Do You Have a New Child on the Way? Here are Some Changes to Consider for Your Self-Directed IRA

Estimated reading time: 3 minutes

Big life changes often bring about big changes to your financial plans as well. Finding a new job, losing your job, getting married, getting divorced, or having a parent or family member suddenly require long-term medical care can all introduce a significant need to reevaluate your long-term plans. Having a child is another instance in which you may wish to consider making some changes to your retirement accounts, including your self-directed IRA.

Prioritize Your Contributions

You should be working to prioritize and maximize the effectiveness of your IRA contributions each year, but it will become even more important when you have a new child. You’ll be faced with many new expenses relating to your becoming a parent, and these financial challenges can sometimes have the unfortunate effect of causing individuals to forego or reduce their annual retirement contributions.

But when you know you have another person counting on you – now and into the future – it’s even more important that you continue executing your long term financial plan. And a big part of this is making sure that you contribute to your self-directed IRA every single year.

Updating Your Beneficiaries

As you work to integrate your new child into your life, you’ll likely be doing things like updating your will, adding your child to your health insurance, and perhaps naming them as a beneficiary of your life insurance policy.

This is also a good time to revisit the beneficiary designations you might have made for each of your financial accounts, including your self-directed IRA. Depending on how they are phrased, these types of beneficiary designations can supersede the terms of your will your will, so you never want to just assume that your assets will be distributed in accordance with what you may have written in your will. The beneficiary designations in your IRA documentation must be up to date.

Converting to a Roth IRA

Also on the subject of beneficiaries, it’s important to note that a self-directed Roth IRA contains a number of different estate planning advantages over a self-directed IRA that’s set up as a traditional account.

Converting an existing self-directed IRA from a traditional account to a Roth account will cause a tax hit in the year of conversion, but if you still have a decade or two before retirement, or you have significant other retirement assets, then performing such a conversion can be a big boost to your overall wealth. And if you haven’t yet set up your self-directed IRA, then consider all of the long-term advantages that a Roth account can provide over a traditional account.

Under ideal circumstances, you should be reviewing all of your financial accounts on a fairly regular basis, including long-term accounts such as your self directed IRA. It’s certainly not uncommon for people to neglect those regular evaluations. But when you have a new child on the way, it’s absolutely essential that you give your accounts another look.

Tips for Navigating the IRA Rules on Required Minimum Distributions

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In general, the concept of an individual retirement account is relatively easy to understand, even for individuals who haven’t yet opened an account for themselves. The IRA lets you save money for retirement by making investments of your choosing (and self-directed IRAs provide even more options in this regard) and you’ll receive certain tax benefits as part of owning an account.

But some aspects of the IRA are fairly new to some people in the first open an account. One of the most potentially confusing concepts is the IRS rules on required minimum distributions (or “RMDs”). Here are some tips for navigating and staying on the right side of the rules.

What is the General Rule for Required Minimum Distributions?

The IRS requires that once the owner of a traditional IRA reaches age 70½, that individual must begin taking distributions from their account. These distributions are subject to a required minimum (which is calculated on the basis of the individual’s life expectancy and account balance), and must be made each and every year. There are several important points to recognize when it comes to this rule.

Roth IRAs Aren’t Covered.

Perhaps most significant rule is that the RMDs only apply to traditional accounts. Roth IRAs are not subject to the RMD rules. This means that an account holder can continue to let their Roth IRA grow for many years into retirement. For retirees who have multiple sources of retirement income (Social Security, 401(k)s, other IRAs, etc.), this can be a great way to maximize their overall nest egg.

In addition, since different types of IRAs – particularly Roth accounts – can be used to achieve various estate planning goals, the fact that Roth accounts are not subject to the rules for RMDs makes them especially attractive savings vehicles.

The RMD Amounts are Only Minimums.

The rules on RMDs don’t exist for the purpose of creating a withdrawal schedule that you must follow during retirement. The amount that is calculated as the required minimum for any given year is just that; a minimum. You are always free to take out more than the RMD amount from your account each year.

The RMD Amounts Change.

Furthermore, because the RMD amount is based in part upon the balance in your account, your investment performance can significantly change the RMD amount from one year to the next. As your account grows, for example, the amount might actually increase significantly from one year to the next.

Self-Directed IRA Considerations.

Special considerations must be given to these rules if you choose to structure your self-directed IRA as a traditional account. Consider how you will satisfy the RMD rules each year once you enter retirement. For example, if your account investment portfolio is comprised largely of real estate, will you need to liquidate any of your holdings in order to meet your obligations?

If you find that satisfying the rules for RMDs from a traditional self-directed IRA may be too onerous, remember you can always evaluate the possibility of converting to a Roth account.

