Getting Started with a Self-Directed IRA When Your Nest Egg is Small

While you might have been initially drawn to a self-directed IRA because of the investment flexibility that this account type offers when compared to IRAs with traditional custodians (e.g., being able to invest in precious metals, and real estate, and private companies), it’s true in all areas of investing that not every investment option is suitable for every investor.

Precious Metals. One way that this quickly becomes apparent is with respect to investing in precious metals. Investing in bullion or investment grade coins can be a great way to diversify and hedge your other investments, but it’s significantly more expensive than more straightforward investments like publically traded stocks. And some of these expenses are baseline fees to get started, regardless of the size of your investment.

Make the Maximum Contributions Every Year. When your self-directed IRA balance is relatively small, it’s vital that you make the maximum contributions to your account each and every year. If you fail to make the maximum contribution in any given tax year (the contribution limit for the 2015 filing period is $5,500, with an additional $1,000 allowed for taxpayers age 50 and over), you won’t be able to make up for that lost opportunity in later years. Once the chance to make the maximum deposit has passed, it’s gone forever.

Consider Maintaining Two Accounts. It’s a common misconception, but taxpayers are not limited to having a single IRA. In fact, it can be good practice to maintain both a traditional self-directed IRA as well as a Roth self-directed IRA, and then decide where to make your deposits each year based on the tax deduction advantages you might be able to get from contributing to the traditional account. The key is to deposit the maximum each year, regardless of the self-directed IRA you choose. And remember that it’s always possible to convert a traditional self-directed IRA to a Roth account whenever you decide that you only want or need a single account.

Does Small Mean Little Investment Experience? If your nest egg is relatively small because you’re just starting out with your retirement savings and don’t have a lot of investing experience, then don’t feel pressured to start investing in the most complicated and advanced investment types right away. Even though the self-directed IRA structure permits investments in a wide range of investments, you’re still free to choose investments that you have more experience and familiarity with.

Use 401(k) Rollovers. Finally, another way to grow your self-directed IRA is through the use of rollovers. Whenever you leave an employer, you’re permitted to roll over the funds you’ve accumulated in your 401(k) to an IRA. Because many individuals are permitted to contribute to both 401(k)s and IRAs, this can be a great technique for building as large of a nest egg as possible.

Why It’s Important To Coordinate Your Taxable Investments With Your Self-Directed IRA Investments

Your self-directed IRA can save you a lot of money in taxes, both in the short term as well as in the long run. If your IRA is set up as a traditional account, then (depending on certain aspects of your financial position) you may be able to take a tax deduction for those contributions. And contributions in traditional IRAs will grow on a tax-deferred basis, while the investment gains within a Roth IRA will never be subject to taxation. Many individuals are well-versed with the various tax implications on this level.

But there’s another perspective from which you may want to consider your self-directed IRA tax analysis, and this is the way that your taxable investment accounts, and investment decisions, can impact your self-directed IRA investments.

Let’s first examine just how valuable your self-directed IRA can be. Consider two hypothetical portfolios of $100,000, one a taxable account and the other a self-directed IRA. Let’s further assume that each portfolio is comprised of stock that pays dividends at a 3% rate annually (with those dividends being reinvested), and that the stock price appreciates 5% annually.

At the end of 25 years, the value of the taxable account would be approximately $525,000, while the self-directed IRA is worth over $630,000. This difference in value is attributable solely to the fact that the owner of the taxable account has to pay taxes on the dividends they receive, even if they choose to reinvest those dividends.

If the self-directed IRA is a traditional account, then you will have to pay taxes on those gains, but they’re likely to be at a lower tax rate (because you’re in retirement and perhaps no longer working full time), and they’ll only be taxed when you take the distribution. If your account is a Roth IRA, then you’ll realize the full value of the investment gains.

So one common tax optimization strategy is for an individual to place income-generating investments that would otherwise incur a tax liability into an IRA in order to avoid that liability.

On the other side of the equation, it’s important to note that there are certain tax advantages that are actually disallowed within an IRA. For example, investment interest (such as borrowing funds to purchase a stock investment, or taking out a mortgage to buy a piece of real estate) can be used to offset gains in a traditional account. But borrowing funds is considered to be outside the scope of permissible activities for self-directed IRAs, and the tax benefit of those expenses will be lost inside the retirement account.

It’s the same situation for investments that have tax advantages built in, such as municipal bonds. Because these investments would already be tax-advantaged outside of an IRA, there’s no reason (and it’s actually a missed financial opportunity) to keep these types of assets inside a retirement account.

Understanding the interplay between your taxable investment accounts and your self-directed IRA will put you in the best position to make the optimal investment decisions.