Why the Self-Directed IRA is the Best Long-Term Savings Vehicle

Estimated reading time: 2 minutes

Being able to save for a financial goal is one of the most valuable skills a person can ever develop. You’ll likely set a variety of savings goals throughout your life, including short-term, medium-term and long-term goals. The ultimate long-term savings goal is saving for your retirement. And the ultimate savings vehicle for retirement is the self-directed IRA.

Let’s look at a few of the reasons why.

Tax-Deferred Growth.

Like other traditional IRAs, the biggest strength of a traditional self-directed IRA is that it provides the opportunity for your investments to grow on a tax-deferred basis. This means that any income you receive from the investments within your account will not be subject to tax for as long as those funds remain in the account. Similarly, any gains from the sale of investments within your account will be free from taxation, provided that those funds (and any investments you make with those funds) remain within your account.

Additional Investment Options.

A self-directed IRA with a custodian such as Quest Trust Company affords the account holder with investment options that traditional IRA custodian will not permit. For example, you can use a self-directed IRA to invest in assets such as private equity and real estate, and to make loans to businesses or even for real estate mortgages. Many of these asset types have long investment timeframes, which allows you make investment choices to precisely match your retirement goals.

The breadth of investment choices you’ll have with a self-directed IRA is even more apparent when you compare them with any 401(k) plan options that you may have through your employer.

Administrative Advantages.

Speaking of 401(k) plans, you’re likely to accumulate multiple 401(k) accounts over the course of your career. Many plan administrators limit your ability to make new investments once you leave the employer, and having to keep track of multiple accounts can reduce your ability to execute on your retirement plan. Having a self-directed IRA as your sole or primary retirement account can lessen your administrative burden.

Additional Roth Self-Directed IRA Advantages.

If the features we’ve discussed above aren’t enough, then consider the additional benefits you receive by structuring your self-directed IRA as a Roth account.

In addition to having your investments grow on a tax-deferred basis as is the case with a traditional IRA, distributions can also be taken from a Roth IRA on a tax-free basis. Furthermore, Roth IRAs are not subject to the rules on required minimum distribution requirements in the same way that traditional IRAs are. These rules require you to take minimum distributions from a traditional IRA once you reach age 72.

Finally, eligibility to contribute to a Roth IRA does not end at age 72 as it does with a traditional IRA. This means that if you have other sources of income during retirement you can continue leveraging the various contributions.

What You Need to Know About Substantially Equal Periodic Payments

Estimated reading time: 3 minutes

You probably know that if you take a distribution from your IRA before you reach age 59½, then in most cases you’ll be subject to a 10% penalty on that amount of the distribution, in addition to any taxes that may be due. (Distributions from a traditional account are generally subject to income tax, while distributions from a Roth account are not.)

You may also know that there are a handful of circumstances in which you can make an early withdrawal from your IRA and avoid the 10% penalty, but not avoid any taxes that are due. These include certain distributions to assist a first-time home buyer in making a down payment, paying for medical expenses, and paying for certain types of higher education expenses.

In certain limited sets of circumstances, these exemptions from the 10% early withdrawal penalty can be useful for certain individuals. But what about IRA owners who find themselves in a extremely serious financial situation that justifies taking money out of their retirement account – is there another option for those individuals?

Fortunately, there’s another option for taking penalty-free distributions that’s far less known. The holder of an IRA can begin taking distributions from their account as part of a series of what is known as “substantially equal periodic payments.”

The “substantially equal periodic payments” exemption allows the account holder to calculate a yearly amount that they can withdraw from their account every year, for at least five years, or until they reach age 59½, whichever is later.

Given the scope of this exemption, it’s essential for an account holder to be completely sure the withdrawal schedule works for them, and that they’ll be able to maintain and build their overall retirement nest egg to adequate levels. Think about this for a moment, a 25 year old who chooses to take a series of substantially equal periodic payments from their account must do so for more than 32 years. Stopping the withdrawals before they reach that point will subject the account holder to significant IRS penalties.

There are three basic methods for calculating the amount of the periodic payments; the “fixed annuitization method” and the “fixed amortization method.” Under a fixed annuitization approach, the account holder uses a life expectancy table and a “reasonable” interest rate (which will be at least as great as 120% of the federal midterm rate). The fixed amortization method uses a simple amortization approach, and generally yields a lower annual payout amount than the fixed annuitization method. The third approach is to use the same method as that for calculating the required minimum distributions that apply to traditional IRAs for account holders age 72.

