There are many types of different retirement accounts ranging from IRAs, 401(k)s, Roth IRAs, pensions and more. This can be confusing at times, but it’s smart to focus on accounts that are relevant for each business situation.

A self-directed IRA is a special type of IRA or Roth IRA  that allows individuals along with businesses to hold alternative assets, real estate, privately traded stock, and even farming businesses. The self-directed IRA has the same tax treatment and contribution rules as a traditional or Roth IRA.

Since these accounts can own non-traditional assets, it’s important to find the right custodian or broker to work with.

Self-directed IRAs have different rules and regulations than traditional accounts, along with higher risk-reward ratios. Having riskier assets like private company stock or horse businesses can lead to higher rewards and a greater chance of loss.

This guide will go into the details of self-directed IRAs, when they’re appropriate, and which broker is best for certain assets. It also reviews the top eight brokerages for self-directed IRAs which include PENSCO and Equity Trust.

Who needs a self-directed IRA?

Self-directed IRAs can be a wise choice if an investor is looking for more diversification and higher returns. Investors that aren’t satisfied with investing in standard stocks, bonds, and ETFs can use this account to explore different choices. Keep in mind that investors that use self-directed IRAs should be savvier than the average person due to the risk.

One type of person who would need a self-directed IRA is a real estate wholesaler. Wholesaling is a special type of real estate investing that involves having the wholesaler buy an undervalued property from a distressed seller. Many distressed sellers want to sell their homes quickly due to factors like bankruptcy and divorce. They’re willing to accept lower terms, which makes it easier for the wholesaler to buy their home.

The wholesaler assigns the contract to a real estate investor, who might want to renovate and resell the home. The second investor is referred to as a “flipper” since his or her goal is to fix and sell undervalued properties for a profit.

This example will clarify wholesaling and flipping:

Wholesaler A buys a home from couple B for $100,000. The couple needs to sell quickly, even though the property is valued at $150,000.

The wholesaler puts down a $5,000 down payment, which can be done in a self-directed IRA.

Then the wholesaler sells the property to a flipper for $125,000.

The flipper wants to fix and sell this property at or above its market value of $150,000.

Lastly, the wholesaler has a net profit of $20,000 ($125,000 – $105,000).

A self-directed IRA could help wholesalers and real estate investors since they can save for a down payment on a tax-deferred or after-tax basis. More importantly, these investors can have the property or wholesale fee owned by the IRA, which allows for preferential tax treatment.

Why use this account?

Keep in mind that investors can’t include collectibles nor life insurance contracts in a self-directed IRA. Some other categories that are permitted include private placements, note investing, and precious metals. Also, related categories like cryptocurrency could be held in some self-directed IRAs. However, most custodians have strict rules and have discretion over controversial asset classes.

For example, some custodians like uDirect IRA, prohibit cryptocurrencies, like Bitcoin and marijuana-related businesses stock. Some reasons for this include that Bitcoin can’t be held in physical custody and marijuana is still illegal on a federal level.

Another good reason to use a self-directed IRA is if an investor wants to invest private placements. Private placements include private equity, the stock of LLCs along with LP stock. These entities are offered to a small audience and aren’t regulated by the SEC. This allows these entities to invest in riskier assets, which could have higher payoffs. Many of these investments don’t have disclosure statements since they don’t have SEC oversight.

Therefore, it’s prudent to conduct extra research and learn about factors like lock-up periods. These lock-up periods tie up investments for years or decades before they can be withdrawn. Lock up periods can interfere with liquidity and RMDs for investors older than 70.5.

Self-Directed IRAs can make it easier to invest in other private placement subcategories like hedge funds, land trusts, and convertible notes. Investors may also have other retirement accounts like 401(k)s, 403(b)s, and even traditional IRAs. Like IRAs, self-directed IRAs can receive former employer 401(k) plans on a tax-deferred basis (i.e rollovers), which makes it easier to save for retirement in case of job loss.

Create a Legacy

Like IRAs, self-directed IRAs can be passed down to beneficiaries, which could include a spouse, child, grandchild, or even a charity. Keep in mind that IRA beneficiary elections supersede other important estate planning documents like wills or trusts.

Therefore, it’s imperative to update these elections if an investor wishes to change his or her estate plan. Also, the beneficiary would have to pay taxes on distributions if the self-directed IRA is classified as pre-tax.

Pre-tax self-directed IRAs allow investors to save on a tax-deferred basis prior to paying taxes when taking distributions. On the other hand, beneficiaries could take tax-free distributions if the self-directed IRA was chosen as a Roth account.

For instance, a beneficiary receives a Roth self-directed IRA with $50,000 in cash, and a rental property worth $150,000. The rental property also generates $1,500 in rental income each month.

