A self-directed IRA plan is simple enough: take your money and invest in practically anything you desire, but direct the investment so it isn’t taxed until retirement.
This special IRA gives you more control over your financial future, offering you the freedom to invest in familiar assets you understand, and the possibilities become almost limitless. Your investments are not limited to just mutual funds or stocks and bonds.
With a self-directed IRA you can direct your contributions into non-traditional investments, like real estate, gold, promissory notes, tax liens, or private businesses. Additionally, you benefit from asset protection and a myriad of tax advantages that accompany government-sponsored retirement plans.
The Employee Retirement Income Securities Act allows you to do this, provided that you maintain a strict separation between your self-directed IRA and your personal funds. You cannot mix the assets, and cannot borrow money from your IRA. Additionally, according to IRS statutes, you must appoint a custodian to manage transactions in your IRA.
The number of people self-directing their IRA is not formally tracked, so the exact numbers are unknown. Yet, according to the Securities and Exchange Commission, it’s estimated that last year about 2% of all IRAs were self-directed, and that works out to more than $100 billion. Indeed, this growth is fueled by investor’s disappointment with Wall Street’s instability.
The Tax Advantage of Self-Directing Your IRA
The important part of a self-directed IRA rollover refers to tax. If your retirement funds are in a deferred tax retirement account, such as a 401 k, for example, the law allows you to transfer those funds to your self-directed IRA tax free. This retains its status as a tax free rollover to your retirement funds, but allows you to transfer to a different account as a self-directed IRA.
There are essentially three types of Self-Directed IRAs:
1. Offered by a Financial Institution
The most popular IRA accounts are offered by large well known financial institutions typically the ones with large marketing budgets. The downside is that investors are limited to investments offered by that financial institution, without much flexibility.
Why do the financial institutions limit the investment options available?
They are not required nor obligated to offer specific options to their IRA investors. Accordingly, most financial institutions will restrict their investment options to only financial products. The reasoning behind this is clear, financial institutions earn their fees from the sale of their financial products, not by allowing clients to withdraw funds from their IRA accounts in order to purchase real estate from third-parties.
2. Custodian Controlled Self-Directed IRA
A custodian controlled self-directed IRA offers investors more options than what’s typically offered at a financial institution. With custodian controlled accounts, an FDIC insured administrator will act as the watchdog of the IRA. Unlike financial institutions, most custodians generate their fees with the opening and maintenance of client IRA accounts. Custodian controlled IRAs are generally held with the custodian, yet at the investor’s direction, the funds will be invested accordingly.
3. “Checkbook Control” Self-Directed IRA LLC
With a “checkbook control” self-directed IRA LLC, the investor has total control over the funds and does not require prior custodian approval for each investment, as in a custodian controlled self-directed IRA. Instead, all decisions are truly yours. When the investor wants to invest funds, simply write a check directly from a checkbook control self-directed IRA bank account.
Should You Consider a Traditional or Roth IRA?
When it comes to retirement planning, many people become confused on choosing among all the investment options. You have a Roth IRA, and a Traditional IRA. In many cases, rolling your money into any individual retirement account will make the most sense; like a 401k rollover, however, since there are several types of IRA’s, becoming aware of the most advantageous account will help with future taxes.
The most significant difference in the Roth and Traditional IRA accounts is the way taxes are applied.
• Money is contributed to a Roth IRA on an after-tax basis. When individuals invest in a Roth IRA, the money grows tax free. This means you will be able to withdraw money without any tax deductions.
• Money invested in a Traditional IRA account consist of pre tax contributions. The tax is deferred; meaning, your contributions are deductible and when you begin making withdrawals, you begin to pay taxes on that money.
Contributions and Deductions
If you are under the age of 70.5 you can contribute up to $5,000 annually and $6,000 if you are over the age of 50, as long as the amount is less than what you have earned for the year. Individuals choosing to withdraw money before they reach the age of 59 ½ will have to pay a 10 percent penalty tax. There are special exceptions when individuals need to make a withdrawal due to special emergency situations.
Individuals can make penalty free withdrawals if they become disabled or have medical expenses. There are also exceptions if you are purchasing a new home.
Should you pay taxes now or pay later?
This all depends upon your tax bracket. If you are in a high tax bracket now, let’s say 35 percent, but you anticipate being in a lower tax bracket after retirement, then it would make sense to invest in a Traditional IRA account.
Where can I open my IRA account?
Individuals can open an IRA account at a bank, brokerage firm or companies that sell annuities. But be aware that the firm you choose to hold your investment money will determine what investments are available to you.
When you consider an investment account, namely a self-directed IRA, or a Roth IRA versus a Traditional IRA account, consider your tax bracket, the flexibility, and whether you can diversify your investments.