Self Directed IRA Investing: The Top 10 Things You Need to Know to Self Direct

To 10 things you must know to SElf Direct

During a recent speaking engagement in front of a large REIA in a Midwestern state, I asked the audience how many of them had set up a self-directed retirement account.  Approximately 85% of the room raised their hands.  After the presentation, I discussed the fact with a friend of mine who has been doing self-directed investing since the late 1970s.  He made the comment that when that questions was asked just ten years ago, only five to ten hands would be raised in a room of over a hundred people.  Clearly the awareness of self-directed investing is growing.

With that in mind I would like to share with you over the course of two articles what I consider to be the top ten recommendations for self-directed retirement account investors.

  1. If you do not understand the deal, do not do it!

This is one of the fundamental rules in all types of investing, whether inside or outside a retirement account.  Understanding the deal means more than just being able to say you understand it.  It means being able to explain it in a way that makes the complex sound simple.  You should be able to explain the deal to an 8-year-old child.  When a person is able to explain something complex in a way that even an 8-year-old child can understand, then you know they truly understand what they are doing.  I have seen too many investors who made investments with a self-directed retirement account and later regretted it because the person with whom they invested or to whom they lent money was far more sophisticated than they were, and they felt like they had been taken advantage of.   Ask me how I know!


Allow me to give you an example of a simple explanation.  I am going to loan $50,000 from my retirement account to Fred.  Fred is going to use that money and other money to buy a house, fix it up, and resell it.  My loan to Fred will be secured by a mortgage against the house he is buying and fixing.  There, in three simple sentences you can explain a deal that many people could take paragraphs to cover.


  1. Always fund your accounts every year.


Many real estate investors are struggling with ongoing monthly cash-flow needs, and they forget to discipline themselves to set up an automatic or systematic program for funding their retirement accounts, whether they are Roth IRAs, 401(k)s, HSAs or CESAs.  Pick the two or three accounts that really matter to you and determine what your monthly budget needs to have to be in order to be able to put approximately $6,000 per year into those accounts.  At a minimum, you should be funding approximately $6,000 into your IRA< your spouse’s IRA, and your HAS.  If you do not fund your accounts, you will have very little to work with for investing purposes.  The discipline of consistently funding your accounts creates the “seed” you will plant it.


  1. Know the things in which you cannot invest.


The list of things in which you cannot invest with a self-directed retirement account is very simple:  collectibles, shares of sub-S corporations, and life insurance contracts.  Once you understand what you cannot invest in, it means everything else is possible.  The same theory also applies to the next rule.


  1. Know the prohibited transaction rules, or hire someone who does.


We all think we understand the rules; but when we are in a hurry and get into a deal with a lot of moving parts, we often don’t take the time to analyze the transaction in light of all the prohibited transaction rules, particularly rules regarding not providing a service to your account, as well as direct and indirect benefit rules.  Many retirement account investors are unable to distinguish between what they believe is a service and/ or managing their investment, let alone explain whether they are using their retirement account in a way that either directly or indirectly benefits them now or in the near future.


It is prudent to at do at least an annual review of the rules regarding prohibited transactions and disqualified persons so you can keep current as to what you can do with your self-directed retirement account investments.  There are many good resources from custodians, administrators and trustees, lawyers, and even some reasonably-priced books on the internet.  These will give you a basic understanding of most of the rules for prohibited transactions and investments, and disqualified persons.  If you are a fact junkie like I am, or if you suffer from chronic insomnia, you may want to take the time to carefully read26 U.S.C. 4975, as well as the Plan Asset Rules promulgated by the Department of Labor.


  1. Remember that it is a retirement account, and you need to treat it as such by doing longer-term, cash-flow-producing deals.


Many times an investor gets trapped in what I call “yield disease.”  They are looking for a high rate of return and are willing to do short-term deals (such as hard money lending) in order to achieve those rates of return.  While 3 points and 15% might sound impressive for a 6-month period of time, that deal pales in comparison to an investment that may last for four years consistently earning a 12% rate of return.  Since the goal is to amass a good-sized retirement account, you need to work toward that goal.  My suggestion is that you do it by focusing on longer-term deals.  Consistency is important, because slow and steady wins the race.