Thus, the beneficiary could distribute the full $50,000 in cash tax-free provided the Roth account has met all eligibility requirements and access $1,500 in tax-free rental income per month.  They could also keep the funds invested, which would compound over time and result in higher tax-free earnings.

Criteria to use when evaluating a self-directed IRA

Self-directed IRAs have many advantages, but there are some factors that should always be considered prior to working with a custodian. These factors include fees, prohibited transactions, guidance, and possible fraudulent activity.

Fees

There is no free lunch in life, including self-directed IRAs. Due to their complexity, brokers charge higher fees than other accounts. For example, transfer fees can cost up to $250 for simply moving brokers. Many brokers have fee schedules that vary based on the underlying asset, making it wise to do appropriate research. Some other standard fees include service, establishment, wire transfer, and account renewal fees.

Even small fees like service fees can add up over time. These service fees are assessed by the broker when they pay a worker on your behalf. For example, an investor has real property owned by a self-directed IRA and hires a gardener to cut the grass. The broker pays the gardener’s fee on behalf of the investor, which leads to a service fee.

A potentially smart strategy to reduce these fees is to an establish an LLC, which will own the self-directed IRA. This gives the IRA owner “checkbook” control over the account, which will allow him or her to handle the transaction details. An LLC owned self-directed IRA will reduce fees over the long term, but there are costs associated with creating an LLC.

LLC owned self-directed IRAs may save money over the long run, but they must be set up properly. Therefore, it’s smart to work with an attorney, accountant or financial adviser who knows these plans to guarantee IRS compliance.

Prohibited Transactions

These accounts have complex rules, especially when it comes to rental real estate. For instance, the IRS prohibits “self-dealing rules”. These rules could be broken if an investor spends the night in a rental property or fixes a bathtub by himself. If the IRS knows about this, the entire account will be considered a taxable distribution, subject to a 10% penalty.

A simple way to avoid breaking self-dealing rules is to consider a self-directed IRA as an account that owns and operates all underlying assets.

Lack of Guidance

Many investments in self-directed IRAs are very complex and are riddled with loopholes. Therefore, many brokers generally don’t have specialized staff that can guide investors through pitfalls. In fact, some custodians and administrators can’t give financial advice, which is why they recommend working with a competent 3rd party adviser like an accountant or lawyer. Traditional brokerages generally have financial advisors who can assist retail investors with asset allocation, standard investments, and high-level financial education. Most of these advisors aren’t as savvy with these unique assets and have to deal with high regulations.

Also, many advisers including those who specialize in alternative assets, strongly suggest having an exit plan. This is very important since some self-directed IRA assets like private placements aren’t regulated by the SEC. By not having a defined plan, investors could be stuck in a mess when trying to pull out money. These assets aren’t nearly as liquid as standard stocks and bonds, and usually have steep penalties for early withdrawal.

Possible Fraud Breeding Ground

Many scam artists use self-directed IRAs to provide a facade of legitimacy. They claim that the custodian has “approved” the investment. However, most custodians follow general IRS rules of included assets and don’t conduct detailed research into the validity of a specific asset.

Since many self-directed IRA investment choices aren’t regulated by the SEC, this leads to looser accounting rules. Many fraudsters could entice victims by showing them promising financial statements and ratios. They could show them income statements that have inflated earnings and inaccurate revenue timing systems. These statements could make the company seem more profitable than it really is.

One famous example of financial statement fraud is Enron, former energy and commodities based company. This company used crooked financial accounting to make the stock seem attracted. Unfortunately, these illegal methods caught up to them, which resulted in the company’s closure and imprisonment of high ranking officers. A horrible byproduct of this event was that thousands of Enron employees lost their entire life savings, as they mostly invested in Enron company stock.

Lack of Diversification

This example leads to another self-directed IRA risk: lack of diversification. Some investment firms tout that self-directed IRAs offer diversification, but the asset could be just one investment class. This is much riskier than say an ETF that invests in hundreds of companies in a single sector.

A few simple ways to avoid self-directed IRA scams include avoiding unsolicited offers, verifying all investment information and staying away from “guarantees.” Many unsolicited investment offers state guarantees that are too good to be true and entice investors to tap their retirement accounts. Tapping retirement accounts prematurely can result in opportunity costs, by placing funds in illiquid, underperforming investments.

Many brokers list multiple alternative asset valuations like the original purchase price, the original purchase price plus returns projected by the offeror, or a price provided by the promoter. Always take extra precautions by independently confirming this information. A great first action to take when verifying investments is asking the promoter detailed questions. The SEC has created a “ask questions” cheat sheet to guide investors.

Lastly, many fraudsters present high-risk investments as “once in a lifetime opportunities” and have high return guarantees of 20%+ per year. Keep in mind that the average long term stock market return is roughly 7% a year adjusted for inflation.

Therefore, any investment that offers triple this amount has substantial risk. Many fraudsters offer “free lunch” seminars that talk about these investments, which turn into upsells and high-pressure sales pitches.


