Why is it such a big secret? Most financial advisors don’t tell their clients about it, because it takes dollars away from their managed accounts. To be fair, not all financial advisors are guilty. Those who are looking out for their clients’ best interests will bring the option to the table, and frankly, many financial advisors are either unaware that it exists or don’t know how it works.
I’m referring to the lesser-known strategy of directing your IRA funds into investments like real estate, secured and unsecured notes, privately held stock, precious metals, Limited Liability Corporations (LLCs), and private funds, rather than the more traditional investments like stocks, bonds, and mutual funds. I have been using this model for my personal investments since 2007, and at Hughes Private Capital, we have made it part of our mission to share this opportunity with others.
It’s a fact: many investors are uncomfortable with the stock market. It’s not the specific performance of the market that makes us anxious, but rather the lack of control that we have when investing in the market. This is one of the reasons why investors (myself included) find it very appealing when they learn that they can hold other types of investments with their IRA that provide greater transparency and monetary control. There is great value in this strategy, but there are a few things to keep in mind.
It’s Not All or Nothing
People often ask me if they must invest their entire IRA. No, it’s not all or nothing. You can choose to leave part of it invested as it is now and set aside a partial amount to diversify into something else.
You’ll Need a Custodian
When investing IRA funds in something other than the stock or bond market, you must place that portion of funds with a third-party IRA custodian. This is not any different from having your IRA placed with a company like Fidelity or Charles Schwab. You will still control your money, but it must go through the custodian. (This protects you, and it is required by law.) Once your IRA is placed with the custodian of your choice, it technically becomes a Self-Directed IRA (known as an SDIRA).
You Cannot Self-Benefit
There are a few important rules you’ll need to follow to be in compliance with the non-taxable status of your SDIRA. The main rule is that you cannot self-benefit from the SDIRA in any way. This includes you, your spouse, and any immediate family on both sides, such as parents, grandparents, children, and grandchildren. Individuals in a direct generational line up or down cannot receive any form of compensation or benefit from the SDIRA or its assets. Only the SDIRA can benefit. It is, after all, in place to fund your retirement.
In order to better explain what self-benefitting means, think of your Self-Directed IRA as its own entity. All the money for expenses and income may only go in and out of your SDIRA account. Just like investing in the stock market, adding or withdrawing funds requires following the rules. It works the same way with an SDIRA, but it’s not as intuitive or clear cut.
You have purchased a single-family residence with your SDIRA and are preparing to get it rented, but it needs a few repairs and some landscaping. You think this would be the perfect time to get your kid’s lazy butt out there to teach him or her how to do some of these repairs and earn some spending money. Unfortunately, this would violate your SDIRA since a direct descendant can’t be paid or benefit through the SDIRA.
You decide that the best place to buy a rental home is your favorite vacation spot. It would be great because you could rent it out, and when it wasn’t being used, you and your family could use it. Again, this would violate your SDIRA since you would benefit from it.
Although these rules might seem silly at first, they actually make sense. If you were to use your SDIRA to pay your kid to work on your rental house, there would be too many ways to cheat the tax man when you pull the money out of the account. Having so many ways to purposely or inadvertently violate your SDIRA account presents some dangers for investors. The easiest (and perhaps safest) way to invest with your SDIRA is with a private fund, like what we offer at Hughes Private Capital.
Being part of a fund eliminates most, if not all, of the problems that could threaten your SDIRA’s tax-deferred or exempt status. Since it is fully managed by someone other than you or your direct descendants, you stay completely out of the mix, so the IRS can never claim that you were self-benefitting from your SDIRA.
This is not to say that you can’t do it on your own. Many people self-manage their SDIRAs successfully. Just keep your eyes open and make sure you understand the rules before starting the process.
One final note and disclaimer: I am not, nor is anyone else in my company, an SDIRA expert. We do, however, have experience working with custodians and SDIRA accounts. We’re happy to answer questions and assist in getting your account set up, but it can only be finalized by the SDIRA custodian you have chosen.