Best Practices for Maximizing Your Tax Benefits With a Self-Directed IRA

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Self-directed IRAs are a powerful tool to help individuals build the largest possible retirement nest eggs. Obviously there is great value to being able to choose from the widest possible range of investment options. But the greatest upside of having a self-directed IRA and making regular contributions to it is the fact that it provides you with long term tax-deferred (or, in the case of a Roth IRA, tax-free) growth.

Here are some of the best practices for maximizing all the available tax benefits you have with a self-directed IRA.

Current Year Tax Deductions for Contributions

If your self-directed IRA is structured as a traditional account, then you may be able to take a current year tax deduction for the value of your annual contributions, depending on your income and whether you are covered by a retirement plan at work. While you’ll be subject to taxation on withdrawals from your traditional self-directed IRA once you reach retirement (which wouldn’t be the case for withdrawals from a Roth account), you may decide that the current year tax advantage is worth it to you.

Hold Tax-Advantaged Investments in Your Taxable Accounts

Because all investment income and capital growth that happens within a self-directed IRA is tax-advantaged, holding investments that have built in tax-advantages is redundant and wasteful in terms of tax benefits. Therefore, if you invest in tax-free government bonds then those assets would be better held in a taxable account, and not your self-directed IRA.

Avoid UBTI

Also in the same category of avoiding mistakes is making sure used to your clear of unrelated business taxable income (UBTI). In the context of self-directed IRAs, UBTI most often becomes an issue when an account holder borrows money to make an investment – commonly by taking out a mortgage in order to buy real estate. Borrowing money to invest is outside of the statutory authorizations of any IRA, so it’s important to avoid any transactions that would lessen the tax benefits of your account.

Maximize Tax Free Growth

In order to maximize the benefits of tax-deferred or tax-free growth within your self-directed IRA, it’s important to let your account grow for as long as possible. One implication is that you should try to avoid taking any early withdrawals from your account. Even if you fall within one of the penalty-free exemptions for doing so, by reducing the amount you have invested you reduce the amount of tax benefit you’ll achieve in the years leading up to retirement.

Consider a Conversion to a Self-Directed Roth IRA

Finally, if you truly want to maximize your tax benefits, consider converting a traditional self-directed IRA into a self-directed Roth account. You’ll need to pay taxes on the conversion amount, but if you can afford that current year tax hit, and you have a number of years before retirement, it may be the best long-term decision.

Of course, tax laws evolve and change over time, so it’s also very important that you stay up-to-date on all the rules and regulations regarding self-directed IRAs.

Three Common IRA Myths to Guard Against

Estimated reading time: 3 minutes

There is a lot of good information out there about individual retirement accounts. Quest Trust Company, for example, has published a great deal of valuable information and guidance about the pros and cons of the various account types, including the self-directed IRA, how to get started, and pitfalls to avoid.

But there’s also no shortage of misunderstandings that people have, as well some common IRA myths have been around for decades, it seems. The biggest problem with this misinformation is that it can lead people to make sub-optimal decisions regarding their accounts, or perhaps even to not open an account in the first place.

Here are three of the most common myths that you need to guard against.

It’s Not Worth Making Non-Deductible Contributions to an IRA.

Many retirement savers are initially drawn to IRAs because their contributions may be tax-deductible in the year they are made. This can be an extremely strong incentive to contribute, as it effectively gives the account holder and immediate “rebate” or return on their investment equal to the amount of their deduction.

The downside of this valuable benefit is that it can sometimes lead people to focus too much on the possibility of a deduction and not enough on the long-term benefits of the IRA itself. For example, Roth IRAs don’t allow deductibility of contributions, but all investment earnings and income within the account can be withdrawn tax-free during retirement. (With a traditional IRA, those withdrawals during retirement would be taxable.)

Even if you are not eligible to make contributions to a Roth account, making nondeductible contributions to a traditional IRA still provide a significant tax savings because of the tax deferred nature of investment earnings. Just keep in mind that you may want to set up a separate account for those nondeductible contributions, just to ease your administrative burden.

You Can’t Make Contributions to an IRA and 401(k) in the Same Year.

Another common misconception is that an individual cannot contribute to both a 401(k) and an IRA in the same tax year. This is simply not the case.

Both IRAs and 401(k)s have annual contribution limits, and your decision to participate in an employer-sponsored 401(k) may impact the type of IRA contribution you can make (deductible versus nondeductible) but you certainly can – and should – seek to maximize your IRA contributions each year.

Self-Directed IRAs Have No Investment Limitations

This myth is really only applicable to self-directed IRAs, but it’s an important one to understand. Self-directed IRAs provide individual investors with far more options than the IRAs that are available from traditional custodians. But there are IRS restrictions that apply to all IRAs (even self-directed IRAs), including prohibitions on self-dealing. For example, you can’t use your self-directed IRA to invest in a business that you draw a salary from, or to purchase art or collectible coins (even if your intention is to make those purchases for investment purposes).

The best way to make sure you understand all the important factors surrounding IRAs is to do your research.