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Self-Directed IRAs (SDIRAs)

7min read
TL;DR As a startup employee, you likely have extra insights into emerging areas of the economy and even the opportunity to invest in them. Unfortunately, most IRA custodians won’t allow you to invest in these opportunities with your tax-advantaged IRA account. However, by setting up what is known as a “self-directed IRA,” you can use your IRA money to make alternative investments.

A self-directed IRA (SDIRA) enables you to invest in alternative assets (including non-marketable securities such as private companies, real estate, private equity, and cryptocurrency) in a tax-advantaged account. As an investor, you may want to leverage the SDIRA to invest in these assets because the gains will be tax-deferred or tax-free.

What is an IRA?

An Individual Retirement Account (IRA) is a tax-advantaged retirement investment account regulated by the IRS that is held by a custodial entity such as a financial institution, trust company, or bank. Popular custodial entities include Fidelity and Charles Schwab. In total, Americans hold over $9T dollars in IRAs (33% of the $28.2T retirement account industry). As of 2017, $50B in assets were held in SDIRAs, which amounts to around 2% of total IRAs.

What are different types of IRAs?

There are various types of IRAs. One common division is between Traditional IRAs and Roth IRAs. Both accounts grow tax-free, but Roth IRAs incur no tax liability upon withdrawal (assuming you meet the required age), whereas Traditional IRAs are taxed at one's ordinary income levels when withdrawn. Further, Traditional IRA contributions are tax deductible in the year they are made, while Roth contributions are not.

What is a Self-Directed IRA?

A self-directed IRA is a tax-advantaged account that you can direct to invest in alternative assets.

While traditional custodians (like Fidelity and Schwab) only allow you to invest your IRA money in traditional investments (ETFs, mutual funds, publicly listed stocks, government bonds, etc.), a self-directed IRA gives you the opportunity to invest into a broader set of alternative investments.

Investable alternative assets for SDIRAs can include things like private companies, real estate, leveraged buyouts, cryptocurrency, and many others.

Self-directed IRAs are prohibited from transactions with “disqualified persons,” meaning transactions with yourself or lineal descendants. For example, your SDIRA can’t invest in a property that you own, nor could it invest in a private company that your parents run.

Why should I have a self-directed IRA?

Self-directed IRAs give you the ability to invest your retirement funds in assets beyond ETFs, mutual funds, stocks, and bonds.These higher risk assets can lead to greater returns which grow tax-free if they’re in an IRA.

Who should have one?

All knowledge workers should have an IRA (preferably a Roth IRA) to grow their investments tax-free.

Most often, (Traditional) IRAs are created when a knowledge worker leaves a job where they had a (traditional) 401(k) and that 401(k) is converted to an IRA. Because only $6K can be contributed to an IRA per year (and for Roth IRAs, you can’t contribute directly if you exceed an income limit), a Traditional IRA usually uses that job change as the initial funding event for a self-directed IRA.

What are the contribution limits or other constraints of a SDIRA?

Contribution limits to SDIRAs are the same as typical IRAs. The annual contribution limit for 2020 is $6k (or $7k if you're age 50 or older). For qualifying investors, that contribution will also be tax deductible.

The self-directed IRA comes with a few additional constraints:

  1. Failure to follow IRS guidelines results in a 10% penalty, immediate ordinary income tax obligations, and closure of the account.
  2. You may not have any transactions between your IRA and yourself, your fiduciary, or members of your family (spouse, ancestor, lineal descendant, or any spouse of a lineal descendant).
  3. You may not invest in collectibles (such as rugs, antiques, coins, stamps, metals except for gold, silver, palladium, and platinum bullion), life insurance, or S-corporation stock.
  4. You may not borrow money from a SDIRA, sell property to it, use it as security for a loan, or buy personal property from it.

How can I fund an SDIRA?

