Self-Directed IRA: Understand the Risks Before Investing

A self-directed retirement account is ideal for individuals who like a hands-on, do-it-yourself attitude. The Financial Industry Regulatory Authority, or FINRA regulating broker-dealers in the United States, issued a warning concerning self-directed IRAs in February 2023.

In its February advisory, the Financial Industry Regulatory Authority (FINRA) said, “Investments in these types of assets are subject to special risks that investors should consider.” These hazards may include a lack of knowledge and liquidity and the possibility of fraud. In addition to these dangers, FINRA warned of complicated tax regulations and costly costs.

To comprehend FINRA’s concerns, it is necessary to recognize that a self-directed IRA is a specialized kind of investing. It is more than just a brokerage account held by an individual without the assistance of a financial counselor. This refers to a standard or Roth IRA. A self-directed IRA is a unique account type that enables individuals to hold assets ineligible for the measure or Roth IRAs. The growth of assets stored in a self-directed IRA is tax-free. Self-directed IRAs are able to hold alternative assets such as real estate, bullion, cryptocurrencies, tax lien certs, promissory notes, and personal securities.

Investors should consider the following possible advantages and disadvantages when electing to invest in self-directed IRAs.

When a self-directed IRA could be a viable alternative

There are instances in which a self-directed IRA may be suitable even though the apparent limitations might make regular and Roth IRAs seem comparatively straightforward. “Investors with specific expertise or an interest in alternative assets may benefit from self-directed IRAs,” says Sean August, the CEO of The August Wealth Management Company in New York. “For instance, if you have expertise in real estate and feel it provides better potential returns than standard investments, a self-directed IRA may help you diversify your retirement portfolio.”

He adds, “it is essential to assess the advantages of investing in alternative assets against the extra complexity and possible hazards.”

In some scenarios, Jason Escamilla, the CEO of Impact Labs in San Francisco, believes a self-directed IRA makes the most extraordinary sense for holding particular assets. It is essential to assess the advantages of investing in alternative investments against their increased complexity and possible hazards. – Sean K. August, New York’s CEO of The August Wealth Management Group
He describes a scenario in which an investment would be subject to adverse tax treatment outside of an IRA but would not be permitted inside a regular IRA. Some real estate and cryptocurrency transactions may be included. Certain assets held in self-directed IRAs may have a tremendous appreciation potential. But, you will not be allowed to invest in your primary residence, life insurance, or collectibles.

A self-directed IRA makes sense if the account’s asset base is substantial enough to cover additional expenses. “Examples include yearly and transaction fees,” explains Escamilla. An investor cannot employ debt or leverage in an IRA without incurring additional tax liability. Real estate and other ventures with a positive cash flow usually need debt financing, frequently backed by a personal guarantee. However, if an IRA account holds the asset, loan financing with an individual warranty generates UBTI or unrelated business taxable income.

A self-directed qualifying account may escape UBTI caused by debt financing if the account owner has not provided a personal guarantee. This is referred to as nonrecourse debt. Additionally, Escamilla notes that there should be no personal gain from a self-directed IRA investment. He jokes, “No pleasure drives on the leased boat.”

Possible Dangers of Self-Directed IRAs
Even if an investor is fully aware of potential dangers, such as those highlighted by FINRA, there are additional pitfalls to avoid. Kristin Petersmarck, an investment advisor representative at Bridge river Advisors in Bloomfield Hills, Michigan, explains that investors can make several mistakes with self-directed IRAs. That includes “not fully comprehending the fee structure of self-directed IRAs or the market risks, term, and/or liquidity of alternative investments. Possibly most egregious is a lack of complete comprehension of applicable IRS code, especially concerning taxation and access to or distribution of underlying assets, “she says.

She adds that astute investors who comprehend the applicable tax code and other associated risks should only utilize self-directed IRAs with caution. August cites many other dangers, including the possibility of fraudulent investments, which can result in significant losses.

How Financial Consultants Can Assist with Self-Directed IRAs

August explains, “Some investors may underestimate the time and effort necessary to handle alternative assets, which may result in bad investment selections.” Before selecting, it is essential to do extensive research on each investment option and talk with a certified financial counselor. He says that financial advisers should also be aware of the possible tax consequences of self-directed IRA investments and any potential fines for breaking IRS regulations.

Jaime Raskulinecz, the CEO of Next Generation Trust Company in Roseland, New Jersey, states that self-guided IRAs only make sense for sophisticated investors who are willing to take the time to understand the regulations on these investments or who are working with a well experienced financial advisor who can guide them in the right direction.

Common Errors in Self-Directed IRAs

“The biggest errors we’ve seen are allowing a disqualified person to use an IRA property, using personal funds to add to an investment or make improvements, lending funds from an IRA to a friend or associate to claim later the loan was a bad one, and jumping into an investment with little or no due diligence,” says Raskulinecz. Raskulinecz also acknowledges the possibility of fraud. “Investors should be suspicious of anybody offering assets promising unrealistic or exaggerated returns, claiming there is a limited time to invest or lose out, and who is unable to explain the investment in depth,” she warns.

Yet, she feels that self-directed IRAs should be employed more, even if an individual needs assistance from a financial counselor. “In an ideal world, more advisers would be acquainted with this technique and the restrictions of self-directed IRAs to expand their practices and assist investors who may be less known but might still benefit from diversification,” adds Raskulinecz.