The biggest difference between the third method and the first and second methods is that the amount of the annual payment amount can vary greatly from year to year, depending on the investment activities that occur within the account.

Have You Made a Plan for Taking Distributions From Your Retirement Accounts?

Estimated reading time: 3 minutes

When most of us think about retirement planning, we tend to focus on the saving and wealth accumulation aspects of the process. That is, we plan how much we think we need to have accumulated by the time we reach our desired retirement age, in order to be able to lead the retirement lifestyle we want.

But a truly effective retirement plan also gives a significant amount of attention to what happens after you’ve built your nest egg and reached your target retirement age. You also need to plan how you’re going to take distributions from your retirement accounts during retirement.

Why Having a Plan is Important.

In short, having a plan for withdrawing money from your retirement accounts is important because you don’t want to outlive your retirement savings. Since it’s impossible for anyone to know when they’re going to pass, it’s important to have a plan, and to build some cushion into the timing of how long you’re going to need to fund your retirement.

Furthermore, this cushion can be vitally important if some of the assumptions you’re making now about your retirement don’t hold true. For example, you might not be able to work as long as you think. Or you might not have accumulated as much as you would have liked, either due to sub-maximal contributions or poor investment returns.

In any case, you’re not likely to be able to reach your retirement goals without giving careful consideration to all the factors relating to that retirement, and coming up with a plan for how and when you intend to take money out of your account.

Are You Subject to the Rules on Required Minimum Distributions?

If your self-directed IRA is set up as a traditional account, then you’ll be subject to the IRS rules on required minimum distributions. These rules state that once you reach age 72, you must begin taking minimum distributions for your account every year for the rest of your life.

Having to make withdrawals from your account every year can require some degree of advance planning, particularly if you’ve used your account to invest in assets such as real estate or private equity, as these assets often require a significant lead time to be able to liquidate.

Roth self-directed IRAs are not subject to the rules on required minimum distributions.

Don’t Forget About Social Security.

Even if you haven’t been relying on your Social Security benefits when doing your retirement planning, there are still ways that the government retirement benefits program can impact your decision making. For example, you may choose to delay taking your Social Security benefits until you’re past your full retirement age, in order to increase the monthly check you receive from the government. Doing so may require you to withdraw a greater amount from your self-directed IRA until you start receiving benefits, but the long-term payout could make for a more comfortable retirement.

Is Your Nest Egg Large Enough for a Self-Directed IRA?

Estimated reading time: 2 minutes

Self-directed IRAs are great foundation for your long term retirement planning. But because self-directed IRAs are not offered by more familiar discount brokerage custodians, some potential account holders may be intimidated at the prospect of paying for services on a different fee structure. This is true regardless of the fact that those fees are reasonable for the services that the individual receives when they invest in more complicated assets such as real estate and private equity.

Furthermore, some individuals may assume that their account balances simply aren’t large enough to effectively invest in a self-directed IRA. This simply isn’t the case. Regardless of the size of your nest egg, you can benefit from having a self-directed IRA.

You Probably Have More Options Than You Think

First of all, let’s be clear that you probably don’t need as large of an account balance as you might think in order to leverage the power of a self-directed IRA. While it’s true that having a modest account might preclude you from purchasing large real estate investments such as multi-family units or apartment buildings (or at least doing so without having to borrow with your account and incur unrelated business taxable income), you’re certainly not frozen out of real estate investments as a whole.

Smaller self-directed IRAs can be used to purchase more speculative real estate investments, including undeveloped land, as well as properties that may be located in areas that have fallen out of favor with homeowners and investors (but which you believe will make a comeback).

Your Account Will Grow Over Time

By making the maximum contributions to your self-directed IRA each year, and investing sensibly, you can expect that your account balance will grow over time. Once you have a self-directed IRA established you can make contributions to that account each year, as well as rollover any other IRAs or 401(k) accounts that you have.

Are You Interested in Traditional Investment Classes?

Another factor that sometimes leads retirement savers to stay away from self-directed IRAs is that they mistakenly assume that such an account can only be used to invest in things such as real estate, precious metals, and private equity. It’s true that those investment classes are possible with a self-directed IRA, but that account can just as easily be used to invest in publically traded stocks and mutual funds.

When it comes to having a relatively small nest egg, the only real limitations on a self-directed IRA are the time and level effort you’re willing to invest. A self-directed IRA can benefit retirement savers at every stage of life, individuals with a relatively small stake, and anyone who wants to maximize their retirement investment options.

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

Estimated reading time: 3 minutes

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.