Flexibility is one of the hallmark benefits of self-directed IRAs – but it can also be a double-edged sword. In the hands of an inexperienced or misinformed investor, the extended range of options under a self-directed IRA can sometimes lead to financial trouble.
But for a certain class of investor with the right mindset, the flexibility offered by a self-directed IRA can prove to be an invaluable retirement resource for growing retirement savings.
Here are five key attributes of a successful self-directed IRA investor.
1. Investment expertise
A self-directed IRA allows you to invest in what you know. Investments such as real estate, privately held companies and promissory notes can sometimes earn higher returns than traditional investments in stocks, bonds, mutual funds and ETFs but may be illiquid and offer higher risk. When self-directing IRA investments, it is crucial that the investor have the necessary expertise to make informed decisions about the targeted investment.
2. Follows the rules
In order to maintain an IRS-compliant self-directed IRA, you must be aware of extra rules that apply when investing in non-traded alternative investments. For example, you are not allowed to use a self-directed IRA to purchase a piece of real estate you already own; you can’t borrow money from the IRA as a down payment and you can’t use IRA funds to invest in a company where you have a 50% or more ownership interest. If you decide to self-direct your IRA investing in alternatives, you should be prepared to pay close attention to identified prohibited transactions with disqualified persons. The IRS does not take ignorance as an excuse and if you break the rules you could be facing a full distribution of the IRA, taxes and penalties.
3. Knows that investing takes work
When you choose to self-direct you and you alone are responsible for your investment choices. It takes time and effort to learn the rules, identify the right investment, consult with trusted advisors, perform due diligence on the investment and principals involved in the offering and select the right service providers for administering the assets in your self-directed IRA.
4. Desire for portfolio diversification
Some people are happy with a simple investment strategy that focuses on stocks, bonds, mutual funds and ETFs – and that is perfectly fine. Self-directed IRA investors seek further portfolio diversification in an effort to offset the extreme ups and downs of the markets. For experienced investors, self-directed IRAs allow them to expand beyond traditional markets and add unique investments to their retirement portfolios in a tax advantaged manner.
5. Risk tolerance
Investing always carries some degree of risk. Some alternative assets under a self-directed IRA plan are particularly risky, meaning they have a higher chance of a short-term loss than traditional assets. For example, large companies like Apple and Exxon are unlikely to go bankrupt in the next year – so your stock investment should be safe – but a brand-new business partnership (which you can invest with through a self-directed IRA) might not fare so well.
In the long-run, this extra risk can potentially earn higher returns than traditional investments. If the business partnership in your hypothetical example above succeeds, then you would receive a much larger share of the profits than what you could ever earn as an Apple investor. But taking those long-term gambles requires a strong stomach tolerant of short-term risk, otherwise you risk making emotional decisions that deter long-term investment strategies.
A self-directed IRA is not for everyone, but the benefits can be rewarding. Read more about following IRS rules here.