Pros and Cons of a Self-Directed Roth IRA

by Jeffrey Joyner ; Updated April 19, 2017
For some, a Roth IRA can represent a significant long-term investment.

Individual retirement accounts, or IRAs, can be an important part of your financial planning. You can invest in a traditional IRA or a Roth IRA – each has its own set of advantages and disadvantages. Likewise, you can choose a self-directed IRA or one that is managed by the fund’s trustee. To determine the pros and cons of a self-directed Roth IRA, you need to examine both parts of the equation: self-directed versus managed and Roth versus traditional IRAs.

Advantages of a Roth IRA

Because your contributions to a Roth IRA are made with after-tax dollars, your contributions are not subject to federal income tax when you retire. Earnings are also tax-free, provided you are at least 59 1/2 years of age and you've had the account for at least five years. If you are younger than 59 1/2, earnings distributions are tax-free if you become disabled or die, and up to $10,000 is exempt if you use the distribution to purchase your first home. No penalty applies for early distribution of contributions, but you may be liable for a 10 percent federal tax on early withdrawal of earnings unless you qualify for one of the exceptions permitted by the Internal Revenue Service.

With a traditional IRA, you must begin taking distributions at age 70 1/2, and once you reach that age, you are not permitted to make further contributions to your IRA. Roth IRAs do not have a set age at which you must take distributions, and you may contribute to your account at any age.

Disadvantages of a Roth IRA

A Roth IRA does not offer the immediate tax benefit that a traditional IRA does. Contributions to a traditional IRA are made with pre-tax dollars, so you can claim the contributions as a deduction when you file your federal tax return. Because contributions to a Roth IRA are made with after-tax dollars, you cannot deduct these contributions.

Traditional IRAs do not have a maximum income limit. To contribute to a Roth IRA, however, your income cannot exceed the limits established by the IRS. As of 2012, single taxpayers cannot have a modified adjusted gross income (AGI) that exceeds $125,000. If you are married and file a joint return, your modified AGI cannot exceed $183,000. Married people who lived with each other at any point during the year, but file separately, can only contribute to a Roth IRA if they earn less than $10,000 for the year. If they lived separately all year, they can contribute if they make up to $125,000.

For purposes of determining your eligibility for a Roth IRA, you must compute your modified AGI. Begin with your adjusted gross income from your Form 1040. Subtract any Roth IRA conversions or rollovers reported on Form 1040 lines 15b or 16b. Add back any deductions you took for a traditional IRA, student loan interest, tuition or domestic production activities. Add back any exclusions you claimed for foreign earned income, foreign housing, bond interest excluded on Form 8815, or adoption benefits provided by your employer that you reported on Form 8839. The result is your modified AGI for the year.

Advantages of a Self-Directed IRA

The only true advantage to self-direction is that you retain greater control over your investments. A self-directed IRA allows you, not the brokerage firm or bank, to decide how you want to invest your money. With a traditional IRA, the fund manager makes most of the decisions regarding the allocation of your investments. However, your options with a self-directed IRA are limited to those offered by the fund’s trustee. Not all brokers and banks offer identical investment options but the majority offer mutual funds, cash equivalents, bonds and stocks.

A self-directed IRA allows you to match your resources, goals and tolerance for risk. If you prefer to play it safe, you can choose more conservative investment options such as mutual funds or bonds. On the other hand, if you prefer to speculate on riskier investments in an effort to maximize your potential earnings, you can allocate more of your assets to potentially high-return stocks. Your only limits are the options offered by your trustee and IRS guidelines on the types of investments that are not permitted for IRAs.

Disadvantages of a Self-Directed IRA

Self-direction requires you to be more knowledgeable about the potential returns and risks of investments than if you allowed the trustee to make decisions. You will be the one evaluating the stock, bond or fund to determine the potential earnings. For those with little experience in investing, the education can be time-consuming.

You also assume more responsibility when you control your own investment. You, not the trustee, will be responsible for documenting the logic behind your investment decisions. If the IRS questions whether you mismanaged your funds or you did not follow the correct method, you could lose some or all of the tax benefits you normally would have received.

About the Author

Jeffrey Joyner has had numerous articles published on the Internet covering a wide range of topics. He studied electrical engineering after a tour of duty in the military, then became a freelance computer programmer for several years before settling on a career as a writer.

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