Given contribution constraints, for most people the best way to fund a SDIRA is by rolling over an existing retirement account. (“Rolling over” is the process of authorizing funds to be wired from your old 401(k) into the new IRA.) The funds can either be transferred directly from your 401(k) plan administrator to your new IRA custodian or can be sent to you directly, in which case you’ll have 60 days from the date you receive those funds to deposit them into your new IRA.

Importantly, the 401(k) rollover will typically need to be from a former employer: existing employers tend not to allow “in-service” rollovers of 401(k)s into IRAs.

Even if you lack an employer or 401(k), you can still participate in a SDIRA. Instead, you’ll need to apply for a new IRA, deposit the maximum annual amount allowed ($6k), and transfer that to the SDIRA, or simply open up a SDIRA directly (where the same contribution limit applies).

Mega Backdoor Roth

In addition to the standard 401(k) contributions ($20.5k annually), for some workers a Mega Backdoor Roth IRA strategy can be an effective way to quickly build up their Roth IRA assets.

The combined maximum annual 401(k) contribution from you and your employer is $61k. However, as an individual, your pre-tax contributions are limited to $20.5k. This leaves up to $40.5k that you and your employer can potentially contribute on an after-tax basis to your 401(k). Then you roll that after-tax 401(k) money over to a Roth IRA, completing the mega backdoor Roth contribution. (Note: this strategy only works for those with employers who allow in-service transactions.)

Functionally, how does a SDIRA work?

There are a few key players involved in an SDIRA transaction.

  1. Depository account: this is where your assets are held.
  2. Custodian: a bank, trust company, or other IRS-approved entity that holds title to the assets, investments, or other property and directs clients’ money (such as by issuing funds and creating accounts).
  3. Administrator or Agent : a company that manages the paperwork (statements and tax reporting) associated with your retirement account, typically acting as the middleman between the account owner and the custodian. (The administrator must be affiliated with an IRA custodian.)
  4. Account holder: Anybody aged 18 to 70.5 can open an IRA so long as they have “earned income” such as wages, salaries, tips, or self-employment income.

What investments make the most sense out of a self-directed IRA?

Real estate is the most common investment from a self-directed IRA: IRA holders procure a residential or commercial property and achieve gains through rent and appreciation Real estate, however, typically returns the same, if not lower returns, as the S&P 500.

Self-directed IRAs may be best utilized for investments in private tech companies. People involved in tech have the unique advantage of understanding the various aspects of tech companies including product complexity, customer satisfaction, and market shifts. Further, private markets are currently creating significant value. As the emergence of more late-stage investors has caused private market valuations to jump, it may be worthwhile to capture some of your investment gains in a tax advantaged account while the company is still private.

When someone invests capital from their IRA into a high-risk asset, they can increase the probability of achieving higher returns. Instead of using their taxable capital (which is subject to taxes and may need to be more liquid), IRA funds give investors another pool of money to invest from on a long-term schedule.

(That said, with the current tax code offering 100% exemption for capital gains on qualified small business stock, it does not make sense to angel invest through an SDIRA. Instead, SDIRA funds would be best deployed in those opportunities ineligible for QSBS treatment but still likely to produce exceptionally outsized gains if they are successful.)

What are the best reasons not to have a SDIRA?

Investing in high-risk assets is risky, bringing with it increased danger of loss. Instead of investing in risky assets through a SDIRA, some investors choose to invest their IRA assets in regular ETFs, mutual funds, stocks, or bonds (where they aim for a 3-7% yearly return).

SDIRAs receive the same tax treatment as typical IRAs, so when their investments close out (become liquid), the funds are transferred back to the original corresponding IRA. However, that trait does not mean SDIRAs are liquid: withdrawal restrictions for a SDIRA are the same as typical IRAs. If you want to withdraw your money early (before 59.5 years old), you must pay a 10% penalty of the withdrawn amount plus any associated income taxes.

If your SDIRA investments perform poorly and you wish to shift it back to a non-self-directed IRA, you can do so. Just keep in mind that there’s no way to recoup the losses from your risky investments, and you’ll also be out the time and effort of setting up and managing the SDIRA structure.