What Is a Self-Directed IRA and How To Set It Up?

If you have questions like, “What does it mean to self-directing a retirement account?”, here’s what you need to know. A self-directed individual retirement account (SDIRA) is a type of IRA that allows you to invest and hold so-called alternative investments for retirement.

Investing in an SDIRA also comes with rules and certain risks. Your self-directed IRA is a kind of Roth or traditional IRA.

In other words, your SDIRA is a tax-advantaged retirement plan with identical contribution limits to a traditional IRA. The difference between an SDIRA and another IRA is only the assets you choose to own in it.

You could have an old 401k from an old job or a current IRA, a Roth IRA, a solo 401k, a HSA or nothing at all: you can self-direct them all (except current 401k from your current job). The term SDRP which stands for Self-Directed Retirement Plan, include all these types of retirement account.

You just need to know that SDRPs and SDIRAs are pretty much the same thing, in this guide we will use the term SDIRA for clarity’s sake.

What Is a Self-Directed IRA and How Do You Set It Up?

Many people want the advantages of an SDIRA but don’t know where to begin. Take a moment to familiarize yourself with SDIRA plans. The key to setting up your self-directed IRA begins with the search for an IRS-approved direct custodian.

What Is a Self-Directed IRA?

A regular or traditional IRA usually contains mutual funds, stocks, bonds or other liquid financial assets. In comparison, a self-directed IRA offers other possibilities.

For instance, you could decide to hold investments of a privately-held business, real estate, or precious metals. To accomplish your desire to hold these investments, you must find a suitable custodian for your self-directed IRA.

After you identify a reputable SDIRA custodian such as GoldStar Trust company, you’re good to go.

Consider unconventional assets for the long term. Let’s say you’re an equestrian. You know horses. It’s possible for you to own nontraded assets, e.g. real estate or a horse farm.

Next, you need to find a qualified custodian. To invest your retirement plan funds in these types of investments, it’s essential to find a recognized custodian with experience in holding these types of accounts.

Evaluate the risks and discuss your proposed investment plan with a professional to determine whether this idea is suitable for you.

How To Open a Self-Directed IRA?

Many broker-dealer firms are custodians of traditional IRAs and other retirement plan types. Most large broker-dealers don’t offer SDIRAs to their clients.

If you want to take more control of how and when you invest retirement funds, you must find a custodian. The custodian often specializes in SDIRA accounts. The custodian is familiar with empowering its clients to make decisions about the growth of their assets.

Custodians may differ from each other. Some will handle certain types of investments but not all of them. For instance, if you want to buy precious metals for your long-term retirement account strategy, you may need to shop around. Note:

  • SDIRAs are more complex than traditional IRA accounts. For that reason, you may benefit from the advice of an experienced financial advisor about opening an SDIRA. For instance, it’s up to you to perform due diligence about the types of investments in your SDIRA. Your custodian is unlikely to question you.
  • The Internal Revenue Service (IRS) forbids certain investments in your SDIRA. You can’t buy life insurance or collectibles for your SDIRA.
  • After you identify an IRS-approved custodian, it’s relatively simple to open the SDIRA. Fill out the required forms and contribute money or assets to the account as you would with any other retirement account.

What Are the Advantages of an SDIRA?

The two primary reasons you may want to assume the risk of a self-directed IRA is to seek both greater portfolio diversification and higher long-term return on investment (ROI).

Let’s say you’re already a precious metals investor. You’ve owned gold bullion coins for many years and believe you understand this type of investment.

In this example, you may want to include higher potential returns and some of the advantages, e.g. less market volatility, to your retirement portfolio.

The SDIRA account is one of the ways to pursue higher yields and the potential for less volatility.

In addition, it’s also possible for you to invest in private companies. Traditional IRAs allow you to invest in the shares of publicly-traded companies or those trading on a stock exchange. If you own mutual funds, you may have partial shares of these companies in your account as well.

A self-directed IRA allows you to invest in private companies' debt and equity (if the custodian agrees to hold these types of assets).

As always, you’re responsible for performing the due diligence required to determine whether private holdings make financial sense for you.

It’s also possible to buy real estate in many SDIRAs. If you’re an experienced real estate investor, it’s possible to find an undervalued property with upside potential or sell/assign the real estate contract to another investor to capture gains.

The bottom line is clear. If you’re a creative and knowledgeable investor, you may be able to use your experience to achieve sizable returns for your retirement. It’s important to understand that gains in your SDIRA are tax-deferred or tax-advantaged.

What Are the Risks of a Self-Directed IRA?

The benefits of your SDIRA are clear, however, there are risks associated with your SDIRA you need to know about.

