Self-Directed IRAs: 4 Considerations for Investors
Recently I was catching up with a friend at a conference when the conversation turned to my work at PENSCO and self-directed IRAs. “Oh!” she said, “I have two self-directed IRAs. One is doing great and the other one really tanked.”
Of course I had to ask more – how did she choose these investments? Did a financial professional help her? Were they suitable for her specific risk profile and return objectives?
As it turned out, the answer to that final question was a probably not – while at the end of the day she was happy that one of her investments was doing really well, the other “bad” investment may have been avoided with a little more research. It is these kinds of experiences that may unfairly give self-directed IRAs and alternatives (non-exchange traded assets like private equity, real estate and commodities) a reputation for being “scary.”
The truth is, self-directed IRAs and the alternatives they invest in have done a lot of good for a lot of investors, and in fact are increasingly becoming a part of investors’ core portfolios. This is probably due to the fact that alternatives have historically offered less volatility and higher risk-adjusted returns vs. their exchange-traded counterparts (i.e. stocks and bonds), and they generally offer portfolio diversification to boot.
But, like any investment, there’s some legwork required upfront to ensure that the asset is suitable for your specific situation. Of course, “alternatives” is an extremely broad category and each investment comes with its own risk and return profile, so there’s no one-size-fits-all approach to determining suitability. But there are a few overarching questions you can start with as you explore using a self-directed IRA to invest in alternatives, including:
1. Do you meet the financial requirements for the investment?
Many alternative assets require high investment minimums, which can be a barrier to entry if you don’t already have the required amount of funds in your retirement accounts. Also, some alternatives ask that you meet “accredited investor” requirements, such as a minimum net worth or income level.
2. Will you need access to that money soon?
Another common trait of many alternative investments is that they are intended for investors with longer time horizons. You wouldn’t want to tie your assets up in a private equity deal if you think you might need to start taking required minimum distributions. And while real estate within an IRA may not be easily converted to cash “tomorrow,” it could be providing a cash income stream – again, all depends on how you may need to put those funds to work.
3. Do you understand the risk/return profile of the investment?
I think this may be where my friend slipped up, but a surprising amount of investors neglect to do their due diligence on an investment category that’s new to them. This can mean working with a financial professional or doing the research on your own. However you choose to do it, understanding the nuances of the investment is important and, in the end, your responsibility as the account holder.
4. Is the investment allowed?
The final “biggie” when it comes to alternative investing and self-directed IRAs is whether the transaction is allowed or prohibited (internally we call these Deal Busters). For example, you can hold rental or investment property in a self-directed IRA, but you can’t buy your own home using one. Similarly, you can invest in a company’s private stock, but it can’t be your own company. As a custodian, PENSCO helps clients answer these questions day in and day out and we pride ourselves on knowing what is possible.
One final rule of thumb when it comes to suitability: When in doubt, ask! A knowledgeable financial professional should be able to tell you the pros and cons of any investment you’re considering, while a self-directed IRA custodian (like PENSCO) can guide you through the murky waters of prohibited transactions.
Self-directed IRAs give people more choice and control when it comes to retirement investing. But, as with anything, this approach requires that people choose investments based on their specific portfolios, risk tolerance and return objectives. By ensuring suitability, you can invest with more confidence. And that’s a good thing.
The PENSCO blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.