 

IRA Financial

A custodian with a special tax twist

ira financial logo

Rating: 4.6/5

IRA Financial is a newcomer on the scene compared to other custodians on this list. It was founded by tax professionals and specializes in alternative assets. It also offers unique services other firms don’t like IRS audit protection. It differentiates itself from the competition by not only offering audit protection but also detailed online education resources and check writing.

See the full IRA Financial review here.


 

uDirect IRA

Specializes in domestic real estate investments and offers check writing services

udirect logo

Rating: 4.5/5

uDirect IRA can be a great choice for real estate investors who want control. This broker offers check writing, which allows investors to have more control over investment operations and to potentially save on fees. Investors can choose any IRS approved self-directed assets, but this firm takes pride in offering plenty of real estate choices like real estate notes, private loans, and tax lien certificates. uDirect IRA offers quick access to funds, which is helpful for real estate investments purchased at auction and tax lien certificates.

See the full uDirect IRA review here.


 

Charles Schwab

A household broker that offers additional banking services

charles schwab logo

Rating: 4.1/5

Charles Schwab is one of the largest and brokers in the US. It manages company 401(k) plans, allows retail investors to have standard accounts and offers self-directed IRAs. This firm is also a licensed bank and offers loans, checking accounts and other banking services.

In fact, its high yield checking account is one, if not the best accounts to use when traveling abroad. Unlike its competitors, this account isn’t subject to foreign transaction fees nor monthly fees and also guarantees unlimited ATM rebates. This means that it will reimburse ATM fees, which can add up over time.

Charles Schwab acts a self-directed IRA but doesn’t offer the wide investment variety that PENSCO or uDirect IRA does. This could be a drawback for some investors but can be explained because it offers unique services most brokerages don’t.

See the full Charles Schwab IRA review here.


 

TD Ameritrade and Merrill Edge

Common discount brokers that have traditional investments and banking services

td ameritrade logo

merrill edge logo

TD Ameritrade Rating: 4/5

Merrill Edge Rating: 3.6/5

TD Ameritrade and Merrill Edge are nationwide companies that have branches, phone-based support as well as manage corporate 401(k)s. These firms offer self-directed IRAs but don’t have the selection of alternative assets others like PENSCO or Equity Trust does. Instead, they offer standard investment products like stocks, bonds, ETFs, and mutual funds. These firms also provide generous signup bonuses for new account holders and access to financial advisors.

Financial advisors charge separate fees and require higher account balances. They have similar fee structures, but TD Ameritrade has funds that have cheaper expense ratios compared to Merrill Edge.

Also, TD offers banking products in Canada since Canadian bank Toronto Dominion owns a significant share of the business. Merrill Edge has a wider selection of mutual funds and the following reviews below go into more detail regarding Merrill Edge and TD Ameritrade.

See the full TD Ameritrade IRA review here.

See the full Merrill Edge IRA review here.


 

Entrust Group

An established group that prevents fraud

entrust group logo

Rating: 3.3/5

Entrust Group has been referred to as a great overall self-directed IRA custodian. It has been in business for over 30 years and carefully vets investments for fraud. This is helpful as many scam artists use self-directed IRAs to hide their scams. Entrust also offers a large variety of alternative investments, but doesn’t offer checkbook writing.

See the full Entrust Group IRA review here.


 

Equity Trust

A self-directed IRA that provides more hand holding

equity trust logo

Rating: 3/5

Equity Trust has been around for decades and it provides investors with advisers. These advisers are well versed in alternative assets and can help investors navigate any pitfalls. Equity Trust has many non-traditional assets like private loans, private equity, and currency. This custodian doesn’t have check writing but has a transparent and low fee structure which helps investors know their exact costs.

See the full Equity Trust IRA review here.


 

PENSCO

Best self-directed IRA for foreign real estate

pensco logo

Rating: 2/5

PENSCO is one of the largest brokers with $16 billion assets under management and over 50,000 accounts. It also has an A+ rating from the Better Business Bureau and offers a variety of alternative investments. It helps match investors with unique alternative assets like private placements, commodities (like oil and crops) and private commercial along with residential real estate assets. It also assists investors to invest in foreign real estate, which can be challenging as every country has its own unique property laws. The main drawback to this broker is the lack of check writing services.

See the full PENSCO IRA review here.


 

Bottom line

It can be daunting to keep track of every retirement account, which is why it makes sense to focus on those relevant to a specific situation. Self-directed IRAs have many parallels between Roth and Traditional IRAs, but they can hold non-traditional assets. Some assets include real property, private business stock and other high risks/high reward ventures. These IRAs have different rules and standards, making it important to choose the right custodian. 

Disclaimer: This article is not tax advice, but education. Consult a tax adviser or CPA for advice.