Traditional retirement accounts like managed individual retirement accounts (IRAs) and 401(k) plans are household staples and well-known to those thinking about their retirement. But if you are an investor looking to expand your investments beyond the stocks, bonds and funds traditional retirement accounts are limited to, a self-directed IRA (SDIRA) may be a good choice to consider.

What’s the difference?

It all comes down to the flexibility you have with your investments.

Traditional retirement accounts are held by banks and brokerage firms who function as the custodian as well as the investment platform. In other words, they hold your money and invest it on your behalf in traditional investments like stocks, bonds and funds. 401(k)s are funded by pre-tax contributions and earnings accrue on a deferred tax basis. With traditional IRAs, contributions may be tax deductible and earnings are tax-deferred until the time of withdrawal. With Roth IRAs, contributions are made with money on which taxes have been paid and earnings can grow tax-free.

On the other hand, self-directed IRAs are held by specialized custodians; transactions can be directed by you as the investor or by the custodian. Traditional, Roth, SEP or SIMPLE IRAs can all be self-directed. The flexibility of SDIRA accounts allows investors to place money into any asset permitted by the IRS, including traditional and alternative investments. Investments are bought, sold and maintained through a self-directed IRA while earning tax benefits on capital gains. They allow the investor to acquire alternative assets, not accepted within traditional accounts, while maintaining the benefits of tax-free or tax-deferred growth.

What counts as an alternative investment?

As mentioned above, the main differentiator of SDIRAs is the type of investments allowed. Some of the most popular alternative investment choices within a SDIRA include:

  • Real estate (investment properties, non-traded REITs)
  • Precious metals
  • Private equity (venture capital, pre-IPO companies)
  • Private businesses
  • Cryptocurrency
  • Secured and unsecured notes (mortgages and deeds of trust)
  • Oil and gas rights

This list isn’t exclusive but is meant to list the most common alternative investment choices. In addition to the alternatives that can be bought, there are also prohibited assets, which include life insurance and collectibles (art, jewelry, antiques, coins, etc.).

What are the costs?

Costs associated with opening and servicing a self-directed IRA are important to evaluate when selecting your custodian, as they can range from hundreds to even thousands of dollars each year, depending on the custodian you choose. But, to many, the ability to invest in alternative assets with a tax-deferred account far outweighs the costs of a self-directed IRA.

Prohibited Transactions

Prohibited transactions refer to transactions made through self-directed IRAs that don’t meet IRS rules.

Prohibited transactions occur when an IRA transaction is conducted with a disqualified person. There are several events in which you may even be considered the disqualified person. A disqualified person typically involves someone who exhibits fiduciary control over the IRA, including certain family members.

Breaking IRA distribution rules can be costly and have serious consequences. If a disqualified person is involved in a prohibited transaction, the IRS imposes a tax on the investor, and the investment loses its tax-free or tax-deferred status. Be sure to consult your CPA or tax advisor.

3 Types of Prohibited Transactions:

  • Per se prohibited transaction - occurs when an IRA engages in transactions with a disqualified person.
  • Extension of credit prohibited transactions - occurs when a disqualified person extends credit to an IRA.
  • Self-dealing prohibited transactions - occurs when a disqualified person benefits directly from an IRA’s investments.

What are the drawbacks of a SDIRA?

Alternative assets help diversify investment portfolios and may help generate a higher return rate but may carry higher risk and are often less liquid than stocks and bonds. Investors also need to be aware and cautious of certain compliance risks specific to SDIRAs. For example, real estate bought through a SDIRA cannot be for personal use and all income generated by the property must come into the account and all costs associated with the property must be paid through the account, i.e. you would not be able write a personal check for a small electrical repair in your rental property.

The Verdict

Choosing a traditional or self-directed retirement plan comes down to personal preferences. If you don’t mind (or prefer) to manage your own investments, a self-directed plan may offer you more freedom to choose assets that appeal to you. If you prefer to contribute to a retirement plan without the hassle of managing it, a traditional plan managed by a custodian may be the better option. With more than one-third of Americans still without any form of retirement savings, the best answer still seems to be the simplest one: save early and save often.

Remember it is easy to accidentally run afoul of the many tax and plan rules, so be sure to consult a tax advisor for help with this important decision.

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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.