When the Individual Retirement Account (IRA) came into existence back in 1974, it offered investors a way to set aside money for the future in a tax-advantaged manner. For many people, either some or all of the funds that were invested into their IRA account could be deducted from income for that year, while at the same time, any gains that were earned in the account would be tax-deferred until the time the money was withdrawn.
Today, the term “IRA” is familiar to most people. In its basic structure, an IRA is a personal savings plan that gives you tax advantages for setting aside money for retirement. By definition, an IRA is “a retirement investment account established by employed workers who earn a salary, wages, or self employment income.” These types of accounts can be set up with a bank, brokerage firm, mutual fund company, insurance company, or other trustee.
Initially, there was just one type of IRA account that was available to investors, which is the type of account that is now referred to as the “traditional” IRA. In addition to allowing deposits – up to an annual maximum dollar amount – to be deferred going into the account, the money inside the IRA grows tax-deferred, and 100% of the proceeds will be taxed as ordinary income when the account holder makes withdrawals in the future.
If an IRA account holder takes money out of the account before turning age 59 1/2, they may also be subject to an additional 10% “early withdrawal” penalty from the IRS (Internal Revenue Service).
When a traditional IRA holder turns age 70 1/2, though, he or she is required to start taking at least a set minimum amount of withdrawal from the account (if they have not already started doing so). If they don’t, they can also face an IRS penalty for not following the Required Minimum Distribution, or RMD, rules.
In 1997, another type of IRA was created. This account, known as a Roth IRA, does not allow an investor to defer funds pre-tax into the account, but rather, all of the money that is deposited into a Roth IRA has already been taxed to the investor.
While they are inside of the account, Roth IRA funds are also allowed to grow without taxation, similar to the traditional plan. However, when Roth IRA funds are withdrawn, they are done so tax-free, which can allow the investor use of 100% of the money when received.
Also unlike the traditional IRA account, a Roth IRA does not require that any withdrawals are taken when the account holder turns 70 1/2. This, in turn, can allow the funds inside of the account to continue growing in a tax-advantaged way – in some cases, for a much longer period of time.
Since IRA accounts were initially created back in the mid-1970s, many investors have felt – oftentimes mistakenly – that the funds inside of their IRA accounts were being invested in a diversified manner.
For example, investors have often felt that they have had the freedom to choose a well diversified mix of investment offerings. These have primarily consisted of stocks, bonds, mutual funds, and CDs (certificates of deposit).
Unfortunately, though, just simply placing funds into different types of “intangible” offerings like stocks, bonds, and mutual funds is really not necessarily considered to be all that diversified.
The reality is that, you could pick and choose from a much wider array of investment options, including real estate and tax liens, that will not only provide your account with a much broader diversification, but that can also provide the opportunity for better, more stable returns.
In order to open the door to these other, “non-traditional” IRA investments, though, it is necessary to first have the right type of IRA account. This plan is known as a self-directed IRA – and the majority of financial services companies do not offer them.
So, why do most banks and investment firms only offer the more “limited” type of IRA to their clients?
One reason for this is due in large part to the fact that most brokerage companies and other financial institutions only offer certain “products” in their inventory, so they have had very little incentive to offer their IRA investors
anything else in terms of investment options.
In other words, by only being able to offer a limited set of investment alternatives, that is what advisors most often will recommend to their clients. But this leaves out a myriad of other asset classes – assets that could be invested in a tax-advantages manner through a self-directed IRA account. It also means that if you only posses a regular traditional or Roth IRA, you may not be getting the returns that you could – and should – be getting in your portfolio.
Throughout the years, the retirement savings industry has traditionally been dominated by large transaction-driven companies that focus only on a very narrow universe of investments. And, while these accounts might be right for some people, they don’t offer the freedom and control that self-directed IRA account can offer.
Contrary to what many investors believe, the Internal Revenue Service (IRS) does not put a lot of limitations on the types of assets in which a self-directed IRA account holder may invest. In fact, there are so many choices with a self-directed IRA account, the IRS does not identify what investments or transactions investors can make in these IRAs, but rather, they state only the few investments or transactions are prohibited.
