Self-directed IRAs can be a very powerful tool to help you reach your retirement goals., But along with this powerful account structure come certain risks that you need to be on guard against……..
Borrowing Money or Using Leverage. Self-directed IRAs are so valuable largely because they can be used to purchase various types of investments that traditional IRA custodians would not allow. A retirement saver with a self-directed IRA at a custodian such as Quest Trust Company can use their account to purchase private equity investments, precious metals and real estate. It’s even possible in some circumstances (and subject to certain conditions) to take out a mortgage with a self-directed IRA in order to borrow money to purchase larger pieces of real estate.
While this type of borrowing or leverage activity is permissible, it also comes with certain tax consequences. Specifically, any investment income is generated using borrowed money or leverage within a self-directed IRA will generate a current year tax liability for the account holder. This can come as a surprise to some retirement savers, since most other investment activities and the gains within an IRA did not give rise to similar liabilities.
Self-Dealing. The laws and regulations regarding IRAs are very clear and strict when it comes to the prohibitions on self-dealing. “Self-dealing” is receiving a benefit from your IRA before you take any formal distribution of assets from the account. And the notion of “benefit” is construed very broadly.
For example, you might choose to use your self-directed IRA to purchase a vacation cabin near a ski resort, with the idea of renting it out now to generate income for your IRA, eventually living in the cabin when you retire. This is a perfectly valid investment within a self-directed IRA, but you cannot personally use that cabin (nor can any family members or “related persons”) before you retire – even if you pay the same rental fees that an unrelated person would. Engaging in this type of self-dealing could result in significant financial penalties.
Investment Risks. Sometimes the funds in an IRA can seem a little removed from an individual’s other assets, particularly when that individual might not have penalty-free access to those funds for decades. This can sometimes lead the account holder to take investment risks with those funds that they wouldn’t feel comfortable taking with their non-retirement accounts.
This can go too far in the other direction as well. Given the importance of a retirement savings account, some individuals are overly conservative in their investment choices within a self-directed IRA. It’s true that capital preservation is important, but that shouldn’t be your only consideration, and it shouldn’t necessarily come at the expense of investment growth. For example, you could be very confident that your account balance would never decline, even temporarily, by investing all of your retirement assets and bank CDs. However, if this is your only investment type for 30 years, you may find it difficult to reach your retirement savings goals.
By understanding all of the rules that apply to self-directed IRAs, you’ll be in a much better position to reach your retirement goals