An advantage of a Self-Directed IRA is that it allows IRA owners to use retirement funds to purchase alternative assets, such as real estate. This can be done with a regular IRA, a Roth IRA, a SEP IRA, or a SIMPLE IRA. What are the different types of Self-Directed IRA accounts? Which one may be the best option for you? First, let’s examine what a self-directed IRA is and how it works.
What is an IRA?
An IRA is an individual retirement account that is set up by individuals. The SIMPLE IRA is typically funded by direct contributions or by money rolled over from 401(k) plans. For the year 2022, the maximum amount you are able to contribute to your retirement fund is $6,000. If you are over the age of 50, you are able to contribute an additional $1,000. There is no limit to how much you can move to your IRA through a rollover.
There are two main types of IRAs: traditional IRAs and Roth IRAs. Traditional IRAs are funded with pretax dollars, while Roth IRAs are funded with after-tax dollars. If you have your own business, you can choose either the SEP or SIMPLE IRA.
There are two ways to make investments with a Self-Directed IRA: (1) through a full-service custodian, or (2) through a Checkbook Control IRA LLC.
How Does a Self-Directed IRA Work?
The main difference between a self-directed IRA and a standard IRA is that a self-directed IRA gives the account holder more control over where their money is invested. The contribution limit for the 2023 tax year is $6,500 ($7,500 for those 50 and over). There are two types of self-directed IRAs that you can choose from- a traditional IRA or a Roth IRA. The contribution rules are the same for both types of IRAs, whether the contributions are made before taxes or after taxes.
The custodian of a self-directed IRA allows you to invest in a variety of assets, including alternative investments, according to Scott Butler, a financial planner at Klauenberg Retirement Solutions.
A self-directed IRA Custodian offers a wider range of investment choices, including real estate and other non-traditional assets. A self-directed IRA custodian allows you to invest in a wider range of assets, including real estate and other non-traditional assets, as opposed to a regular IRA where the custodian limits your investment options to approved securities like stocks, bonds, exchange-traded funds (ETFs), and mutual funds.
Some custodians offer self-directed IRAs that can invest in gold bars, silver ingots, or even cryptocurrency like Bitcoin. Some investors want the tax advantages that come with an IRA for investments in non-traditional asset classes. This could potentially lead to more profitable returns.
You cannot buy non-traditional assets from a self-directed IRA custodian. You have to buy them from another broker and then the custodian will hold them. The process of setting up a self-directed IRA becomes more complex when you factor in the possibility of fraud if you purchase alternative assets from an unreliable source.
Full Service/Custodian Controlled
An IRA opened at a custodian that offers self-direction has one more investment option than an IRA opened at a financial institution that does not offer self-direction. In order to invest in the way you want, you will need to find a custodian that allows for those investments.
IRA custodians usually generate fees by opening and maintaining IRA accounts, instead of offering financial investment products or platforms. With a custodian-controlled Self-Directed IRA, the funds are usually held with the custodian. The custodian will make the investment(s) you want, without giving advice or recommendations.
Checkbook Control/IRA LLC
The Self-Directed IRA LLC with “checkbook control” is a popular vehicle for investors looking to make alternative assets investments, such as rental real estate, that require a high frequency of transactions. A limited liability company funded by an IRA is created under the “Checkbook IRA” format. You, as the IRA owner, are the manager of the plan.
You can avoid certain fees and delays by using a self-directed IRA custodian. The Checkbook IRA LLC structure allows the investor to quickly invest in opportunities as they come up, without delay or extra cost.
Self-Directed IRA Choices
Traditional Self-Directed IRA
The ERISA of 1974 established the first traditional IRA. The amount you can deduct each year for contributions to your 401(k) plan is set by the IRS.
You can withdraw money from your account at any time, and the amount you withdraw will be taxed. However, you will have to pay a 10% early withdrawal penalty if you withdraw money before you turn 59 1/2 years old. The only tax that will be due on the distribution is the tax on the age.
At age 72, you are required to take mandatory withdrawals from your account, which are called required minimum distributions (RMD). The required minimum distribution for someone with traditional IRAs is about 3% of the total value of all their accounts. If you withdraw money from your account, it will be considered taxable income each year.
Best For:
Individuals who wish to receive an income tax deduction. Since a traditional IRA is funded with pretax money, you don’t pay tax on the money contributed to the plan. This means that your taxable income is lowered by the amount you contribute to a traditional IRA.
If you earn more than $129,000, you will not receive a tax deduction for your 401(k) plan. If you do not have access to a workplace retirement plan, you can still deduct money from your income.
This means that you don’t have to pay taxes on the money in your IRA until you withdraw it.
Self-Directed Roth IRA
. . The Taxpayer Relief Act of 1997 allowed taxpayers to establish a Roth IRA, in which after-tax income is used to make contributions that are not taxed when withdrawn during retirement. A Roth IRA is a retirement savings account that is funded with money that has already been taxed, unlike a traditional IRA. There is no upfront tax deduction. However, all qualified distributions will be tax-free during retirement. In order to qualify, you must be at least age 59 1/2 and any Roth account must be open for at least five years. This means that you can withdraw your contributions to a Roth IRA at any time without having to pay taxes or penalties.
You can contribute to a Roth IRA as long as you have earned income and you are below the income restrictions set by the IRS. For 2022, individuals earning over $144,000 and those married filing jointly who earn over $214,000 cannot directly contribute to a Roth IRA. The annual contribution limits for the traditional IRA and Roth are the same.
