Self-directed IRAs: advantages, challenges, and options.

• Author: Scott, Cathy
• Position: Individual retirement accounts

American taxpayers have several options for saving and investing for retirement. The recent shift from company-sponsored defined-benefit pension plans to 401(k) defined-contribution plans, along with the uncertainties associated with Social Security, has some taxpayers beginning to feel an urgent need to supplement their retirement savings. Individual retirement accounts (IRAs) can be an excellent addition to any retirement portfolio. IRAs allow individuals to save up to $4,000 in 2007 ($5,000 if age 50 or older) for retirement in a tax-advantaged account.

There are two types of IRAs available to taxpayers, traditional and Roth IRAs. Traditional IRAs, under Sec. 408, allow qualified individuals generally to deduct contributions on the current-year income tax return. In addition, traditional IRAs also allow tax deferral of capital gains on investments and retirement savings that are not taxed until age 70 1/2. Roth IRAs, under Sec. 408A, allow qualified individuals to contribute $4,000 a year into a tax-free account. Taxpayers contributing to a Roth IRA do not receive a tax deduction for the annual contribution; the contribution to the account is made with after-tax dollars. However, assuming that retirement savings will grow, the Roth IRA generally allows taxpayers to receive all of the growth tax free. In other words, the Roth IRA requires individuals to pay taxes on the seed, instead of the harvest. On the other hand, the traditional IRA requires individuals to pay taxes on the harvest and defers the tax liability until withdrawal. Other types of IRAs include the simplified employee pension (SEP), the savings incentive match plan for employees (SIMPLE), and self-directed IRAs.

Background

Since 1974, IRAs have given individuals the flexibility to place funds into a trust or retirement account for the exclusive benefit of their beneficiaries or themselves. Sec. 408, which governs IRAs, specifically identifies who can serve as custodian of an IRA. It also establishes strict guidelines for operation. Under Sec. 408(a)(2), a trustee can be a bank or other person granted permission by the Secretary to serve as custodian to the account.

A self-directed IRA is simply an account in which the custodian agrees to allow the taxpayer to exercise greater control over investment decisions. (The term "self-directed" does not actually appear in the Code.) Self-directed IRAs are often called "real estate IRAs" but can contain any investment allowed under...