A range of retirement plans are available to meet investors’ specific needs and financial situations. Long-term retirement plans are typically designed to benefit individuals by reducing their tax bill while earning interest over time. Investors can choose from various types of retirement plans, with options including plan structure, type of investments, and management of the plan.
Individuals establishing their own retirement accounts typically set up Individual Retirement Accounts (IRAs) through a financial services firm like a bank or a brokerage. Any individual earning an income can create such a tax-advantaged long-term savings account.
IRAs have become popular vehicles for building post-retirement financial security, thanks to the investment and diversification benefits they provide. As of the fourth quarter of 2022, assets in individual retirement accounts in the US totaled as much as $11.5 trillion. Around 44 percent of the IRA assets, or $5 trillion, was invested in mutual funds. Equity funds were the most common type of investments in these accounts, accounting for $2.8 trillion in capital. Moreover, since money in an IRA vehicle can be invested in a broad range of financial products, including some alternative investments, IRAs also have the potential to generate higher rates of return.
In this article, we will explain how IRAs work, the different types of IRAs available for investing, and how individuals can build a diversified IRA investment portfolio.
IRA accounts allow individuals to save their money on a tax-deferred or tax-free basis over time. There are several types of IRAs available in the market. The type of account someone may want to open depends on several factors including age, income, overall financial goals, and the degree to which they want to be involved in the management of the portfolio.
Each type of IRA also has specific eligibility criteria, as well as contribution, taxation, and withdrawal rules. Further, an individual’s marital status and their retirement plan at work impacts tax requirements for contributions and withdrawals in IRA accounts.
In a traditional IRA, all contributions are tax-deductible. Post-retirement, withdrawals from the IRA are taxed as regular income. Another option is a Roth IRA. Contributions are taxed in a Roth IRA, while withdrawals and future investment gains are tax-free.
In 2023, the total contribution that an individual can make to either a Roth or a traditional IRA cannot exceed $6500 (or $7500 for people older than 50 years), and individuals can start withdrawing funds without penalty after they are 59-1/2 years old.
Additional IRA options are available for self-employed individuals and small business owners. Two of the most popular are the Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) IRA.
IRAs are also differentiated by the management of investments held in the account. This is an important consideration to make before opening an IRA because it impacts the type of investments that can be held in these vehicles.
A self-directed IRA is managed by the account holder, who has control over all investment decisions. Individuals are required by law to have a custodian or a trustee for protection and oversight, but they are responsible for many key decisions of the account, including selecting investments and doing requisite due diligence. In a managed IRA, however, a brokerage house invests on behalf of the account holder and is in charge of all trades.
The benefits of opening an IRA account are not limited to helping individuals grow their money over time while saving on taxes. IRAs can also potentially protect investors against inflation and short-term market volatility by increasing their exposure to both long- and short-term assets.
Traditional IRAs are typically invested in stocks, bonds, index funds, and mutual funds. Investors looking for diversification could also consider securitized real estate options like a real estate investment trust (REIT) or industry/sector-focused ETFs. More savvy investors with self-directed IRAs have access to a wider range of investment opportunities, including alternative investments such as real estate, private equity, venture capital, undeveloped land, cryptocurrencies, and precious metals like gold.
Here are some of the asset classes you may consider investing in with your IRA to diversify your holdings:
Real estate: Real estate is a long-term investment that may provide stable income returns throughout the life of the investment as well as appreciation in property value over time. Investors can purchase real estate––ranging from single-family residential properties to shares of commercial assets such as multifamily properties, offices, warehouses, hotels, and restaurants––using their self-directed IRA funds, as long as the property has been purchased for investment purposes. All real estate income, profit and appreciation from investments made through a self-directed IRA return back to the account (and are not taxable).
To understand the benefits of this strategy, consider this example: An individual purchases a residential asset for $150,000 using funds in his self-directed IRA and spends $50,000 in maintenance and other capital expenditure requirements. Within one year, the investor finds an interested buyer and is able to sell the asset for $250,000, making a $50,000 profit. By using his retirement funds instead of his cash account, the investor has been able to avoid paying the standard 25% marginal tax rate on the sale. Additionally, the $250,000 will eventually be returned to the account and the investor can utilize the funds to make additional investments.
Of course, there is no guarantee that you will make a profit on these investments. To avoid penalties, investors need to ensure all costs associated with real estate and other investments can be covered through their IRA funds.
Private Equity and Venture Capital: Investors can increase their exposure to private equity (investments in mature and revenue-generating private companies) and venture capital (investments in early-stage companies or start-ups in need of growth capital) through self-directed IRAs. To do so, individuals can choose to make investments directly into these companies, including limited liability companies and limited partnerships. They can also invest alongside other retail and institutional investors into a pooled private equity or venture capital fund managed by a general partner.
Crowdfunding projects: Investors are able to invest in crowdfunding projects using funds from their self-directed IRA. There are several crowdfunding websites and marketplace lending platforms that provide individual investors access to investments in sectors such as real estate, private equity, private debt, and consumer products. Crowdfunded investments typically have lower minimums than some direct investments, which could be beneficial to individuals holding a smaller-sized retirement account.
Cryptocurrency: In recent years, some investors have opted to invest part of their self-directed IRAs into digital currencies. There are tax advantages to investing certain types of IRAs into cryptocurrencies. A Roth IRA, for example, would help avoid any taxes on capital gains incurred from cryptocurrency trading, since withdrawals are tax free. However, investors should also be mindful of the challenges of investing in this niche asset, including high fees and extreme price volatility.
Ultimately, your available resources and investing experience will help you determine the IRA investment strategy that is right for you. Using IRA funds to invest in alternative assets may boost your portfolio’s performance. However, these assets are also illiquid and riskier in nature than traditional stocks and bonds, and require a high level of investment knowledge.
Experienced investors with expertise in alternative assets may consider rolling over some of their capital in a traditional IRA or their 401(k) to a self-directed IRA and investing from there. Others may prefer to use the services of a brokerage who can manage the IRA on their behalf.
Whichever route you choose, IRAs are designed to provide investors with tax-advantaged retirement savings, along with a range of investment and diversification benefits.
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