Once you reach age 72, there are no required distributions. This allows your Roth to grow untouched. If you don’t need the money, you can give it to your beneficiaries.
Best For:
Individuals who don’t need the immediate tax-break of a traditional Individual Retirement Account (IRA) may be better off in the long run using a Roth IRA. This job may be better for younger people who haven’t reached their earnings potential yet. However, anyone can benefit from tax-free money during retirement!
High earners can still get money into a Roth but they cannot contribute directly and won’t receive the tax break of a traditional plan. As of 2010, the IRS no longer has income restrictions for making Roth conversions. The Backdoor Roth strategy can be used to significantly increase the amount of money you have in retirement that is not subject to taxes.
Even though IRA contributions are not tax deductible, the opportunity to shelter Roth IRA gains from tax in the future is very advantageous.
Self-Directed SEP IRA
The 1978 Revenue Act established the Simplified Employee Pension IRA (SEP IRA), which allowed small business employees to contribute to a retirement account. A SEP IRA can only be adopted by a business based in the United States. It is essentially a profit-sharing plan. In 2022, taxpayers can contribute a maximum of $61,000 to their SEP IRAs. The contribution must be made in pretax funds. In order to make a contribution, an employee must agree to have a specified percentage of their income/salary (20% or 25% if W-2) deducted from their paycheck. Eligible employees must make contributions to all employees.
Best For:
A small business or sole proprietor. Before 2001, the SEP IRA was the most popular retirement plan for small business owners and the self-employed. However, in 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed and helped bring the Solo 401(k) to the top. There are several advantages to having a Solo 401k if you are self-employed or have an owner-only business. These advantages include the ability to make higher contributions, the option to take out a loan, and the Roth feature.
However, if all of your employees are part-time, you are still eligible to set up a Solo 401(k). If you’re self-employed, the SEP IRA is still the best retirement savings option for you, especially if you don’t have a 401(k).
Self-Directed SIMPLE IRA
The 1996 Small Business Job Protection Act saw the implementation of the Savings Incentive Match Plan for Employees ( SIMPLE IRA ). An employer can set up a SIMPLE IRA plan if they have 100 or fewer employees.
A SIMPLE IRA has a lower limit for employee contributions than a 401(k) plan, but, like an IRA, it uses a trust to hold employees’ contributions. By 2022, employees will only be able to defer $14,000 annually, with a $3,000 catch-up contribution for those aged 50 or above.
Best For:
business owners who are looking for a retirement plan that is easy to set up and maintain, and also cost-effective. The SIMPLE IRA is not as popular as the other types of IRA’s because it is not as strong as a 401(k) plan. If you don’t mind contributing a small amount each year, this could be a good option for you as a business owner. All other retirement plans should be considered first.
What Assets Can You Own in a Self-Directed IRA?
You can own the following non-traditional assets in a self-directed IRA:
- Cryptocurrency , like Bitcoin or Ethereum.
- Precious metals, including gold, silver and palladium at or above certain standards of purity standards.
- Real estate properties, although there are a variety of special rules that govern investing in real estate via a self-directed IRA.
- Startups, via crowdfunding platforms like Wefunder, SeedInvest or StartEngine.
- Tax liens and deeds on foreclosed properties.
- Foreign currency, via so-called forex IRAs.
At this time, you cannot invest in life insurance or collectibles that do not meet IRS purity standards. This includes things like artwork, antiques, and precious metals. If you choose to withdraw the money, you will be responsible for any taxes or penalties that apply.
Self-Directed IRA Benefits
People generally seek out self-directed IRAs for two main reasons: to pursue higher returns or to diversify their retirement savings outside of more traditional assets, such as stocks and bonds.
Potential for Higher Returns
The main advantage of self-directed IRAs is that they are flexible, according to Syet Nishat, partner with the Wall Street Alliance Group.
In a self-directed IRA, you are able to invest in alternative investments that are not allowed in a traditional IRA held by a brokerage company. You can also put your retirement money into high-risk, high-reward assets like Bitcoin and early-stage private companies. However, you should only do this if you are willing to accept the possibility of losing all of your investment.
Investments that have the potential to earn higher returns than the stock market also come with increased risks.
Increased Diversification
Many retirees are concerned that market volatility will cause inflation to decrease the value of their savings. For them, the ability to invest in alternative investments means they may be able to protect themselves against economic decline or the depreciation of their money over time.
Investing in gold, for example, is often seen as a way to protect your investments from economic recession and inflation. The popular belief is that gold is less volatile than stocks, but this is not always the case. In the short term, gold can be just as volatile as stocks. While investing in safe haven assets like gold and cryptocurrency can help diversify your portfolio, there are no guarantees that you will not experience a loss.
If you’re worried about market volatility and inflation, you may do better with inflation-protected government securities, like funds that invest in Treasury Inflation-Protected Securities (TIPS). You can hold these in a regular IRA.
How to Open a Self-Directed IRA
1. Find a Custodian
Self-directed IRA custodians can be banks, trust companies, or other entities approved by the IRS. When choosing a custodian, be sure to research their reviews and see if any complaints have been filed against them with federal agencies.
2. Choose What Products to Buy
After you decide where you want to open a self-directed IRA, you can then choose which alternative investments you want to buy. If you have decided on which alternative asset classes you would like to invest in, you may need to find a reputable dealer to buy from. This is especially true if your custodian does not have already-established partnerships. It may be helpful to choose a custodian that specializes in the type of alternative asset you are looking to invest in. For example, if you are interested in investing in gold, you may want to choose a custodian that specializes in gold assets.
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