Understanding Self-Directed Retirement Accounts

SDRAs are a good option for clients interested in alternative investments, ranging from real estate to bitcoin and more.
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Self-directed retirement accounts are accounts held with a custodian that allows investments in a range of alternative assets inside of the account. Depending upon what the custodian allows, these could include IRAs (both traditional and Roth), SEP-IRAs and Solo 401(k)s.

Why a self-directed retirement account?

A self-directed retirement account, or SDRA, can be a useful tool in an adviser’s toolkit for their clients. Most clients likely will have investment portfolios that largely comprise traditional asset classes such as stocks, bonds and cash.

Using an SDRA can offer your clients a place not only to diversify their overall portfolio with any number of alternative investments, it offers them a chance to diversify using their retirement accounts -- which can add another dimension to this diversification.

Self-directed retirement accounts are subject to the same contribution limits and restrictions as the same type of account would be otherwise.

What types of investments are eligible?

Alternatives that your clients can utilize inside of an SDRA, include:

  • Real estate investments
  • Private equity
  • Private debt
  • Gold and precious metals (subject to certain restrictions)
  • Loans including mortgages
  • Crowdfunding of various types
  • Hedge funds
  • Structured settlements
  • Bitcoin, cryptocurrencies and digital assets
  • Futures and commodities
  • Livestock
  • Structured settlements

Many alternatives have a relatively low correlation to stocks, which can help your clients hedge against volatile market cycles like the one we are seeing now.

Most traditional retirement account custodians don’t allow all or most of these investments in regular retirement accounts, so this is not an option for your clients for whom these types of investments make sense in their retirement accounts with these more traditional custodians.

What restrictions must you be aware of?

There are some investments that are not allowed in retirement accounts, including:

  • Life insurance (not allowed in an IRA or SEP-IRA)
  • Collectibles like wine, art, antiques and some similar items
  • S-Corp stock
  • Precious metals, except those specifically allowed

Additionally there are rules against self-dealing and prohibited transactions that you need to be aware of to ensure that your clients don’t violate these rules and trigger an unwanted tax hit.

Generally, self-dealing means that your clients must keep investments in their self-directed retirement accounts separate. They cannot engage in transactions or business arrangements that benefit the account holder or their family using these assets.

Examples of prohibited retirement account transactions would include:

  • Purchasing stock in a company where a family member owns over 50% of the stock, for example your client’s son or daughter.
  • The client uses funds in their IRA to make a loan to a disqualified person such as a child, spouse or other close family member.
  • Purchasing rental property and then taking a family vacation and using the property rent-free.

Liquidity and Alternatives

One downside of many alternatives is that they can be relatively illiquid. Unlike stocks, mutual funds and ETFs, there often is not an active secondary market that offers daily liquidity as with more traditional investment vehicles.

This actually plays well into using retirement accounts to invest in these types of assets. For clients with many years until they need to tap these accounts in retirement, alternatives can be a great fit. Since they have no immediate need for any sale proceeds from these assets, the nature of many of these assets fits well with their retirement time horizon.

Holding alternatives within a retirement account versus investing in them with taxable funds can make sense for clients in terms of their overall liquidity. If alternatives are held in a taxable account and the client needs to raise money for whatever purpose, alternatives may be difficult to sell, the sale may take some time and they may not receive full value from the sale. If they hold more traditional assets like individual stocks, mutual funds and ETFs these assets have a readily available secondary market with regular asset pricing.

Taxes and Alternatives

Alternative investments may have tax implications. Holding these types of assets in a retirement account can negate many of these tax issues for your clients.

For example, the tax ramifications for bitcoin and other cryptocurrencies are complex and confusing. Investing in these instruments inside of a retirement account can eliminate this situation in the current year as these investments grow tax-deferred or tax-free in the case of a Roth account.

Rental properties generate regular income and can generate taxable gains if eventually sold at a profit. As long as these proceeds remain inside of the retirement account, there are no immediate tax ramifications, the money will be taxed when withdrawn from the account in retirement or come out tax-free in the case of a Roth account if all applicable rules are followed.

Many other types of alternative investments have tax implications, some of which can be a bit quirky. Holding these assets in a retirement account can make sense for clients from a tax perspective.

Other Considerations

For clients for whom investing in alternatives makes sense, you might consider placing these investments in a self-directed retirement account.

If this is the right path for your clients, be sure to choose a self-directed firm that is experienced and knowledgeable about the ins and outs of SDRAs. While your good advice and counsel are key, you will want to partner with a firm that understands the rules and who can partner with you to ensure that your client doesn’t unknowingly run afoul of some of the complex rules on some of these investments.

Not all self-directed firms offer all types of retirement account options so you will want to ensure that if your client is looking to invest in a self-directed Solo 401(k) that this type of account is offered for example.

Self-directed retirement plans are not the right answer for all clients, but for those for whom investing in alternative assets makes sense, they are something to consider.