Self-directed retirement accounts have gained traction as a viable retirement solution as the democratization of finance leads to smarter investors. Self-directed retirement allows investors to control their own retirement by making investments outside of the traditional marketplace. This allows them to make alternative investments such as partnerships and private mortgages. The nature of the self-directed solution may lead to outsize returns, while raising an investor’s risk profile.
The advantages of self-directed retirement accounts are multifold. The most obvious of these benefits is the diversification of an investment portfolio. Investors are not as dependent on stock or bond market returns as they would be with a traditional IRA. The self-directed solution gives investors access to products that normally only institutional investors can purchase. Investors can build a far-reaching portfolio that allows them to invest in assets in which they may have an expertise. While there are prohibitions on certain investments such as artwork, coins and other purchases, there is a wide variety of permissible investments.
Favorable Tax Treatment
Another major benefit of a self-directed account is the favorable tax treatment. Like a traditional IRA, investors can defer taxes on their investment gains until retirement. This tax deferment leads to a higher rate of return on investment as investments can be rolled over and compounded without having to pay taxes. Also, some self-directed IRA plans allow you to pass wealth to future generations after death with favorable tax treatment.
These accounts are suitable for high net worth investors who hold most of their assets in their retirement account. Generally, investors in self-directed IRA’s should have a certain degree of investment knowledge and savvy. These products are not suitable for every investor.
There are some drawbacks to self-directed retirement plans. The first is the greater risk that comes with alternative investments. While the reward for these investments can be great, there is also a greater risk of losing one’s entire investment. Alternative investments are not as transparent as more traditional investments, and that increases the risk of this type of retirement account. In addition, because of the nature of the investments made in this account, investors are at a greater risk of fraud. Thus, it becomes all the more critical to find trusted individual retirement solutions.
Another drawback of self-directed retirement account is the complex tax rules. Although these accounts are generally tax deferred, there are some triggering events that could cause a tax liability. The rules regarding tax treatment for these investments are esoteric and difficult to understand for the average investor. Usually, investors are best off consulting with an accountant or lawyer in order to understand these tax rules and not run afoul of the Internal Revenue Service.
Additionally, for those investors who do not have a long-term outlook, self-directed IRA’s may not be the most suitable option. The alternative investments that are covered by this account are generally not the most liquid securities. Thus, it can take a long time to close out of a position. For investors that would need shorter-term access to their money, that would be difficult to gain in a self-directed account.
There are some benefits to a self-directed IRA. In order to explore this option, consult with an investment professional.