Another benefit of doing longer term deals is that it is much easier to do the necessary due diligence and underwriting for one longer-term deal that for a series of shorter-term deals.  There are fewer demands on your time and fewer opportunities to make mistakes.

6. Do small-dollar deal until you get really comfortable with doing all the due diligence, underwriting and documentation that goes along with self-directed investing.

If you do a small-dollar deal (remembers, all accounts started out small) and something goes wrong, you only lose small dollars. If you do a large-dollar deal, particularly at the beginning if your investing career, and something goes wrong, if could be fatal. As your confidence and experience grows, you can do large-dollar deals.

7. Dealing and acting like a business owner inside a self-directed retirement account is not a good idea.

Many people will tell you that UBIT can be your friend, and I would agree that in certain circumstances, UBIT or UDFI are potential allies to your retirement account; but acting like a dealer or owning a business inside your self-directed retirement account is not wise. Not only does it create a higher risk of liability and lawsuits, but there is a greater likelihood that it will attract the attention of the IRS. You will also have to file a more complex tax return because the debt or business Activity Income inside your self-directed retirement account is not tax-free.

I’ve had people say to me, “But, Jeff. I’ve been told that in order to have a truly self-directed retirement account, I must have checkbook control.” Checkbook controls comes when the IRA owns an entity, such as an LLC or trust that is funded with IRA dollars, and the checkbook is in the control of the account holder. My response to that is that IRA-owned entities can either be awesome or awful. You had better know when, which and why.

It’s a rule of practice in my office that I will not assist a self-directed retirement account holder in setting up a single-member LLC to be owned by an IRA wherein the account holder insists on being the manager (person in charge of the funds), I insist that they have an independent, non-disqualified third party as the manager of that LLC or the trustee of that trust.

8. Open a Roth account

Many investors who are getting up in years have lamented that they only have traditional accounts, and they don’t think there is any way they can get a Roth account. My response to that is that anyone with a pulse and a way to earn and report active, earned income can have a Roth account, and they need to get one NOW! There are simply no excuses. Once you have learned the definition of what constitutes active, ordinary, earned income (income that is subject to income tax or self-employment tax such as W-2, paycheck, 1099 or Schedule C income), you will understand the importance of getting some of that money into a Roth IRA or Solo 401(k) with Roth component. The magic of the Roth is absolutely crucial. Not only does the money get to grow tax free, but under the right circumstances, it can be withdrawn from the account in the form of a qualified distribution tax free.

9. Make sure you double check the beneficiary designations for the accounts you have established.

This rule actually applies to every type of retirement account, investment account, or bank account you have. You need to double check your beneficiaries. Is that money going to go to the person you want it to go to in the event of your death? Is the beneficiary designation consistent with your overall estate plan?

Jeffery S. Watson serves as general Counsel for National REIA and practices law at the Jeffrey S. Watson Law Firm, LTD located in Conneaut, Ohio.

10. Become creative and learn how to play nicely with financial friends.

Self-directed retirement account investing is a team sport. It is not a solo activity, Anyone who understands the prohibited transaction and disqualified investment rules understands that you cannot take money from your self-directed retirement account and use it for you own investments or put some of you current assets into those accounts, so you must learn how to work with other individuals in a cooperative manner, You need to find individuals by networking with them at your local REIAs to determine if their business standards are the same as yours, if their objectives are similar to yours, and if they seem like the right kind of person to put on your investing team.

When you play nicely with financial friends all of you prosper and benefit. Avoid doing a deal with someone who believes they alone need to be the one who profits and benefits from the transaction. If the investment is not mutually beneficial, it shouldn’t be done by a group of financial friends. One of the benefits of developing a group of financial friends is that you can do repeated deals with them as various situations and opportunities arise.

First 5 were originally published in the RE Journal from National REIA Fall Issue 2015.

Second 5 were  originally published in the RE Journal from National REIA Winter 2016.