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Is a Self-Directed IRA a Good Idea?

A reader writes in, asking:

“I recently made an acquaintance who works in the financial industry. He suggested to me that I look into opening a ‘self directed IRA’ where I would have more choices of how to invest, including some things that sound pretty attractive. Is this a good idea, or should I be skeptical?”

A self-directed IRA is an IRA with a custodian that allows you to invest in things other than the standard choices available in a typical IRA at a brokerage firm (e.g., stocks, bonds, mutual funds, CDs, etc.). In other words, a self-directed IRA is a way to use your IRA to invest in so-called “alternative” investments (e.g., real estate or a small business).

And it’s not unthinkable that you might want to invest in something other than what’s available via a typical IRA account, so there’s nothing inherently bad about the self-directed IRA concept.

That said, opening a self-directed IRA sometimes works out very badly for either (or both) of two reasons.

There Are No Investment Unicorns

In many cases, a self-directed IRA is opened at the suggestion of somebody who is recommending a particular investment product/strategy, suggesting that such product/strategy will offer outsized returns. Unfortunately, in such cases the only sure bet is that the person recommending this strategy will make a good chunk of change if you buy what they’re selling.

It’s absolutely true that there are all sorts of things that have the possibility of higher returns — even much higher returns — than a boring “total stock market” index fund. But if anybody tells you that such higher returns are available without a higher level of risk, that person is either a) ill-informed or b) trying to take advantage of you.

Prohibited Transactions Are Bad News

The second reason that self-directed IRAs can be a bad idea is that they dramatically increase your chance of engaging in a prohibited transaction.

Internal Revenue Code section 4975 outlines several types of transactions that are prohibited for IRA accounts. Most IRA owners don’t have to worry very much about such prohibitions, because the typical IRA at a brokerage firm or fund company is relatively foolproof in this regard. That is, the IRA custodian keeps you pretty well safe by limiting the things you can do with the account. In many cases, a self-directed IRA will have no such protections. And with self-directed IRAs, people do run afoul of the prohibited transaction rules on a regular basis.

So what happens when you engage in a prohibited transaction? Here’s how the IRS describes the result:

Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year. If your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income.

In case it isn’t clear, that’s a very bad outcome. You would have a large amount of money appearing as taxable income in a single year (assuming the account is of a significant size, that is), and you would completely lose out on the continued benefit of the IRA going forward (i.e., the ability to grow your money at a faster rate due to not having to pay tax along the way).

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