Dreaming about your retirement can be both exciting and scary. Obviously we all look forward to the point in which we can sit back, relax, and finish with our hectic career life. However, with that said, if we want our retirement to be happy and relaxing, we need to be prepared financially. This means making sure we have enough money saved and set aside. It’s at this point in the process that people start to think about setting up a retirement plan.
If you’ve been thinking about retirement lately, and want to be sure you set yourself up wisely, then you may want to look into a Self-Directed Roth IRA. There's a good chance you haven't heard about Self-Directed Roth IRA plans, but not to worry, that’s what we’re here for!
In this article we will take a close look at what this type of retirement plan is, how it works, how you can set one up, and how it can benefit you. We will also take a comparison look at Roth IRA vs. traditional IRA plans. So let's get to work!
The Definition of a Self-Directed Roth IRA
We understand it can be a bit overwhelming when you are looking into retirement plan options. You obviously want to pick the one that works best for you and your needs, but how do you do that? A Self-Directed Roth may just end up being that perfect solution for you, which allows you to live the kind of retirement you deserve.
Self-directed investing is all about giving people choices, and putting them in control of their investments. As the name suggests, you are the one who directs the investing, which is of course one of the big advantages of Roth IRA investing. The “IRA” in the title stands for “Individual Retirement Account”. With these kinds of plans there are many different types of investment options, which can be quite appealing to people of all ages and stages in life.
Typically people jump to the conclusion that they will be investing in bonds and stocks. While you can certainly do that, there are also different types of investments you can make. Other options available include investing in partnerships and real estate if you choose. Now to get more specific, your Self-Directed Roth is funded by money that has already had the taxes deducted from it.
The way this plan works is that as your investment grows either by income from dividends, capital gains, or interest - it is all tax free. As you can imagine, this can really start to accumulate to a nice amount of savings over time. The moment you make a contribution is when you pay taxes.
Understanding the Requirements of your Self-Directed Investment Account
Of course just like any retirement savings plan, there are some set requirements when you open your Self-Directed Roth IRA. Keep in mind that, if you happen to be married, you'll both be able to hold your own self-directed investment account, and, thus so, make your own contributions. As for the requirements, there are just two things you need to keep in mind.
The first requirement is that you'll need to make sure that you're not going over your income limits of your Roth with your AGI. Your AGI is your adjusted gross income. The second requirement is that all the taxable compensation you owe in that year has to have been made.
Here's another thing you'll want to be aware of. If you want to transition from a traditional Roth IRA to a self-directed one, there is actually no income limit. This came into effect in 2010. The same can be said if you're converting an employer-sponsored retirement plan to the popular Self-Directed retirement plans.
What are the Difference Between Roth IRA and Traditional IRA?
Now that we’ve mentioned the traditional IRA, we should clear up the difference between Roth IRA and Traditional IRA. It all comes down to the taxes, as that is the defining factor here. With the Roth self-directed IRA you will be paying the taxes when you make the contribution. This is referred to as paying taxes on the "front end". With the traditional IRA you'll pay taxes when you withdraw, called the "back end". There’s no getting around the taxes, so it’s a matter of when you want to pay them.
Another difference is the fact that there are income limits which restrict your contribution on the Roth IRA self-directed account. Meanwhile with the traditional IRA, there are no income limits on the contributions. If you make a lot of money, the traditional IRA may be the way you have to go.
If you don’t plan on waiting until retirement to make withdrawals, the Roth IRA is usually a better option. It allows for more freedom in these cases. The traditional one is ideal if you plan to leave it in until retirement. You will actually have to start withdrawing it by the time you reach 70 years of age.
It’s not all about the differences though. What these two options have in common is that while the IRA grows, it is all tax-free.
What is the Self-Directed Roth 401K?
