Five Questions to Ask Before Setting up a Self-Directed IRA

A 2012 report by McKinsey and Co. found a 14% increase in alternative investments, from $2.9 trillion in total funds invested, to $6.5 trillion in 2011. Alternative investments include self-directed IRAs, in which account holders can invest in a broad array of options, such as small businesses, real estate, and more. Since the market crash of 2008, the rate of movement away from traditional IRA options and towards alternatives such as real estate has accelerated, as more investors seek the stability of underlying assets such as real estate. Investing with a self-directed IRA takes more commitment than turning your savings over to a financial manager, however.  In addition to learning about and performing diligence on your investment choices, you also need to be aware of the IRS rules that govern the use of IRA funds. Here are five questions you should ask before setting up a self-directed IRA.

1. How Will I Invest my Retirement Savings?

self directed ira retirement planningIt seems obvious, but this is a critical starting point.  Just wanting to diversify away from the stock market is not an investment strategy in and of itself.  You need to know what you plan to invest in and how you plan to approach those investments.  If you want to invest in real estate, will you pursue rentals, flipping or being a hard money lender?  Do you know your local real estate market well, or do you plan to invest out-of-market in regions where the ROI is higher and the cash requirements are lower than in your local area?  Will you focus on cash flow or potential for appreciation?  Is leveraging with a mortgage part of your plan?  By starting with an investment focus, you can then work with your investment team to make sure you are asking the right questions and planning for long term success.

2.  What type of Self Directed Plan do I need to Achieve my Goals

There are several types of self-directed IRA and 401(k) retirement plans with different features and benefits.  Ensuring that you select the right platform to suit your needs is a critical factor. Two previous blog posts share additional information about each plan type to help you select the right one, view part I and part II of the series.

Common types of self-directed plans include:

Custodian Managed Self-Directed IRA Account

An IRA with a self-directed IRA custodian (generally a trust company) is just like any other IRA, except for the fact that self-directed custodians have the capacity to document the ownership of non-traditional assets such as private placements, real estate, precious metals and other investment options not available through the public exchanges served by Wall Street firms.  This model works well for investments that are more singular and static in nature such as buying shares of a privately held company or undeveloped land.  The reason is that the custodian executes all transactions for the benefit of the account, and must therefore sign every document, issue payment for all expenses and receive all income.  Each of these account interactions requires paperwork, a few days for processing and processing fees.  Such accounts are poorly suited for more complex or time-sensitive investments such as owning rentals, flipping houses, investing in tax liens, or even holding a number of static investments such as private mortgages.

Checkbook IRA LLC or Solo 401(k)

IRA and 401(k) plans offering Checkbook Control are superior to a custodian held account for investors wanting to participate in more time-sensitive or interactive investments, or who wish to have a broad array of assets within their plan.  Through the creation of a legal entity such as a LLC or Trust that can be controlled by the account holder, these plans are able to operate out of a bank or brokerage account of the investor’s choosing.  All plan transactions then take place through the entity account without the need for 3rd party processing, delays and fees.  Because of the immediate access to funds provided by these plans, an investor can participate in foreclosure or tax lien options.  For managing real estate rentals or flipping houses, the ability to deal with expenses immediately is critical.  Imagine having a water heater break in your rental and needing to find a plumber willing to do the work today, but get paid from your IRA custodian in 4-7 days. IRA plans are broadly applicable.  A Solo 401(k) can be a nice program for those investors who are self-employed and have no full time employees.  In addition to providing self-directed investment choices with checkbook control, the 401(k) offers generous contribution limits and other features not available in an IRA.

Business Funding IRA

IRA and Solo 401(k) plans are designed for passive arm’s length investments where all returns are tax-sheltered back into the plan.  For those investors wishing to utilize existing retirement savings to start or grow a business in which they are personally involved, a different format known as a Business Funding IRA or Rollover as Business Startup (ROBS) Plan is used.  Unlike an IRA or 401(k) where the IRS rules strictly prohibit any personal benefit from the plan investments (other than growing your retirement savings, of course) this option allows the investor to be actively engaged in a business in which their retirement plan is a shareholder.  The difference is that the business itself operates in the taxable realm.  Plan funds can be used to start or acquire a business and pay for operating expenses including your own salary.

3.  Has my IRA provider earned positive customer reviews?

Selecting an IRA provider is a significant decision that will impact your investments for years to come. The self-directed IRA industry is served by many reputable firms with long track records of delivering excellence, but also some firms with less than stellar customer service (much like traditional banking and investment services).  While the plans are not new, demand for self-directed plans has exploded in the last ten years and many newer firms have entered the market.  Therefore, it’s wise to spend some time researching customer reviews, Better Business Bureau information, and the word on the web about each IRA team you consider.  Be sure to focus on the expertise of the advisors and what level of access you will have to ongoing support.  Setting up the plan takes a few weeks, investing with the plan is something you will do for many, many years.  A lot of firms can market the products, but only a handful back their plans with support provided by experts in the areas of tax law and non-traditional investments such as real estate.

4. What is my long-term exit strategy?

Retirement investing with an IRA or 401(k) is not just about your returns for the next quarter or year, but about the financial foundation you are building for your golden years.  Investing for cash flow is different than investing for value, especially once you start drawing down the account in retirement.  Will you have income other than your IRA and social security in retirement?  How much will you need to access from your IRA to live on?  Will you be able to get by on the earnings from your investments, or will you need to liquidate the investments and draw down the principal on the account?  Asking these questions now and planning accordingly can eliminate a lot of sleepless nights down the road. Another long-term consideration is whom you will designate as your IRA beneficiary or beneficiaries. Retirement account beneficiaries are not determined by wills. Rather, inheritance is set by a special beneficiary form, which must be filled out when the account is opened. Of course, you may later change your beneficiary as you choose, to family members, friends, a charity, or a trust. This complex issue demands its own attention; for more information we encourage you to read our blog on the advantages and disadvantages of naming spouses, children, or a trust as your IRA beneficiaries.

5. Who can I bring onto my team for investment success?

It takes a team to manage a strong retirement investment account. As the account holder, you will maintain prime responsibility for handling your account. For success, it’s best to create an ancillary team of realtors, lenders, property managers, lawyers, and financial wizards, depending on your plan and investment types.  Just because the plan is self-directed does not mean you have to go it alone. Clearly there is more to self-directed investing than just calling around and selecting a plan provider.  As you research your options with a self-directed IRA or 401(k), be sure to consult with experts who can help you ask yourself the right questions and thereby help you setup the right plan, choose the best investment strategies and achieve success in building for your future.

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