The most certain way to avoid mistakes made by rookie IRA investors is to avoid becoming a self-directed IRA investor in the first place. So what are the advantages and disadvantages of managing your own retirement funds? When you come to the age of retirement or reach 59 1/2 -- at which age the IRS deems you old enough to withdraw your retirement funds without tax penalties -- and you have investments in an employer's 401(k), 402(b) deferred compensation plan, or an employer's defined benefit plan, you most likely have the option to roll your account over into a self-directed IRA or take your defined benefit as a lump sum instead of a monthly payment.
In an IRA, your funds are protected from payment of U.S. income taxes until you take them as Qualified Distributions, at which time they are regarded as ordinary income. The exact details of whether this is possible will depend on the terms of your employer's pension plan. If a rollover to a self-directed IRA is of interest to you, you should follow up with your employer to find out how to do this.
Human resources departments and financial counselors attached to your company or agency's plan may not always have the correct information, or may even try to steer you toward investment choices that benefit them as much as you. So if you do want to go with a self-directed IRA, you need to make this clear to them, and if you are told that it is not possible, then make sure that's actually the case by statute in your particular circumstance. Not all professions are allowed to roll defined benefit pensions over into self-directed IRA accounts.
It is a stretch to consider not opting for a self-directed IRA to be a rookie mistake, because each individual must decide what is right for him or her. But if you are thinking about a rollover into a self-directed IRA, here are a few pros and cons to consider.
For Defined Benefit Pensions And/Or Employer Investment Plans:
- You know exactly how much you will get, and this is guaranteed by a finance company or government agency that is unlikely to go out of business.
- You may also get an annual COLA (Cost of Living Adjustment), which means that the payment you receive increases each year.
- You may be able to take a lower payment in exchange for survivor benefits so that the pension will be paid to your husband/wife or civil partner if you die early.
- Professional management of your money may get you the best possible return.
Against Defined Benefit Pensions And/Or Employer Investment Plans:
- There may not be enough income for you to retire. Potential returns will inevitably be diluted by invisible management fees.
- If you die immediately after you retire, your dependents might get nothing from your pension. It may not even pay for your funeral.
For Self-Directed IRAs:
- You get all the cash at once, so if you want it for some other purpose -- such as buying a private island or starting a taxi service -- you can do so. However, you will have to pay income tax on the money in the year you withdraw it.
- If you die immediately after you get the rollover, the entire balance goes to your estate.
- You can invest in stocks, bonds, options, ETFs or other instruments and potentially make a better return on your money than if it were managed by a corporation. You can, in fact, be your own personal hedge fund manager, and hold your head up high when U.S. Immigration and Customs asks you for your occupation:
4. If you wish, you can put all your money in Apple (AAPL). (No professional will ever do this.)
Against Self-Directed IRAs:
- You may get a lower return than what you'd receive from your defined benefit or employer plan. You may even lose all your money and end up destitute or having to un-retire and go back to work.
- There are no mulligans in the stock market. You may become senile or incapacitated and make egregious errors.
- Do you really think you can do better than professional money managers?
The Bottom Line
It may or may not make sense for your to take a lump-sum pension and move it to a self-directed IRA and manage it your self. This will depend on your confidence in your own ability to manage investments and to "seek alpha." It will also depend on your personal circumstances -- your own needs and the needs of your family. You may have pensions and retirement accounts from several employers in different types of accounts at the same time. And don't forget Social Security.
Disclosure: I am long AAPL.