What is a Self Directed Roth IRA?

What is a Self Directed Roth IRA?

The average worker can pretty confused when considering IRA’s. Advertising houses can come up with cute names to describe their client’s product in trying to pull in new business. If you start researching IRA’s, you will encounter a number of options: Traditional IRA, Roth IRA, Educational IRA, Spousal IRA, Self Directed IRA, etc. How is a person supposed to make sense of it all?

Only Two IRA Concepts

In the IRA world, if you need to learn and understand two concepts. With these two concepts, you can quickly figure out an IRA that comes by another name. Both concepts involve the tax status of contributions going in, and withdrawals coming out of the IRA.

  • Traditional IRA – this is the original form of IRA that first came on the scene in 1974. The basic premise is that the amount of your contributions going into the IRA each year, subject to a number of rules, reduces you’re your salary subject to income tax.. In effect, your contributions may be considered tax deductible (even though this is technically a wrong way of viewing it). When you retire and start making withdrawals, the money you take out is taxable as ordinary income. So, money is tax deductible going in, taxable coming out.
  • Roth IRA – This IRA works in reverse when compared to the Traditional IRA. You make contributions after your salary has been taxed in full, or after tax contributions. When you make withdrawals at retirement, all money comes out tax free. So, money gets no tax break going in, but all money is tax free coming out. Again, this is a simplified description and subject to a number of rules.

That’s it for IRA theory. All IRA’s, no matter what name they come under, use one of these two tax theories.

So what is a Self Directed IRA?

A self directed IRA in not another legal form, nor another tax form, of IRA. It is simply a term describing who has the power to select the actual investments held in your IRA.

In most cases, if you want to open an IRA, you go to:

  • a bank – to put your IRA contribution in a savings account or CD, or
  • a mutual fund company – to put the contribution in one or more mutual funds, or
  • a brokerage account – to put the money in an account that will then be used to buy stocks, bonds, and a myriad of other individual securities. (Click Here for a discount brokers that offer IRA accounts)

You might be inclined to call a bank or mutual fund a self directed account since you are picking the investments. No! In these instances, you are only selecting the channel or conduit for the investments. When you put money in a saving account, the bank credits you interest, and the bank decides what the actual investment will be to produce interest (make loans, invest in treasury securities, invest in real estate, etc). When you put money in a mutual fund, it is the mutual fund manager who picks the stocks, bonds, or other investments that will produce your investment return in the mutual fund.

An IRA opened at a brokerage firm may or may not be a self directed IRA. Why? In a normal brokerage account, you as the account owner select the stocks, bonds or other securities that will be purchased with your contributions.

You are directing the investments yourself, or “self directing” your IRA. So, you have a self directed IRA. If you have a brokerage account, but give the power to select the securities to an investment manager at the brokerage firm, you do not have a self directed IRA. You have simply have a normal IRA and hired an investment manager.

As you can see, a self directed IRA concept is no big deal. It is a simple concept that advertisers, working for the brokerage community, tried to turn into some type of new and improved form of IRA.

Even though the concept is no big deal, the investments that can be bought in a self directed IRA are a very big deal, and open up your IRA to a number of opportunities to get higher investment returns. These IRAs allow you to invest in more than just individual stocks and bonds. Investors use their self directed IRA to invest in business start up opportunities, limited partnerships for various purposes such as Oil and Gas exploration, gold and silver, etc.

Why Would an Investor Want to Open a Self Directed IRA

Even the average worker may want to consider a self directed IRA if he is investment savvy.

  • If you’ve been working for a number of years, you probably have most of your savings locked up in a Pension or 401k plan. Under your pension plan, you have absolutely no control over investments. In your 401k, you can pick the general category of investments (stock, bond, cash), but your investment choices are both limited and conservative. If you want to diversify your overall savings further or invest in an unusual situation, your IRA will often be your best source of money to make this investment.
  • There may be potential to profit from a private investment than common stock of public companies. For example, using your IRA to make an investment in a start up business may give you a large payoff if it is successful.
  • If you want to invest in residential real estate, it’s hard to find this in a mutual fund or ETF.
  • The same idea holds true for other investments. Owning Gold or a food franchise is different than asking your investment manager to buy share of a gold trust or shared of Burger King. Yet all these investments are permitted, within the rules, in a self directed.

