Self-Directed Investing 101: Here’s What You Need to Know

Today, there is a sense of urgency when it comes to saving money. That urgency comes with anxiety when you’re stuck watching and waiting for your retirement savings to grow behind the closed doors of big banks and brokers holding your IRAs and 401(k)s. Now, more than ever, control over your investing is a necessary life raft in a sea of uncertainty. For many investors, this level of control comes in the form of self-directed investing, or in other words, empowering themselves to call the shots.

Personally, I first discovered self-directed investing when I worked at the Kennedy Space Center in Cape Canaveral, Florida and started making investments in commercial and residential real estate. I saw the value of going from “forever taxed” to “never taxed” by increasing my net worth and giving me the opportunity to control my financial future.

If you’re just starting out, maybe you’re wondering how self-directed investing is any different from what you’ve been doing. What are the benefits? Better yet, how are self-directed accounts taxed?

Whether you’re new to the game or already experienced, we would like to set the record straight on how self-directed investing works.

How ‘Self-Directed Investing’ Works

Self-directed investing and IRAs have been around since 1975. Back then, those accounts were presented as an option for only the very wealthy and weren’t very widely known or used. The definition is self-explanatory: you choose your investments, and through an account administrator, you can direct every transaction.

By rolling your retirement savings into a self-directed account and having an administrator or custodian conduct transactions on your behalf, the gains you would have made through traditional investment accounts will flow back into your self-directed account.

What’s the difference? You’re the one in control.

With you at the helm, self-directed accounts require less management (and therefore less management costs) than traditional investments like stocks, bonds, and funds. Self-directed accounts also allow you to have your money work for you with investment choices like real estate, business ventures, private placements, and even precious metals. Other than the few types of transactions prohibited by the IRS, the ability to choose investment opportunities means that your ability to direct your savings becomes bigger, broader, and more advantageous.

Not only do you have the freedom to choose what investments to make, but you also have more options on how to use them. For example, if you purchase and renovate a house with your IRA, the income you make from renting or selling that property flows back into your IRA either tax-deferred or tax-free (depending on the type of account you choose). Tangible investments like these may provide you with fairly reliable returns.

Tax Rules

All tax-advantaged retirement accounts have varying rules and regulations that are required by the IRS. Contribution limits, income thresholds, early withdrawal penalties, prohibited persons, and required minimum distributions are just some of the requirements you may run into with your retirement account.

Self-direction provides a wide range of investment selections to choose from and allows you to use your own knowledge and expertise to monitor those investments. Transactions go through an approved administrator or custodian and are subject to the same tax rules as gains made through a traditional account.

But the IRS does not see self-directed retirement accounts as different than any other type of retirement account. In fact, they are treated the same!

Even with tax-rules and IRS stipulations, all the following can still be converted into self-directed accounts.

Types of accounts in which PRE-TAX dollars are contributed and original contributions and earnings are taxed upon withdrawal include:

• - Traditional IRA
• - Simplified Employee Pension (SEP) IRA
• - Traditional 401(k)
• - Traditional Solo 401(k)
• - SIMPLE 401(k)
• - Small Business 401(k)
• - 403(b)

Types of accounts in which POST-TAX dollars are contributed, making original contributions and earnings tax-free upon withdrawal include:

• - Roth IRA
• - Roth 401(k)
• - Roth Solo 401(k)

Accounts that provide a tax-exemption on contributions and no tax on distributions include:

• - Health Savings Account (HSA) *
• - Educations Savings Account (ESA)

* HSA accounts are tax-deductible going in and are tax-free when withdrawn for medical expenses.

With these accounts, you’re being taxed “on the seed” instead of “on the crop”. Let’s say you purchase a house in your Roth IRA for $200,000 and you hold it for three years. You collect $72,000 in profit after expenses, and the property is worth $260,000 at the time of sale. So, your $200,000 investment has now yielded $132,000 in profit tax-free.

When it comes to the vehicle of your financial future, isn’t it nice to know that you have the option to be in the driver’s seat?

I’d love to hear from the BiggerPockets community. If you have any questions on self-directed investing, please feel free to ask. For those who have already utilized self-directed accounts for investing, please share your stories!