prohibits, even for self-directed IRAs, such as collectibles and alcoholic beverages.
For more on prohibited types of IRA investments, and other triggers for penalties or additional taxes, see this section of IRS Publication 590, and read our 5 Investments You Can't Hold In An IRA/Qualified Plan. And for an example of the complexities of choosing a custodian for one type of self-directed IRA, see Analysis: Should You Get a Gold IRA?
Features of the Best Custodians
- Wide Selection: The greater the selection of investment options, the better. This applies to all types of investments, but especially to individual stocks and bonds as well as mutual funds and ETFs. If you are a self-directed IRA investor, look for non-traditional investment opportunities including real estate or privately held companies.
- Low Fees: Fees come in many shapes and sizes and include annual account maintenance fees, loads (for mutual funds) and commissions charged for making trades. Just because one custodian charges a specific type of fee does not mean all do. Maintenance fees, for example, are not a “given.” One important area, if you are considering mutual funds, is to look for a custodian that offers a variety of no-load mutual funds.
- Customer Service: Unless you're comfortable with a robo-advisor, the availability of knowledgeable specialists to answer your questions – online or by telephone – is very important. Nothing is more frustrating (especially if you are managing a self-directed IRA) than receiving incomplete or confusing answers to your questions.
- Easy-to-Use Website: Make sure the website is easy to use and that you can monitor your investments and make transactions efficiently. Even without committing to investments, you should be able to navigate the custodian’s online site extensively enough to determine if it is a comfortable fit for you.
- Consolidation Savvy: If you already have multiple IRA accounts, some experts advise that you consolidate them into a single fund with a single custodian if possible. This means seeking a custodian that is knowledgeable about the rules regarding consolidation and understands which types of IRAs cannot be combined.
- No Restrictions: Watch out for custodians that restrict your investment options because of the nature of their charter. It's important to note that IRA custodian restrictions are not the same as IRS restrictions on IRAs themselves or rules based in tax law.
The Bottom Line
When opening an IRA, it’s important to ask yourself several questions before choosing a custodian. Do you prefer a traditional or Roth account? Or both?
Are you happy investing in CDs, mutual funds, stocks and bonds or do you yearn for the more adventurous options available with a “self-directed” IRA?
Once you’ve made those decisions, it’s time to consider custodians and factors that distinguish one from another such as investment options, fees and customer service.