The bottom line is you need a self directed IRA if you want to control your investments, buy individual securities, or put your money in securities or investments beyond the normal asset classes.

How to Open a Self Directed IRA

If you want the responsibility of deciding which securities to buy, and will be limiting your investments to the normal asset classes, such as stocks, bonds, treasury bills, then you simply have to open an IRA account at a brokerage firm. Popular low cost firms are TD Ameritrade, Scottrade, E Trade. Do a Google search for these firms, call them, and a representative will walk you through the account opening process.

Be aware that there are a number of rules if you are moving money from another IRA or 401k into the brokerage account. Read How to Roll Over a 401k into an IRA which describes the rules you need to be aware of when transferring money.

If you are going to put your money in more exotic investments such as individual real estate holdings, certain gold coins, a food franchise, you will have to find a Custodian for the investment. The IRS has rules that you must select an approved custodian for your investments.

You are not permitted to simply buy a house and pay for it with your IRA money. The house must be held in Custody so the IRS gets reports of the investment, and transactions can be tracked. This is an area that the IRS focuses on because investors can get pretty creative in the types of investments they try to buy with IRA funds. Since the IRAs are tax deferred, the IRS is particularly interested that the investor is acting within the rules.

The IRS is Watching Self Directed IRA’s

Self-directed IRAs can get very hairy if you want to be an active participant in the business or property you’re investing in. There are a load of tax rules limiting the types of investments you can make. The main rules are:

  • No self dealing in the IRA – these rules forbid you from owning a business in an IRA if you are an officer of that company, or your own a controlling interest in the firm. If you own an investment such as a vacation home in an IRA, you can’t use it for your own benefit – you can’t live in the house or let your family members live there. Many investors have tried this trick and got tagged by the IRS.
  • You can buy individual real estate property for the IRA, but the rules are complicated if you only have enough funds in the IRA to make the down payment and you need to take a loan for the rest. Under no circumstances can you combine personal assets with IRA assets, so be careful here.
  • Other areas, such as unrelated business income rules, will create problems for you in the an IRA. If you are going to invest in exotic securities or situations, you want to make sure you have a good accountant who is familiar with the particular investment.

Having Several Self Directed IRA’s

You might get the impression that you either have to open a bank account or a mutual fund or a brokerage account, but you can only choose one. Not true. You can mix and match as you wish with IRA providers. You might open a bank IRA to hold the conservative portion of your money, open several IRAs at various mutual fund companies to get a broad investment diversification of your equity money. You can then open an IRA with an appropriate custodian to buy and hold your gold coins. All this can be done within the IRA rules as long as the total of all your IRAs do not go over the various income, withdrawal, contribution limits specified in the IRA rules. For more information read Roth IRA vs Traditional IRA.

{ 2 comments… read them below or add one }

Margaret R. Johnson November 2, 2012 at 5:15 pm

Question: Can I open an Individual IRA through a separte custodian and make deposits using rental income generated from property owned by a self-directed IRA?


Gary Kowalski January 3, 2013 at 9:39 pm

Dear Margaret:

Most custodians will not allow your IRA to invest in real estate, though it is perfectly legal to do so. With Entrust, you can establish an IRA, use it to invest in real estate and yes, the rental income it generates would be deposited into your IRA account. Thus, the rental income would either be tax-deferred or, in the case of a Roth IRA, tax free subject to the criteria of a Roth.

Please see our website for more information, or to call our Client Services department with any additional questions. 800-392-9653.


Gary Kowalski
The Entrust Group


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