What is the difference between a regular IRA and a self-directed IRA? What are the benefits of a self-directed IRA? Amanda Holbrook, from Specialized Trust Company shares her knowledge.
Tell us a little bit about you.
I work at Specialized Trust Company, where our expertise lies in self-directed IRAs. For anyone looking to diversify, that's where we help empower you through education on how to take control of your finances.
What are the main differences between a regular IRA, for example, Fidelity or Vanguard, and a self-directed IRA?
When you're with some of those large financial institutions, they might pat you on the back and say, "Oh, you can go and pick your stocks, bonds, and mutual funds yourself." That is not true self-direction. True self-direction means investing in what you know. The same types of retirement accounts—Roth IRAs, traditional IRAs, 401(k)s, and health savings accounts—are available, but with a self-directed IRA, instead of selecting investments from the limited options in the stock market, we give you access to a broader array of investment opportunities. You can participate in big commercial deals, become a private money lender, or own rental properties within your retirement account, rather than relying solely on the stock market. These options have been around since the 1970s, and the common reaction I hear is, "Why haven't I heard about this from my professional network?" Often, it comes down to financial incentives, as many institutions don't profit when you create an account and invest locally, away from Wall Street.
Can we invest in other assets besides real estate?
The possibilities are almost limitless. The IRS doesn't explicitly list all the investment options you can explore to take advantage of the tax code; instead, it tells you what you cannot do. As long as you avoid certain rules like self-dealing (buying something you already own) or conducting business with immediate family members (parents, grandparents, spouse, children), you have a wide range of options. Transactions involving more distant relatives like siblings, aunts, uncles, cousins, nieces, and nephews are generally permissible. Your siblings can fund your deals, and vice versa, or you can invest in subchapter S company stock or life insurance. With just a few exceptions like collectible artwork, almost anything else is feasible: tax liens, private lending, precious metals, oil and gas, timber, and more. For instance, I have brothers near Fort Worth who raise cattle within their retirement accounts because it aligns with their expertise. While real estate is a popular choice, there are numerous ways to participate in it. You can flip houses, adopt a more passive role as a lender, or pursue various other strategies to address unique challenges.
Are there different benefits from W-2 employees, business owner's, and real estate professionals in using a self-directed IRA?
The overarching benefit for all three categories is the ability to generate tax-deferred and tax-free profits by investing in what you know. Each category may qualify for different types of accounts. For instance, those in the W-2 world often have side hustles, LLCs, and multiple income streams. These individuals typically find self-direction beneficial. Similarly, full-time entrepreneurs, whether involved in real estate or not, may benefit from self-directed IRAs. In the case of real estate professionals, it's often more about their tax status. When distinguishing between W-2 employees and entrepreneurs or side hustle owners, the key factor is whether your income is personal or business-related. If you have earned income, a heartbeat, and a social security number, you can establish an IRA. However, you can't simply decide to open a 401(k) without a qualifying business that generates income. It's essential to understand the distinction, as it's a question we encounter regularly.
For the kids, what would be the benefit if they're not working to have a self-directed IRA?
Children can be considered entrepreneurs if they have earned income, which is a requirement for setting up a Roth IRA. Roth IRAs are popular for kids because they allow you to pay taxes on the initial contribution rather than on the growth. This means that any earnings grow tax-free. If you establish such an account for a young child, even if the account performs poorly over time, they could still accumulate substantial wealth by the time they reach 59 and a half due to the power of compounding.
How do you think that most of these entrepreneurs are paying their kids who are not 18 yet? There's a way for entrepreneurs to pay their children as employees of their companies, up to a certain limit. This option is especially relevant for real estate professionals and those with side businesses. By compensating their children via a 1099, they can provide earned income to their kids, equaling or exceeding the $6,500 limit for Roth IRA contributions. For minors, the limit is just under $13,000 per year. This strategy not only benefits the children but also provides potential tax advantages for the business owner, creating a win-win situation.
For the children, the parents have the company and they are the ones paying the kids, there is a limit of 13,000 per year, at the max, the IRS will allow you to pay a minor per year. Can they put the entire 13k in the Roth IRA?
Minors can contribute up to $6,500 per year, and this limit increases to $7,500 when they turn 50 or older.
So that's 6,500 a year and there are fees associated with it, you need to make sure that you are paying less in fees than what you're receiving from the IRA yearly. What do self-directed accounts cost?
For children's accounts, we are strong proponents of Roth IRAs, which renew at a cost of $50 per year. If you can't generate more than $50 in earnings annually, it's worth reassessing your financial strategies. In general, fees for self-directed IRAs typically hover around 1.5% when the account balance is close to or under $100,000. As the account balance increases, the percentage fee decreases. It's worth noting that fee-based advisors may add their fees on top of these costs, but many clients find the investment opportunities offered by self-directed IRAs to be well worth the associated fees.
Is there anything that is important for our audience to know that we haven't covered yet?
The key takeaway is not to be passive about your retirement savings. Take a close look at your returns, understand what you're earning, and consider whether there are more profitable non-traditional investment opportunities that align with your expertise. If your financial professionals aren't discussing self-directed options with you, it's essential to take the initiative to explore these opportunities. Don't be the client who discovers the benefits of self-direction too late, at 59 and a half, when market volatility jeopardizes your retirement plans. Reach out for a consultation to learn how to make your money work for you and unlock new opportunities.