Self-directed IRAs (SDIRAs) are very popular and continue to enjoy widespread use yet remain a bit of a mystery to not a few investors. The savvy investor can position himself to take advantage of all the potential rewards with SDIRAs, but unfortunately he will have to accept the many associated risks. To make the best informed decision whether self-directed accounts are a good fit for your particular financial lifestyle, it’s important to separate truth from myth.
Debunking Some of the Myths Surrounding SDIRAs
If you inquire, you’ll hear quite a few statements being said about self-directed IRAs. It seems that almost everybody is an expert. Of course, some of the things you’ll be told are pure fiction spouted by those who really don’t know what they’re talking about, while other myths you come across can actually contain a grain of truth. But how do you know which is which? To help you get things sorted, keep reading as we examine a few of the popular fairytales people associate with SDIRAs.
Myth #1 – It is very difficult to establish a self-directed account
Fable. Illusion. 100% false. The simple fact is that most SDIRAs are very easy to establish. All you really have to do is contact the financial institution with which you want to set your account up and discuss your desire to do so. Most banks and credit unions offer an easy-to-follow plan. They will guide you through the account creation process whether you opt to use their services (as a custodian) or go the truly self-directed approach with a checkbook IRA.
Myth #2 – You cannot use your IRA to purchase real estate
This is most certainly true, but only for traditional and Roth IRAs. Regarding a self-directed IRA, this is 100% myth (it is false). In fact, you can use your SDIRA to invest in real estate as well as a plethora of various investment options—all of which are not available for those holding traditional IRAs.
Simply put, it is all of these various options (that don’t involve typical investment fare) that genuinely make SDIRAs so attractive to many investors. Now, with that said, there are some very stringent requirements surrounding real estate purchased via SDIRAs that you must follow if you want to stay on the right side of the IRS by avoiding silly penalties and damaging tax repercussions.
Myth #3 – In order to have an SDIRA you must have an LLC
This one is true, but only sometimes. Only a “checkbook IRA,” also known as a self-directed IRA LLC, requires a Limited Liability Corporation to be established. If your IRA is controlled through a bank or other custodian then an LLC is not necessary. However—and this is very good to know—custodial accounts cannot offer nearly the same privileges regarding privacy, risk and asset protection that your LLC can provide.
Myth #4 – Your IRA cannot legally own a business
This is another fiction. It’s completely false. You already know that you can purchase real estate with your SDIRA. Likewise, you can buy a business with an IRA too. In the same vein as an IRA that aggregates real estate, so too there are strict rules that must be heeded when considering business ownership by the IRA as well as profits derived therefrom.
Understanding the Severity of Risk of Self-Directed IRAs
Now that we’ve explored the authenticity of IRA myths, we should give equal time to the risks involved, because these kinds of accounts definitely come with the serious potential for loss. To be blunt, this is not an investment vehicle that works well for novice investors, generally speaking. However, for experienced investors and those willing to learn and play by the rules, it can be highly rewarding.
Risk #1 – Fraud
This one is glaringly obvious: there is the very real risk of being defrauded. There are people who seek out and prey on self-directed IRA investors because these malcontents know that not every account will have the benefit of a custodian and that, sadly, not every investor will utilize the seasoned financial advice of others who are more experienced.
Risk #2 – Finding yourself in non-compliance with IRS rules & regulations
This is a big one. Any time you fail to strictly adhere to the published rules of the IRS governing IRAs you can be subject to enormous penalties, fines and fees that cost you more than you’re earning. Nobody wants to take a loss in their investments, which is why it’s paramount you understand the letter of the law while investing in SDIRAs.
Risk #3 – Loss of investment, loss of profit
By their very nature, investments are risky. This is obviously why they can be so lucrative; the bigger the risk, the larger the potential benefit. Since you’re basically on your own with a SDIRA, you and you alone must bear the brunt of your miscalculations and ignorance. Educating yourself is the best plan of attack here; making sure you don’t walk into this blindly and ensuring you follow all investment requirements.
Risk #4 – Hey! Where are all my advisors?
Even if you opt to create an account having a custodian, bear strictly in mind that that person’s role is not to advise you of any legality, wisdom or potential fraud in your plans and schemes. This means you’re solo: there is nobody watching your back acting in the capacity of a fiduciary or as an advisor helping you grow your investments while also steering you clear of legal complications.
Investors enjoy a tremendous amount of freedom with self-directed IRAs, but there is a price to pay. The risks are substantial. Profits certainly aren’t guaranteed. This is neither an investment for the faint of heart nor for those who need to be coached and monitored. But if you’re the type who is comfortable teaching yourself and you’re confident in your own acumen, the financial payoffs are abundant as you invest wisely, timely and in accordance with the rules of the road.