4 Questions to Ask Before Venturing Into a Self-Directed IRA

The stock market has posted tremendous gains during the past three years, with the S&P 500 gaining nearly 30% on an annualized basis and many more aggressive funds posting even gaudier returns than that.

But because the financial crisis was so bruising--and because stocks have exhibited plenty of volatility since they bottomed out--many investors are still feeling lukewarm on stocks. New flows into bond funds have been robust, and investors have also been gravitating toward commodities and alternatives investments. Equity funds, by contrast, continue to see redemptions, even when you factor in relatively strong inflows into equity exchange-traded funds.

Against that backdrop, the notion of a self-directed IRA might seem promising. Such vehicles enable investors to buy into asset classes that are often outside of the purview of fund companies and brokerage firms--including nonpublicly traded real estate, private equity, precious metals, and partnerships and joint ventures. These investments might exhibit radically different performance patterns than stocks and bonds, a quality that bear-market-battered investors could be craving.

In some respects, all IRAs are self-directed, in that as the account owner, you're entirely in control of what you put inside of your account. And on the surface, self-directed IRAs have features that are comfortably similar to conventional IRAs that hold stocks, bonds, or mutual funds. The contribution limits are the same, rollovers from other IRAs are permitted, and you can opt for a traditional or Roth version.

Some articles about self-directed IRAs make it sound like the big brokerage firms and mutual fund companies are in an evil cabal designed to keep you out of the best-performing investments. However, investing in a self-directed IRA isn't as simple as sending a check to Fidelity or Vanguard and tuning out; instead, it's far from it. In addition to analyzing the investment merits of a prospective self-directed IRA investment, it's also important to consider how the inclusion of a single, possibly large, and undiversified investment interacts with your other holdings. You also need to be aware of the different rules governing these accounts because you could run into serious trouble if you run afoul of them.  

Here are some of the key questions to consider before taking the plunge into the world of self-directed IRAs.

What will it cost?
If you hold stocks or mutual funds in an IRA, your costs will be pretty transparent: mutual fund management fees and any commissions you might pay to buy and sell. Self-directed IRAs charge another layer of fees because you must go through a custodian, who in turn will invest in the assets on your behalf. As a result, there's typically a setup fee for a self-directed IRA as well as ongoing administrative costs; these costs can vary widely by custodian, so you really need to do your homework. And if you choose to set up a limited liability company that your IRA invests in, thereby giving you more control over your investments, your startup costs are apt to be even higher. Your ongoing administrative costs might be lower, however. Of course, investing in mutual funds or individual stocks isn't free, but taken together, the extra costs associated with self-directed IRAs mean that your investments will need to perform that much better than traditional stocks and funds just to pull ahead.

How does it fit with the rest of your portfolio?
Even if you're sold on the merits of an investment you'd like to put inside of a self-directed IRA--such as a rental property or gold bars--it's still important to consider how it fits within the context of your overall portfolio. Are you sinking a disproportionate sum of your money into a single asset? Property holdings are among the most common investments held inside self-directed brokerage accounts, and real estate guru Ilyce Glink points out that a reasonable rule of thumb is that real estate holdings--including a primary residence--should compose no more than 25% of a person's net worth.

Do you thoroughly understand the rules?
Self-directed IRAs come with a whole separate set of rules, the majority of which are designed to prohibit self-dealing, which is, essentially, obtaining use from an asset even though you're receiving a tax deferral on it. Say, for example, you buy an apartment building in a self-directed IRA, but your son is living in one of the units. You're receiving tax-deferred income on your rentals, but you're also receiving a benefit at the same time. If the Internal Revenue Service gets wind of this self-dealing, the entire sum in that IRA could be considered taxable and subject to the 10% early withdrawal penalty because you've effectively distributed your IRA holdings prematurely. Consult with a qualified legal or financial advisor to ensure that your self-directed IRA investment is on the up and up and that you're hewing to the rules on an ongoing basis.

Could an ETF accomplish the job with fewer complications?
True, self-directed IRAs allow you to invest in assets that mutual funds don't invest in, such as individual plots of farmland and residential properties on which your IRA can, in turn, earn income. However, it's worth noting that many of the asset classes that had historically been the domain of self-directed IRAs are now available in some fashion via exchange-traded funds and conventional mutual funds. Investors can now buy ETFs that invest in private equity firms, gold, and farmland, for example. Of course, such funds might not be a pure play on a given asset; for example, private equity ETFs and funds invest in publicly traded private equity firms. But the fund format provides more diversification potential than you'd be able to obtain by sinking a large sum into a single property or company as well as fewer administrative obligations and costs.  

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