During your research about self-directed Roth IRA accounts, you may also come across the term self-directed Roth 401K. This actually came about in 2006 thanks to congress. It was at this time that they combined the solo 401K with the Roth IRA. It then officially became known as the Roth Solo 401(k). The idea was that it was the best of both worlds giving people the tax benefits found in the Roth IRA and the contribution limits found in the Solo 401(k). Contributions can be made with salary deferral.
If you happen to be over the Roth IRA income limits, then this is well worth considering as a solution. In general this one is meant for self-employed people and those who make more money.
Setting up your self-directed Roth IRA is relatively easy. Any large and established financial institution should be able to help you. This includes such places as brokerage houses, mutual fund companies, and of course banks. Before you decide on which one to use, you'll want to ask about their pricing. The fees differ quite a bit from institution to institution, so again a little due diligence will pay off.
Whoever you decide to use is then called the custodian. This custodian must be regulated and licensed by the IRS, again something you will want to ask about. The IRS states that:
“An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets all of the following requirements.
The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian…”
Source: IRS Publication 590
This custodian will be subject to audits and will have to follow all the rules and regulations set forth by the IRS. They are able to hold titles to property, investments, assets, and they can issue wire funds and write checks. With all that said you want to be sure you pick a custodian you feel comfortable with.
Questions to Ask of a Potential Custodian
Now that we have emphasized how important a good and reliable custodian is, it’s important to pick one that meets all your criteria. We’ve come up with a list of questions you can ask as you shop around for the perfect one.
- Make sure the custodian is licensed and regulated. You will also want to ask how long they have held the designation.
- Asking for references is acceptable and common.
- Ask if the custodian is insured by the SPIC, FDIC, or perhaps both.
- The custodian should be part of the Better Business Bureau, if they aren't it's a red flag.
- Ask about their insurance where error and omissions are concerned.
- What is their auditing schedule? How often are they audited?
- Ask about the fee structure - is there are per transaction fee, a yearly fee - how does it work?
- How long has the custodian been in business?
- What kind of investments do they deal with?
- How can you reach them if you have any questions/concerns?
Feel free to ask as many questions as you want, and never feel pressured to make a decision on the spot. This is your retirement savings that you are talking about, you want to be sure it’s in good hands.
Can I Make Withdrawals?
A popular question that people have is whether or not you can make withdrawals from your self-directed Roth IRA, before retirement. In general this isn’t a good option. Technically you can, but the negatives usually outweigh the positives. The way it works is that you can take the money out of your Roth IRA; however, there will be a penalty whenever you withdraw earnings that have been made on those contributions. As a further deterrent, once you take the money you, you can't put it back. This isn't good news for your retirement fund down the road.
Now there are some specific instances where you can make a penalty free withdrawal. These are if you need money to pay for a disability that has suddenly occurred, if you are purchasing your first home, if you need to pay a medical expense that totals more than 7.5% of your adjusted growth income, or if you are paying college expenses. The college expenses count if they are for you, your children, grandchildren, or your spouse.
In general if you need access to money, withdrawing from your Roth IRA isn’t a good option at all. In the long run your retirement savings will suffer.
This all changes once you hit the age of 59 ½. At this point you can start to make withdrawals tax-free. There is a catch though, your account must have been in existence for at least five years.
What are the Best Investments to Make?
Another common question is what you should be investing in? Since a self-directed Roth IRA gives you so much flexibility and freedom, you may have a hard time deciding. Well, experts say you shouldn’t make a choice, instead it’s best to spread your investments around. Go ahead and invest in bonds, stocks, real estate, and more.
The market is always changing, which means you can see your money go up and down. The more you spread around your investments, the better you will likely be in the long run. Don’t put your eggs all in one basket are great words to remember when it comes to investing.
When it comes to your money, and your retirement, you want to be sure you are making a well-informed decision. Asking questions, doing research, and making sure you don’t make spur of the moment decisions are all important. Because you can have a self-directed Roth, as well as other retirement saving plans, you can really diversify your portfolio and cover all the bases. Not only is this usually the safest thing to do with your money, it’s usually the most lucrative route to take.