The Pitfalls of Self-Directed Roth IRAs

If a typical Roth IRA doesn’t give you the investment opportunities you’re looking for, a self-directed Roth IRA might be of interest. However, you’d better know what you’re doing.

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Tech mogul Peter Thiel made headlines in June after revealing he has $5 billion saved in a Roth IRA (opens in new tab) that he’ll never have to pay taxes on in retirement, and he did it in a rather unorthodox way. It’s unrealistic for an average person to amass that kind of wealth in IRAs, and more importantly, they should understand there’s a lot of risk in trying to follow his model.

Savers can contribute up to $6,000 a year to their Roth IRAs in 2021 (or $7,000 if they are age 50 or older), based on certain income limits. To contribute, single filers must have incomes below $140,000, and for those who are married filing jointly, their incomes must be below $208,000. There are ways to invest those funds to rapidly build a Roth IRA, but they are rare, and if it’s not done correctly, the account can be subject to huge tax penalties.

Building Your Roth IRA Nest Egg

Thiel and others who have successfully built their Roth IRAs to be worth millions (or billions) of dollars have done so by investing in start-ups before they go public. This is difficult — if not impossible — for most people simply because most Americans don’t have the connections and opportunities to invest in companies ahead of their public offerings. Even if you have access, 90% of start-ups fail (opens in new tab), potentially leaving your Roth IRA vulnerable to increased risk.

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Fortunately, there are specific types of Roth IRAs that make building wealth more easily accessible to investors. Self-directed Roth IRAs, for instance, give investors more freedom to invest in a greater variety of investments to grow their money. With a typical Roth IRA, savers are usually limited to mutual funds. But self-directed Roth IRAs can be used to invest in real estate and precious metals, as well as partnerships and tax liens.

With real estate investments within a self-directed Roth IRA, any rental income goes straight into the Roth IRA tax free. If you buy a home and later sell it through a self-directed Roth IRA, the profit goes back into your IRA until you begin distributions. If those distributions qualify under I.R.C. 590-B, they will be tax-free.

Prohibited Transaction Rules

While self-directed Roth IRAs can be profitable through real estate investments and private equity, incorrectly completed transactions may be subject to heavy tax penalties. One example is the sale or lease of property in a self-directed IRA. The owner of the IRA cannot initiate a transaction with a spouse, linear family member or a fiduciary. Even allowing a family member to live for free in one of your investment properties is not allowed.

If any prohibited transaction occurs, a 15% penalty tax (opens in new tab) on that transaction could apply. If that transaction isn’t corrected during the same tax year, you could receive a 100% penalty tax on the prohibited transaction. Furthermore, a prohibited transaction could cause your entire Roth IRA to lose its tax-free status. Ultimately, these violations are rare, but it’s important to be fully knowledgeable of the law when engaging in any of these transactions.

In addition, most investments in private companies or direct real estate require substantial capital. For most investors, this would consume most, if not all, of the value of those Roth IRA accounts, exposing the portfolio to unnecessary unsystematic risk. This could lead to a lower probability of meeting future financial objectives.

Defined Financial Planning, LLC (“DFP”) is a registered investment adviser offering advisory services in the state(s) of California, Nevada, and in other jurisdictions where exempted. The following content is provided by DFP and is subject to change at any time without notice. The content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding your specific financial situation. Past performance may not be indicative of future results. All references to future rates of return are provided for illustration purposes only and are not guarantees of future performance. All investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful. California Insurance License #0L77279 and #4042728.

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Samuel V. Gaeta, CFP®
Principal, Director of Financial Planning, Defined Financial Planning

As Principal and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five domains of financial planning -- Cash Flow, Investments, Insurance, Taxes and Estate Planning. He is responsible for prioritizing clients' financial objectives and effectively implementing their investment plans and actively monitors the ever-changing nature of clients' financial and investment plans.