A self-directed IRA is an individual retirement arrangement in which the owner directs the assets into nontraditional investments. These can include all manner of investments, including real estate, small business enterprises and commodities. These are popular among some investors who are not satisfied with the returns available in stocks, bonds and mutual funds, or who already have sufficient financial holdings and wish to diversify into other asset classes.
How Self-Directed IRAs Work
When an investor creates a self-directed IRA, he typically forms a limited liability company to hold and control the IRA assets. He cannot control the assets directly, but he can control the LLC he owns. He then opens a business checking account in the LLC's name. He directs his existing IRA or 401(k) custodian to transfer funds to his LLC's bank account in a direct trustee-to-trustee transfer. Once the funds are in the account, he then uses them to purchase allowable IRA assets.
IRAs are prohibited by law from entering into certain kinds of transactions. For example, you cannot borrow money from your IRA, nor can your IRA lend money to any party related to you. You may not pledge your IRA assets as collateral for a loan, nor can you purchase or sell to any closely related parties. You also cannot sell assets to your IRA. You cannot commingle IRA and non-IRA funds in the same account, nor can you take money out of the IRA without triggering a taxable event.
You can invest in livestock, including cattle, if you choose. You cannot, however, use IRA assets to invest in collectibles, including antiques, art, rugs, wines, stamps, coins or gems. You can invest in some forms of gold but not in other precious metals.
Advantages and Disadvantages
IRAs can be effective at sheltering your investments from income and capital gains taxes. Provided you do not engage in any prohibited transactions -- thus disallowing the favorable tax treatment of the IRA -- all assets within the IRA receive tax deferral. There are no income taxes or capital gains taxes within the IRA. However, there are severe restrictions on the IRA, as well. For example, you cannot own real estate for your own benefit in the IRA, and you must not intend to use any assets in it for your own benefit. You cannot feed or provide for the upkeep of livestock using assets from outside of your IRA -- the whole operation must be entirely self-contained. You also cannot eat the meat, wear the leather or drink the milk. You must maintain a strict arms-length distance between yourself and the assets in your IRA, or the IRS will disallow the favorable tax treatment of the IRA. IRAs don't qualify for favorable long-term capital gains tax treatment afforded to assets outside of the IRA. If you sell your cattle outside of your account, you will pay ordinary income tax, not the more favorable capital gains tax.
Jason Van Steenwyk has been writing professionally since 1998. A former staff reporter for "Mutual Funds Magazine," he has been published in "Wealth and Retirement Planner," "Annuity Selling Guide," "Registered Rep." "Bankrate.com" and "Senior Market Advisor." He holds a Bachelor of Arts in humanities from the University of Southern California.