Why to Choose a Self-Directed IRA

Interested in a retirement-friendly, tax-deferred way to invest in, say, reality TV? How about a beach house in Malibu or a burger franchise in Eastern Europe? Well, self-directed IRAs can help.

Unlike traditional IRAs that limit investors to stocks, mutual funds and bonds, this alternative account allows for a broader, more creative range of assets, including real estate, private equity, foreign companies and even racehorses.

David Cole, a developer in Fort Worth, Texas, recently rolled over part of his retirement fund into a self-directed IRA. Now, he's investing in two real estate development projects and a reality TV series. "My purpose was twofold," says Cole, 44. "I wanted to take advantage of opportunities in real estate and defer the taxes, [as well as] diversify away from the stock market."

The payoff from a self-directed IRA can be higher than an average mutual fund, but the related dangers may be greater as well, experts say, because it's not as diversified as a basket of stocks, funds and bonds.

"The higher leveraged you are in any investment, the greater the risk," says Nora Peterson, author of Retire Rich With Your Self-Directed IRA. "For example, if you've only got $2,000 and you buy someone's tax lien, it could be great. But if you haven't done your homework, the [entire] IRA can be lost."

Getting Started

The first step is pinpointing an alternative investment, and investors should rely mostly on their own judgment.

"There isn't a market where you just look up [various] opportunities," says Tom Anderson, CEO of Pensco Trust, a custodial firm for self-directed IRAs. "There's nobody bringing [ideas] to the IRA owner and saying, 'Choose A or B.' There's no one driving the bus for you."

Cole, fortunately, has insight as an experienced property developer, and the two projects he's invested in are managed by fellow developers he trusts. The reality TV program seemed sound because it was already in production and just needed additional bridge financing.

The next step for investors is to hook up with custodial firms, such as Pensco or Sunwest Trust Co., which facilitate the investment and keep the books for a fee.

Don't Self-Deal

Individuals are not allowed to get involved with or have any personal gain from an investment before they begin making withdrawals in retirement.

For example, says Ed Slott, owner of Irahelp.com, "You can buy [a] house, but you can't live in it or rent it to your mother." Otherwise, you've engaged in "self-dealing," one of the worst violations in the tax code. Self-dealing exposes the entire account to taxes and penalties.

The same goes for a business: Investors can't get involved in the operations of a business if it's included in their self-directed IRA.

The Exceptions

The IRS prohibits investing in collectibles like an antique pinball machine or a Persian rug. Furniture, artwork and life insurance don't qualify either.

Cole stored about 25% of his retirement money in his three investment choices, which is the maximum recommended by some IRA experts. "It's not like I want to go out and stick 75% of my [money in one piece of property] ," he says, "not any more than I would in one stock."