Both let you invest in things Wall Street won't sell you, like mortgage notes and private loans. The big difference is when you pay the tax: now, or later.
A self-directed IRA works like any IRA. The only difference is what you can hold. Instead of just stocks and funds, it can own real estate, private loans, and notes. You can set one up as a traditional IRA or a Roth IRA. Here's how they compare.
| Traditional self-directed IRA | Roth self-directed IRA | |
|---|---|---|
| Tax on money going in | Contributions may be tax-deductible now | No deduction. You put in after-tax money |
| Tax on money coming out | Withdrawals are taxed as income | Tax-free in retirement, if you meet the rules |
| Required withdrawals | Yes. Required minimum distributions (RMDs) start at age 73 | None while you're alive |
| Who can contribute | Anyone with earned income. Your deduction may be limited if you have a retirement plan at work | Income limits apply to direct contributions |
| What it can hold | The same for both: real estate, private loans, mortgage notes, private companies, and more | |
Traditional: pay the tax later
You may get a tax deduction today. The money grows tax-deferred. You pay income tax when you take it out in retirement.
The catch is RMDs. Starting at 73, the IRS makes you take a set amount out each year, whether you want to or not. That can push you into a higher tax bracket.
Roth: pay the tax now
You get no deduction today. But once you're 59½ and the account has been open at least five years, everything you take out is tax-free. That includes all the growth.
No RMDs either. You can leave the money growing as long as you live.
There are income limits for putting money straight into a Roth. If you earn too much, ask your CPA about converting traditional IRA money to a Roth. You'll owe tax on what you convert, but after that it can grow tax-free.
How to choose
- Expect a higher tax bracket later? A Roth usually wins. Pay the tax now at the lower rate.
- Expect a lower bracket in retirement? Traditional may save you more.
- Don't want forced withdrawals? Roth.
- Not sure? Many people keep both. That gives you choices about which to draw from each year.
Why this matters for note lending
Lending on mortgage notes produces steady interest. In a regular account, you pay tax on that interest every year. Inside an IRA, it's sheltered.
In a traditional self-directed IRA, the interest grows tax-deferred. In a Roth self-directed IRA, it can grow completely tax-free. That's why I use my own self-directed IRA in the same deals my lenders are in.
The rules for self-directed IRAs are strict, though. Your IRA can't lend to you or your family, and everything has to run through the IRA. I cover those rules on my IRA investing page.
General education, not tax, legal, or investment advice. Tax rules change. Talk with your CPA or tax attorney about your situation. All investing has risk, including loss of principal.