For instance, “alternative” investments such as real estate and mortgage notes have always been permitted in IRAs, but few people seem to know about these additional investment options. So, while many investors are familiar with traditional and Roth IRAs, there are a majority who are not as familiar with how a truly self-directed IRA account works.
So, how exactly do self-directed IRAs work?
In general, self-directed IRA accounts are quite similar in structure to regular traditional and Roth IRAs. Where they differ is in the element of control that is provided to the account owner in terms of investments that can be placed inside of the account.
Unlike regular IRA accounts, self-directed IRAs allow investment in tangible assets such as real estate, commodities, and precious metals. These investments are typically made with the assistance of a self-directed IRA custodian.
A self-directed IRA account can actually be considered a type of “subset” of the traditional and the Roth IRA. These accounts allow their holders to make investment choices on behalf of the account itself, rather than just simply because a financial firm carriers something in their “inventory”.
These accounts are unique in other ways, too, because of the elements of control that they offer to their investors. For instance, in a truly self-directed IRA account, it is the account holder who directs what investments go into the account, rather than being restricted only to what is available to them through the bank or brokerage firm where the account is being held.
Just some of the many investment options that are allowed to be placed inside of a self-directed IRA account include the following:
- Real estate – residential and commercial
- Mortgages and deeds
- Private notes and loans
- Gold and certain other precious metals
- Commercial paper
This means that taxes are not due until the assets are actually withdrawn if you have a self-directed traditional IRA, and that the money that is withdrawn from a self-directed Roth IRA is tax-free.
Unfortunately, many financial advisors who work in the traditional investment community do not realize that these types of accounts even exist – and those who do, typically cannot offer self-directed IRA accounts. This is why there is so little information available about self-directed IRA accounts today.
Over time, many financial services firms have touted their offering of “self-directed” IRAs. But, while this may lead you to believe that you have a broad range of investment options for your account, the reality is that most of these entities are simply referring to the fact that investors can pick and choose from stocks, bonds, mutual funds, and other, more “traditional”, investment alternatives.
Few investors realize that they have the option to “self-direct” the investments in their IRAs into real estate and other tangible assets, while still benefiting from the tax advantages that those IRA plans provide.
But even if you are familiar with truly self-directed IRA investing – and you want to move forward with using your IRA funds to make purchases of real estate and / or other non-traditional investments – you won’t be able to do so with a regular IRA account.
In fact, there are actually several limitations that you are subject to when you have an IRA account that is not truly self-directed. These can limits can include the following:
- Only certain products are allowed in the account. While having a selection of mutual funds and other equity vehicles can seem like a “variety” of investments to choose from, a regular IRA account will limit you only to certain options, whereas a truly self-directed IRA opens the door to a whole host of both intangible and tangible investment choices.
- Transaction fees. When purchasing stocks, mutual funds, or other types of equities within a regular IRA, you will typically be subject to transactional fees. With a true self-directed IRA account, though, you will no longer need to pay a transactional fee for each and every investment that you make. In fact, the annual custodial fees on self-directed IRAs are considered to be some of the lowest in the industry.
- More paperwork. When making investments in a regular IRA account, it can often require various paperwork to be submitted. But with a truly self-directed IRA, if you find an investment that you wish to purchase, you may simply be able to write a check on the spot in order to secure the deal.
Over the years, it is likely that you will be presented with many potential real estate deals – and it could be that the money that is inside of your IRA account will be the only funds that are available to you in order to move forward with the purchase.
By using a truly self-directed IRA, you can take advantage of these deals much more quickly, in turn, allowing you to boost your investment returns, as well as provide you with the additional diversity that you may need in order to hedge assets against inflation – and to protect assets from a volatile stock market.
By placing funds into a self-directed IRA account, you can also open up a whole new world of investment options, as well as provide your savings with added protections – essentially giving yourself a “best of both worlds” retirement investment scenario.
Although traditional and Roth IRAs are both types of Individual Retirement Accounts, there can be some significant differences between the two. List three of the key differences between a traditional and a Roth IRA.
- 1. Traditional IRA contributions may go into the account pre-tax, while Roth
contributions are after-tax.
- 2. Traditional IRA withdrawals are typically taxable, while Roth withdrawals
are tax-free (provided the account owner is over age 59 1/2).
- 3. There are adjusted gross income limits for Roth IRA eligibility, but not with