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Retirement

What is a Self-Directed IRA (SDIRA)?

In 1999, Peter Thiel bought 1.7 million “founder’s shares” of PayPal for $1,700 with his Roth IRA. Within three years, PayPal went public and was acquired by eBay. His initial $1,700 investment turned into $28.5 million. Peter then used that money to make further investments from within his Roth IRA. He invested $500,000 into Facebook, which became worth well over $1 billion, and also invested into his new startup, Palantir, which also netted him over $1 billion.

In twenty years, Peter turned his initial $1,700 investment into over $5 billion. And because he invested through a Roth IRA, he didn’t owe any taxes at all.

A regular IRA doesn’t let you invest in alternative assets like venture capital, private equity, real estate, or cryptocurrencies. To invest in a startup using a Roth IRA like Peter did, you would need to open a self-directed IRA (SDIRA).

What is a self-directed IRA (SDIRA)?

A self-directed IRA is a traditional or Roth IRA that lets you invest in alternative assets. With a regular IRA, your investments are usually limited to stocks, bonds, mutual funds, real estate investment trusts (REITs), and ETFs. With a self-directed IRA, you can invest in things like real estate, private equity, and cryptocurrencies.

The contribution limits, tax treatments, and withdrawal rules are the exact same as a traditional IRA or a Roth IRA. The only difference between a regular IRA and a self-directed IRA is the type of investments you’re allowed to hold in your account.

You’re allowed to open a self-directed Roth IRA or a self-directed traditional IRA.

  • A traditional IRA is funded with pre-tax dollars. You get a tax deduction for the year, but your withdrawals in retirement are taxed as regular income.
  • A Roth IRA is funded with after-tax dollars. You pay taxes when you contribute, but your withdrawals in retirement are completely tax-free.

You can start taking qualified distributions from an IRA when you reach the age of 59½ years old. Any early withdrawals are hit with a 10% penalty along with income taxes on the amount drawn.

However, with a Roth IRA, you’re allowed to take only your contributions out of your account without penalties at any age. In order to withdraw your earnings, you’ll need to wait until you’re at least 59½ years of age and your account must be at least 5 years old.

How does a self-directed IRA work?

With a regular IRA, you can normally only invest in traditional assets like bonds, stocks, mutual funds, and ETFs. If you want to invest in alternative assets, you need to open a self-directed IRA with a plan provider that offers the investments types that you're looking for.

For example, if you're looking to invest in cryptocurrencies with your IRA, then you would need to find a self-directed IRA with a plan provider that specifically allows cryptocurrency investments. Most large banks and brokerages do not offer these options.

You still need a trustee or custodian

Any IRA account must have an IRS-approved institution that serves as the account's custodian. For a regular IRA, the custodian is usually the bank or brokerage that provides you the IRA. With a self-directed IRA, you have to go out and find a 3rd party custodian for your IRA.

A self-directed IRA is not 100% controlled by you. You need a custodian who acts as the intermediary between you and the investments. If you want to invest in crypto or write a check into a startup, you don't have checkbook control. You have to go through your custodian and ask them to invest in it for you.

Your custodian is also responsible for maintaining all records, filing IRS reports on your behalf, and performing other administrative duties for your account. Depending on the custodian, prices could be steeper than holding a regular IRA, and they may charge fees every time they perform a transaction for your account.

If you're looking for checkbook control over your IRA there's also something called the IRA LLC, also known as the Checkbook IRA.

With a self-directed IRA, custodians are not allowed to give you any financial advice. You must do all your own due diligence, choose your own investments, and make sure that you're not breaking any rules.

Benefits of a SDIRA

The main benefit of a self-directed IRA is that you have a wider variety of investment options that can provide higher returns. Instead of being limited to stocks, mutual funds, and ETFs, you can start to invest in assets like crypto and real estate. You can also invest in startups through your account, like Peter Thiel.

Risks of a SDIRA

The risks of a self-directed IRA is that you're responsible for your own investments and for staying in compliance. Your custodian cannot give you financial advice when you have a self-directed IRA.

Here are some of the main risks and things to look out for when you have a self-directed IRA.

Prohibited investments

You can invest in almost anything with a self-directed IRA, except for two things:

  1. Collectibles: Art, antiques, rugs, stamps, gems, rare coins, and alcohol are all classified as collectibles. You can view the full list of what items are classified as collectibles in IRC section 408(m)(2).
  2. Life insurance investments: You cannot invest in cash value life insurance that act as permanent policies and accumulate in value over time.

Prohibited transactions

This is perhaps the trickiest part of keeping your account in compliance. Essentially, your IRA cannot transact with a disqualified person. You, your spouse, lineal ascendants and descendants, fiduciaries, or any entities controlled by such persons are considered disqualified persons.

Fraud

You're at more risk of fraud with a self-directed IRA since your custodian is not liable for evaluating the legitimacy of investment options.

Less liquidity

With alternative assets, it may take longer to find a buyer to sell your holdings when you need the money. With assets like stocks, ETFs, and mutual funds, you can sell them quickly when you need money. But if you're holding things like real estate, physical gold, or even NFTs, you may have a tough time selling if there aren't enough buyers. This can be a more serious problem if you're over the age of 72 and are required to start taking required minimum distributions.

A Roth IRA does not have required minimum distributions, but a traditional IRA does.

More fees

With a general IRA, you can typically buy and sell assets without paying high (or any) account management and trading fees. A self-directed IRA could have steeper management fees, setup fees, and additional fees based on the alternative assets you're investing in.

Lack of diversity

While you have more investment options with a self-directed IRA, a common trait amongst people who hold self-directed IRAs is that their investments are fully concentrated into just one or two investments.

How to open a self-directed IRA

To open a self-directed IRA, you must first find a custodian for your account. The IRS requires that all retirement assets are held by a qualified custodian. This could be a bank, credit union, or trust company and each one is different in the kinds of investments they let you invest in. Make sure to look for a custodian or broker that allows the types of investments you're looking for.

Once you find a custodian, open an account, and complete any required paperwork. Then, you're off to the races to start investing in the alternative assets you want to hold in your account.

Once you find what you want to invest in, choose a broker that will facilitate the transaction (for example, a crypto exchange, real estate agent, etc) and then inform your custodian to fund and complete the transaction.

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