Prohibited Transactions in Your SDIRA

Yes. There are certain prohibited transitions. To avoid penalties and interest associated with prohibited transactions, follow the rules:

Avoid self-dealing

You aren’t supposed to borrow money from an SDIRA, sell a property you own to it, or make other interactions. For example, if you invest in a rental property held in the SDIRA, remember—this is a tax-advantaged investment.

If something breaks, you can’t fix the problem yourself to save money on the repair. This is considered “furnishing services” to your retirement account and it’s prohibited by the IRS.

If your repair is discovered, the IRS will consider that the entire account is now distributed—and taxable. You will owe penalties, all in the interest of saving some money.

Similarly, don’t sleep in your IRA-owned real estate

Consider that the IRA owns and operates all of your assets. Pay a provider to perform maintenance and don’t appear to live in the rental property, even for a night.

Ask questions about IRS-prohibited transactions in your SDIRA as part of your due diligence process.

Indirect Benefits in Your SDIRA

As an SDIRA account holder, you mustn’t seek to immediately benefit from an account. To do so violates the IRS code and guidelines. Your retirement plan is structured to replace income in your retirement years.

An indirect benefit considered improper use of a tax-advantaged account means the account holder may have benefited from ways that could disqualify your tax-advantaged benefits. Examples of indirect benefits include:

  • Inhabiting a property owned by your SDIRA. You should not use or inhabit the property for personal reasons.
  • Paying out-of-pocket for IRA-property-owned expenses. Your SDIRA should pay these expenses when they’re necessary.
  • Loaning SDIRA money to an unrelated party can be problematic. That person must not then lend the funds back to the accountholder.

What Is a Disqualified Person Relating to Your SDIRA?

The following parties can’t conduct business with your SDIRA:

  • An account owner
  • A SDIRA beneficiary
  • A spouse of the accountholder
  • SDIRA holder’s lineal ascendants and/or spouses
  • Custodians, administrators, plan fiduciaries, and any advisors
  • An entity in which the SDIRA owner maintains 50 percent or higher interest

Similarly, a business partner or other entity that is at least 50 percent owned by a disqualified party is also disqualified.

For instance, if you loan funds to a partner who’s half-owner of the company, you violate IRS rules concerning disqualified parties even if you don’t transact this through the company.

The same IRS rules apply to any other retirement plans you own.

Whether you own a 401(k) or another type, you may not borrow money from the IRA plan if you attempt to loan money from the plan.

Under current IRS law, a related party isn’t necessarily disqualified. For instance, your IRA could do business with the following parties in some situations:

  • The IRA account owner’s sister or brother
  • The IRA account owner’s cousin
  • The parents of a spouse, or the account owner’s in-laws
  • The IRA account owner’s stepparents/step-grandparents
  • The IRA account owner’s nephew or niece
  • The IRA account owner’s friends

What is Due Diligence as It Relates to an SDIRA?

The law says it’s your obligation and privilege to know about the investments and decisions made in your SDIRA. Your custodian or administrators can’t offer financial advice. Their role is to follow your directions, not tell you what to do.

Realize that you must do all of the homework regarding your SDIRA investments. Consider due diligence as you would an operational audit.

Take the time to consider the future expenses and revenues for any investment in your SDIRA to understand if every investment meets your future goals, objectives, and risks.

When you self-direct an IRA or other retirement plan, you must perform the proper due diligence or research before making an investment decision. In short, the term means that you ensure that your investments are smart and with purpose.

It’s up to you to investigate any possible investments before directing your custodian to put your funds in them. Follow these steps to help you perform the proper due diligence before investing in your SDIRA.

What Does SDIRA Due Diligence Include?

You’re also responsible for vetting any business partners or potential partners associated with your SDIRA investments. It’s up to you to gain knowledge about the rules and laws associated with your retirement assets of choice.

It’s fine to seek advice from trusted parties and successful investors. Ultimately, however, the choice about your SDIRA investments is yours.

You must also obtain a full understanding of the taxes associated with any investments included in your retirement plan. A SDIRA custodian such as Equity Trust does not vet the investments in your self-directed retirement account. You are the sole manager of these investments.

What Are Your Investment Options?

First, learn about the different available investment options. If you’re unfamiliar with them, learn about more traditional investment vehicles, e.g. stocks or bonds. Learn more about so-called alternative investments, e.g. private notes, real estate, or precious metals also called gold IRAs.

Once you understand the pros and cons of each investment type, it’s easier to know which is right for you.

How to Research the Potential Investments?

After you know the types of investments you want to include in your SDIRA, research these potential investments. This is an essential step in your decision-making process. It helps to ensure that any and all investments made are good fits for your retirement portfolio.

Investing in a business with your SDIRA

For instance, if you’re considering making an investment in a business, learn all you can before investing. Review their financial statements, their management, and the outlook for their overall industry.

