Self-Directed Retirement Accounts: Possibilities and Pitfalls

Accountants and financial advisors alike agree that investing in tax-advantaged retirement accounts like 401(k)s and IRAs are a great way to save for retirement. Many investors save money on taxes in the year they contribute to the account, and the contributions grow tax-free for decades until the account holder withdraws the funds. Other investors may choose to pay taxes by making an after-tax contribution today in exchange for future tax-free fund withdrawals by contributing to a ROTH account.

While the tax advantages make some retirement options attractive, many investors prefer to be more active in their investment decisions or prefer to invest in more volatile assets. Most brokerage firms limit retirement account investment options to publicly traded stocks, bonds, mutual funds, CDs, and ETFs. Thus, some individuals may find traditional retirement accounts limiting. That is where self-directed retirement accounts, especially the self-directed IRA, come in.

Self-directed IRAs offer two main advantages:

  1. Allows investments in alternative assets
  2. Gives the investor control over buy/sell decisions

All retirement accounts have restrictions such as contribution limits, early distributions, or required minimum distributions. However, self-directed IRAs carry much more complex compliance and reporting requirements that could cost owners substantially in the case of an accidental violation.


Self-Directed Possibility #1: Invest in Alternative Assets

Allowable alternative assets include:

  • Real estate
  • Precious metals
  • Cryptocurrency
  • Private businesses
  • Livestock
  • Oil and gas interests
  • Promissory notes


If an investor has a strong interest and expertise in a particular type of investment, self-directed IRAs provide flexibility without compromising on tax savings. Since these markets are much risker than stocks, bonds, and mutual funds, these investment options are only appropriate for investors ready for a considerable commitment of time and attention.

Potential pitfall: The IRS has specified that certain assets may not be purchased in self-directed retirement accounts such as life insurance and collectibles like art, antiques, stamps, rugs, and coins. Additionally, cash will need to be contributed to the self-directed IRA before assets are purchased. The self-directed IRA itself, not its owner, must purchase the asset directly.


Self-Directed Possibility #2: Control Buy/Sell Decisions

The first step in establishing a self-directed IRA is opening an account with a custodian that offers such accounts. Typically, the custodian will be a brokerage or investment firm. This custodian holds the IRA assets and executes the purchase or sale of investments on the investor’s behalf.

While the custodian cannot provide financial advice, they play an important role in administration and compliance. The custodian will file a Form 5498 every year for every IRA it oversees to report contributions and the fair market value of the account.

Investors who seek even more direct control over their retirement account may establish a “checkbook IRA.”

To form a checkbook IRA, a limited liability company (LLC) is established and owned by the IRA. A business checking account is linked to the IRA funds. The IRA owner manages the LLC and controls the transactions in the account. But while a checkbook IRA can eliminate some delays and fees associated with using a third-party custodian, it opens the investor to serious risks.

Potential pitfall: Engaging in self-dealing or prohibited transactions can cause your self-directed IRA to lose its tax-advantaged status, resulting in an unexpected tax bill.

The IRS rules for IRA investments are complex, and violations can occur accidentally. Examples of violations include:

  • Investing in prohibited assets
  • Selling property to your IRA
  • Borrowing money from your IRA
  • Using the IRA or property in the IRA as collateral for a personal loan
  • Using property in the account for personal use, such as vacationing at an investment property or renting an investment property to your ancestor or descendant
  • Receiving money produced by an IRA investment into your personal account


If you violate any of the IRS rules and therefore lose tax-advantaged status, all the money invested into the account will be treated as a taxable distribution.

Furthermore, owners of checkbook IRAs are responsible for the filing requirements that custodians typically handle.

Given the consequences of the potential pitfalls of investing in a self-directed retirement account, they are likely only beneficial to the most hands-on, risk-friendly investor.


Main Takeaway

While self-directed IRAs can be a powerful tool for opening unique investment opportunities, it is critical to work with a team that understands the risks and pitfalls. K&R Tax Accounting Services can assist you in the set-up and oversight of such accounts. If you are interesting in exploring whether a self-directed retirement account might be right for you, contact our office at 480-392-6801.

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