Growing ranks of people are setting up self-directed Individual Retirement Accounts (IRAs), allowing them to call their own investment shots. Unfortunately, most investors are undermining their long-term wealth-building plan by making easily avoided mistakes or the wrong choices.
Self-directed IRA accounts are typically set up through a broker, but you decide what and when to buy and sell. Call your broker and he or she will show you how to do it. However, since you're completely in charge of the account once it's set up, it's important to follow these basic guidelines.
Unlike traditional IRAs, which typically limit their investment menus to publicly listed securities such as stocks, bonds and mutual funds, self-directed IRAs allow more exotic investments. These include real estate, private equity, precious metals and promissory notes. Self-directed IRAs are only offered by special custodians, and they can be funded in all the traditional ways an IRA is funded, such as rollovers from another IRA or 401(k), or from contributions from earned income.
The idea of escaping the box of stocks and bonds may sound appealing. But while self-directed IRAs offer investment flexibility and greater opportunities for making money, they have a number of drawbacks, and they have been the arena for fraudulent investment schemes, according to the Securities and Exchange Commission.
Among their drawbacks are a lack of transparency. Unlike publicly traded securities, such as stocks and mutual funds that must report audited financials regularly, many of the alternative investments in self-directed IRAs are under no such requirements.
Custodians that specialize in these IRAs may offer general guidance on how to set up and administer them, as well as broad guidelines about what's O.K. and what constitutes a prohibited transaction. But they won't provide opinions about the quality or legitimacy of specific investments.
To be sure, innovative investments abound, even in this risky market. If you make the right choices, you can beat what promises to be a mediocre market at best this year. But if you're unsure about whether an investment is financially or legally sound, consult with an attorney or financial professional.
Tricky rules are another potential pitfall. Self-directed IRA owners also need to avoid prohibited transactions that could lead to substantial penalties and taxes. One tricky twist is "self-dealing," in which an investment is bought from or sold to a person the IRS disallows, like a close relative. So in a real estate transaction, for example, buying a house from a parent would constitute a prohibited transaction.
Similarly, you can't buy a condo with IRA money and rent or manage it yourself. And any regular expenses, such as a mortgage, utilities, repairs and taxes, must be paid from the IRA.
Lastly, self-directed IRAs are also subject to IRS rules for any IRA that does not allow investment in antiques, collectibles and life insurance. These rules also prohibit borrowing.
Also beware stiff penalties. If the IRS sniffs out a prohibited transaction, the IRA would lose its tax-deferred status and the account owner would be subject to income tax (and if a person is under age 59½, a 10% early distribution penalty) on the entire value of the IRA, not just the portion used for the prohibited investment.
Yet another danger: higher costs. Fees vary depending on the type of investment and custodian, and are higher than those for traditional IRAs. Typical charges include set-up, account administration, transaction fees, and fees to close the account. There may also be fees for sending checks to pay bills associated with an investment, and storage fees for physical gold or other precious metals. If you don't see a fee disclosure page on the custodian's website, call and ask for one.
Other costs, such as establishing a fair market value for real estate or other assets to comply with IRS requirements, aren't as obvious. In some cases it may be advisable to hire an expert to conduct due diligence on an investment, which can cost hundreds or even thousands of dollars.
Self-directed IRAs appeal most to hands-on investors who like to have a say in how things are run, have a special expertise in assets such as real estate or private equity or who need their IRA stash to invest in a business or other investment.
For further advice, consider consulting the financial advisors at Fidelity(FNF) - Get Report , Charles Schwab(SCHW) - Get Report , TD Ameritrade(AMTD) - Get Report , or T. Rowe Price(TROW) - Get Report .
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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.