A self-directed IRA (SDIRA) can be an excellent wealth-building tool that accompanies many unique investment opportunities, such as real estate, cryptocurrency, gold, and private equity, which are not typically found in conventional IRAs. However, the freedom to invest in almost any asset type comes with potential pitfalls and a great deal of responsibility. To be successful with your SDIRA investment, you should have a thorough understanding of self-directed IRA services, the possible missteps that can occur, and how to navigate through them.
In this blog, we will discuss everything you need to know before making a self-directed IRA investment. Let’s look at some key pointers that can help you avoid common mistakes and maximize returns.
Six Common Pitfalls to Avoid in Self-directed IRA Investments
1. Lack of Familiarity With Self-directed IRA Investment Options
The common mistake we often see is the lack of proper understanding about what you can and can’t invest in. If you’re a self-directed IRA holder, having a scrupulous knowledge of the investment options, rules, regulations, and risks is important. Failure to understand these can lead to adverse tax consequences and penalties. Although SDIRAs are often said to offer the flexibility to invest in any type of asset, in reality, they are restricted and subject to various limitations. The Internal Revenue Service (IRS) doesn’t explicitly outline permissible investment options for self-directed IRAs but maintains stringent guidelines on what investments are prohibited. Below is the list of prohibited investments.
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Investment in life insurance
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Investment in collectibles
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Investment in S corporation stock
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A self-directed IRA does not allow investments that involve prohibited transactions, such as self-dealing.
Below is a list of some permissible investment options.
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Real estate
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Privately held corporations, partnerships, or LLCs
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Private debt obligations
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Startups
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Precious metals
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Private Equity
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Cryptocurrency
Before entering into any investments, investigate thoroughly all implications of each investment.
2. Neglecting Due Diligence
Inadequate due diligence is one of the biggest mistakes that can lead you to potential fraud and investment failures. To ensure compliance and to effectively recognize, analyze, and manage risks, you should properly investigate the asset you want to invest in before committing your funds. Some of the best practices to perform due diligence are:
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Thoroughly research your investment options
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Seek out the opinions of other investors
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Scrutinize the backgrounds of the individuals and companies involved
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Get investment advice from trusted professionals
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Diligently analyze and grasp the nuances of the paperwork before putting your signature on it
3. Violating the Prohibited Transaction Rules
An account can easily fail to qualify as an IRA or lose its status as one by participating in any transactions that are prohibited by the IRS. To refrain from invalidating your retirement savings, you should have a clear understanding of prohibited transaction rules.
Some of the major prohibited transaction rules in self-directed IRAs are listed below.
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Do not invest in life insurance, collectibles, and S corporation stock.
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Avoid transactions with disqualified persons such as family members, fiduciaries, etc.
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Self-dealing is not allowed. You cannot use your SDIRA funds for personal benefits.
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Avoid over-contributions. (The IRS establishes annual limits on contributions to SDIRAs based on income and other variables. Exceeding this limit might result in severe penalties and even disqualification of IRA.)
4. Failing to Diversify Your Investment Portfolio
To balance the risk and returns in your investing portfolio, you must achieve an adequate level of diversification among different asset classes and types of investment. Investing in various assets lowers your portfolio’s overall risk and maximizes long-term returns. You may think concentrating on one asset can maximize your returns. But in effect, by owning a single asset, you may end up in a huge loss.
For example, if you placed a substantial investment in a single sector and the market slumped, the consequences may be devastating. Therefore, to reduce the asset-specific risk and to have a steady stream of growth, allocate your funds wisely to different investment options.
Note: Although diversification is the best way to protect your investment, over-diversification can also be a problem, stunting returns. So, find the perfect balance and diversify your portfolio wisely.
5. Forgetting to Review and Rebalance Investments Periodically
The biggest mistake you can make if you are invested in a diversified portfolio is the possibility of missing out on your investments’ up and down. So always keep a peeled eye on all your investments, carefully assess the risks, and analyze long-term growth prospects. Make sure your SDIRA portfolio aligns with your retirement goals and risk tolerance. If required, rebalance your portfolio by eliminating non-productive assets and allocate funds wisely to other well-performing assets.
6. Choosing the Wrong Custodian
Selecting the right self-directed IRA custodian for your account is crucial to ensure that your assets are in good hands. In contrast to traditional IRA custodians, self-directed IRA custodians only act as trustees who manage and administer assets as per your investment directions. They don’t provide due diligence on investments. It is your sole responsibility to verify the legitimacy of the investments you make. Also, keep an eye out for fraudsters who can use numerous disguises to conceal their intentions and lack of qualifications. So, it’s important to conduct a thorough investigation and due diligence.
The following are the key factors to keep in mind while choosing a custodian for your SDIRA.
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Check if the custodian is on the IRS list of Approved Nonbank Trustees and Custodians
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Evaluate the track record, areas of expertise, and years of experience of the custodian
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Review and compare the fee structure of different custodians
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Verify the registration and licensing of potential custodians
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Find all about the cybersecurity precautions taken by the custodian
Conclusion
A self-directed IRA gives you the flexibility and freedom to decide how to invest your funds, where to invest, and what you invest in. However, being aware of the rules and common pitfalls of SDIRA investment is important. By avoiding the common pitfalls listed above and adopting a prudent and informed investment approach, you can successfully navigate the self-directed IRA investment landscape to secure a more financially stable retirement future.
