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“Have It Your Way” Retirement Accounts: 4 Things to Know About Self-Directed IRAs

Stocks. Mutual funds. Cattle? When it comes to investing in Individual Retirement Accounts (IRAs), you might have more options than you think. But those options may come with additional risk.

Some retirement savers want to look beyond stocks, bonds, mutual funds and other conventional investments offered by standard IRAs. For those interested in investing their IRA dollars in alternative investments, whether it be real estate, private placements or even livestock, there’s another choice: self-directed IRAs.

According to IRS rules, IRAs can invest in just about anything with the exception of life insurance, most types of collectibles and S corporation shares—that is shares in a company that elects to pass corporate income and losses through shareholders for tax purposes.

Self-directed IRAs can be set up as either a traditional IRA or Roth IRA. The same potential tax benefits of tax-deferred growth, or tax-free growth apply.

And the same rules and restrictions associated with standard IRAs apply to self-directed IRAs. That means, while technically you can withdraw money at any time, doing so before age 59½ can trigger hefty tax penalties.

Sometimes people choose to save for retirement using a self-directed IRA because they’re an expert in a certain field and want to capitalize on their expertise while garnering the tax benefits of an IRA. For instance, if you know a lot about real estate, you might believe buying a building with your IRA could be worthwhile.

The Retirement Industry Trust Association (RITA), a self-directed IRA industry trade group, estimates that assets in these types of retirement accounts represent 3 percent to 5 percent of total assets held in IRAs.

Before you think of using your hard-earned retirement dollars to purchase even a single cow with a self-directed IRA, it’s important to know the following four things:

Do Your Due Diligence, And Don’t Expect Your IRA Custodian To Do It For You

When you open any kind of IRA account, you must find an IRS-approved institution that will serve as the account’s custodian. With standard IRAs, this might be a bank or a brokerage firm that offers investment options.

With a self-directed IRA, there is a third-party custodian too, but this company simply serves as an intermediary between you and the investment. The custodian holds and administers the assets, and handles recordkeeping, but generally doesn’t assess the investment’s value or legitimacy.

You, the account owner, are responsible for choosing investments, evaluating them and keeping tabs. Don’t expect the custodian to do any of this work for you.

If you decide to open a self-directed IRA, it might make sense to work with a financial professional who can help vet and monitor your investments.

Certain Transactions Are Prohibited—And Breaking The Rules Could Cost You

You might have more control over what you invest in with a self-directed IRA, but you have to be careful about what you do with those investments. The IRS prohibits transactions between an IRA account and the account’s owner, its beneficiary, or other “disqualified persons,” such as certain family members.

The reasoning behind this: IRAs were created with the idea of ensuring future retirement stability. Any transactions conducted by an IRA must be for the exclusive benefit of the retirement plan.

For instance, if your self-directed IRA account owns a condo, you can’t live in it. Nor can your child live there, even if that child is paying rent.

What happens if you don’t follow the rules? Even if you make an unintentional mistake, it will cost you. Typically, if an IRA owner or another disqualified party engages in a prohibited transaction, the IRA account loses its IRA status as of the first day of the year that the transaction took place.

And you might have to pay a 10 percent penalty as well.

There Is Potential For Fraud

The Securities and Exchange Commission (SEC) issued an Investor Bulletin warning investors of the potential risks associated with investing via self-directed IRAs.

Specifically, the bulletin states: “Fraudsters may be more likely to exploit self-directed IRAs because custodians or trustees of these accounts may offer only limited protections.  Custodians and trustees typically have only limited duties to investigate the assets or the background of the promoter.”

How do you avoid getting trapped? Be wary of unsolicited investment offers, ask questions, and always be skeptical of anyone who promises “guaranteed returns.” It can often be wise to get a second opinion from someone not involved in the opportunity and to take steps to independently verify the prices and asset values of the assets involved.

It’s Important To Understand What You’re Investing In And Be Aware Of The Risks

With self-directed IRAs, you’re in control. But with control comes responsibility. In short, know what you are investing in.

It’s important to ask yourself whether the freedom of picking and choosing investments in your IRA is worth the potential risks involved.

Because of the tax implications of a self-directed IRA, you may want to consider consulting with a tax specialist.