Investigate further

After you decide that a possible investment is apparently a good fit for your long-term goals and objectives, investigate further. Read reviews, talk to other investors, and read and consider the fine print of paperwork provided for signature.

Make sure to consider your comfort level.

Before you put money into the investment, learn what experts say about it. The experts won’t be able to make the investment decision in your self-directed retirement account, but you can gather, compare, and contrast information now.

In an SDIRA, you’re the only one who must understand your investments. Take the time to thoroughly perform your due diligence. Doing so can mean great future rewards for you.

How to Perform Real Estate Due Diligence?

Many investors include real estate investments in a self-directed IRA. To perform due diligence on your potential real estate investments, look at the property location, its condition, and whether it meets your criteria for investment in real estate in an SDIRA.

Consider the fees associated with your purchase and property ownership. Visit the property before investing when possible to ensure that it meets your expectations.

Real estate is a potentially beneficial investment in your retirement portfolio but your due diligence before investing is crucial.

Don’t assume that because a real estate deal looks cheap that it’s the right investment for your SDIRA.

Protect your SDIRA plan assets by taking the time to perform due diligence. Once invested, review your account positions to ensure they continue to meet your long-term investment objectives and risk parameters.

What Fees Are Associated with a Self-Directed Individual Retirement Account?

Before opening an SDIRA, learn about the self-directed IRA fees associated with the account. Fees may depend on the custodian or the type of assets you want to hold in the account.

Understand that your SDIRA allows you to diversify retirement funds in a variety of assets. The assets may be less liquid than investments traded in an exchange environment.

It’s important to leave your retirement plan assets in the account over the long term and to avoid taking early distributions.

Minimum and Required SDIRA Distributions?

You pay additional penalties and taxes if you take distributions from the plan before age 59-1/2. You must take minimum distributions by age 71-1/2.

SDIRA Fair Market Valuation (FMV)?

Your custodian must report your retirement plan’s asset values or current selling price at least once per year. Your FMV is submitted to IRS so record any change in the values of assets in the SDIRA.

Due diligence before making an investment and account management after making an investment can help you to overcome “lack of transparency” issues.

If you question what you know about an investment or what it’s worth, the Security & Exchange Commission (SEC) states that you’re ultimately responsible to consider the price at which any of your investments could be sold (if at all).

If you’re investing in any alternative investment, it is important to consider an exit or sales plan. If you’re investing in real estate, you may need to consider how and to whom you could liquidate the investment.

IRA Fraud

One of the best ways to protect against fraud in a self-directed IRA is to identify qualified and IRS-approved custodians.

In addition, fraudsters may claim that a custodian approved their proposed investment but, according to the SEC, qualified custodians are prohibited from evaluating the quality—or legitimacy—of investments in SDIRAs or their promoters.

Self-directed IRAs can help dedicated, diligent investor to improve their portfolio diversification. Unfortunately, SDIRAs can also lack diversification because the accountholder feels confident about an asset class or specific investment idea.

Diversification is a basic premise of investing because, over time, greater diversification yields safety.

The Benefits of Your SDIRA for Retirement

A self-directed retirement plan empowers you to make decisions about the investments held for your benefit in retirement. The disciplined investor has more choices about which assets to include in their portfolio.

The SDIRA account holder can’t personally use property in their account before taking distributions in retirement. In other words, the account holder cannot:

  • Store precious metals or gold at home: these assets must be held in a qualified US depository.
  • Live in or otherwise us real estate owned in the SDIRA

Violation of these rules and others can disqualify the account under IRS rules and result in penalties and fees.

Take note of self-directed retirement account tax rules, including:

  • Your SDIRA contributions are typically tax-deferred. No tax is paid until your withdrawal from the plan at retirement.
  • Roth Self-Directed IRAs differ because contributions made to the account are made with after-tax dollars. Any retirement distributions from the plan are tax-free.
  • Your chosen custodian files Form 5498 with the IRS. You are not assessed taxes an no taxes are due when Form 5498 is filed.
  • If your SDIRA incurs UBIT (Unrelated Business Income Tax), the account must submit a tax return. Taxes owned must be drawn from the retirement account.

How to Set Up a self-directed IRA?

Now you know the answer to “What is a self-directed IRA and how to set it up?”. Still unsure whether or not you should open one? Read this article to find out.

After making the decision to take more control over your retirement plan assets, find an IRS-approved direct custodian. Read reviews about the custodian. Ask lots of questions to learn more about the custodian's offer.

To set up an SDIRA, fill out the forms and paperwork required by the custodian. Deposit cash or request a transfer of assets from another custodian. Pay any fees required by the custodian to activate your SDIRA.

Finally, it's essential to actively participate in the management of your SDIRA. You are solely responsible for making decisions about the quality of investments. You alone direct the custodian to buy or sell assets in your account.