By: Henry Yoshida, Co-Founder and CEO of Rocket Dollar
While self-directed IRAs are not commonly known, even among financial advisors and Wall Street investment bankers, they are an excellent retirement option for investors who want to diversify their assets beyond stocks, bonds and mutual funds.
As the CEO of Rocket Dollar, a company created to give Americans more information about self-directed retirement investment options, I have learned that diversification is one way for investors to accumulate wealth and lower their risk, especially when the stock market is volatile and bond markets are producing low returns. Too many investors mistakenly believe that they can not invest in real estate, startups or other alternatives using an IRA account.
Nothing could be further from the truth, though -- Rocket Dollar’s Self-Directed Solo 401(k)s and Self-Directed IRAs allow investors to roll over qualified funds and make a wide range of alternative investments to achieve true 21st century diversification.
Comparing Traditional and Self-Directed IRAs
While traditional and Roth IRAs do not allow those investments, self-directed IRAs are broader and do not have these same restrictions. Although they remain less popular, they are not a recent phenomenon.
Investors can use self-directed IRAs to save for retirement in a tax-deferred account and diversify their assets by investing in nontraditional assets such as startups, agriculture, real estate, precious metals, commodities and private placements. All of the assets in the account, whether they are investments in a new business or a new real estate deal, are administered by a trustee or custodian.
The only difference between a traditional or Roth IRA and a self-directed IRA is the type of assets you are allowed to hold in them. Traditional and Roth IRAs have tighter restrictions and require that investors stick to stocks, bonds, mutual funds and exchange-traded funds (ETFs), giving high-net-worth individuals fewer choices. However, many millions of people use traditional IRAs as a way to continue a retirement investment strategy that started with a corporate 401(k).
For many people, this can be a worthwhile strategy to build a good retirement savings asset base. Once your assets have grown to a point where it makes sense to diversify beyond traditional options offered by large financial institutions such as Fidelity, Charles Schwab or Vanguard, using a self-directed IRA can be an excellent strategy to supplement existing investments.
Former presidential candidate and governor of Massachusetts Mitt Romney went under greater scrutiny when it was revealed that he had socked away a fortune in his self-directed IRA. He disclosed during his presidential run that the IRA was worth between $20.7 million and $101.6 million.
Romney was able to accumulate that wealth and exceed the annual contribution limit at the time because he allocated venture capital and private equity investments (paywall) in a private equity firm he founded using his self-directed IRA. When the shares of the companies became profitable and started rising, Romney’s wealth ballooned exponentially — even though experts heavily debate the tax benefits of this strategy.
The strategy that Romney followed is not just limited to millionaires or wealthy entrepreneurs. Anyone can open a self-directed IRA and diversify their holdings.
Making the Most of Self-Directed IRAs
The maximum contribution limit for an IRA in 2018 is $5,500, or $6,500 for investors who are over the age of 50. If your $5,500 investment in a burgeoning startup, neighborhood business or other alternative investment booms within a few years, then your total return could be a large sum. Meanwhile, you will reap the benefits of making a tax-deferred contribution and continuing to enjoy tax-deferred growth.
Take, for example, a younger investor with a very distant horizon when they need to tap retirement funds as a source of income. This investor should look to investments with a higher return potential and higher-risk investments within their traditional or self-directed IRA.
Identifying the Right Custodian Company
The only catch is that investors must search for companies who specialize in providing custodian services to self-directed IRAs, since traditional brokerage firms don't offer them. To select a self-directed custodian or self-directed IRA provider, you want to carefully evaluate the costs and the level of support you will receive from the time you open an account through the post-account-setup process. Typical costs can range from several hundreds of dollars to several thousand dollars for initial account opening and ongoing services. However, it's important to keep in mind that the ability to own an alternative asset within a tax-deferred, self-directed IRA account could outweigh the costs of ownership in a taxable structure.
This new style of investing is increasing in popularity as more investors want more exposure to other assets and do not want to be limited by the offerings that brokerage firms have traditionally sold. It’s the reason we started Rocket Dollar -- to provide everyday investors with a simple way to diversify their retirement assets and invest in the things they love, including startups, real estate, angel investing and crowdfunding opportunities. Learn more about how Rocket Dollar is helping shape the future of retirement investing.