Expert Insights: Legal Advice for Self-Directed Traders

Expert Insights: Legal Advice for Self-Directed Traders

What is the best legal advice for self-directed traders?

Investing is more accessible than ever, thanks to the rise of online and mobile-focused brokerages. But just because it’s more accessible than before doesn’t mean that self-directed trading is for you.

Downloading investing apps may be easy, and you have many choices. However, building a successful approach to self-directed trading is more complex. “Investing is an education in the discipline,” investment expert Patrick Lane says.”The first lesson you have to learn is how to combat greed and fear.”

This key insight laid the groundwork for financial plans safeguarding investments across every income bracket. Even if you’re investing on your own, you should emulate this approach.

What is self-directed trading?

There are principally two choices in the universe of investments: employ a professional to manage your money or go ahead and arrange the investments yourself. Self-directed trading, or do-it-yourself investing, falls into the second category.

Self-directed trading allows you to buy and sell stocks, mutual funds, exchange-traded funds (ETFs), and options on your own. When you get a self-directed brokerage account, you choose what to invest in and when. Independent trading gives you the power to captain your financial ship by allowing you to make investment trades and direct your way to your chosen financial destination. But before you do that, being informed on the subject is critical.

Self-directed trading in general, and self-directed IRAs in particular, is rising, with trading volume surging during pandemic lockdowns. The many online, “zero commission” stock trading apps have made it easier for anyone to manage their stock trades.

However, many people may not appreciate the mechanisms or risks of some trades, particularly complex products. In response, the SEC (Securities and Exchange Commission) has initiated regulatory changes to protect self-directed traders.

However, the SEC can only do so much. Self-directed traders are mostly on their own when they take control of their finances. That is particularly true when dabbling in self-directed IRAs.

What are the rules for self-directed IRAs?

The account will be invested in publicly traded products like stocks, mutual funds, and bonds in a standard IRA (individual retirement account). With a self-directed IRA, the account owner can choose many alternative assets. However, the danger with self-directed IRAs is that they are advertised as allowing “almost any type of alternative investment” without specifying the myriad of rules that apply.

Self-directed IRAs are regulated and subject to a wide variety of limitations. These limitations do not restrict types of investments. However, they may impose burdensome reporting requirements and restrictions on transactions with the account owner or related parties. It can be easy to break some rules, and the consequence may be losing the tax-favoured status of the IRA or a deemed taxable distribution from it.

There are many benefits to a self-directed IRA. They include portfolio diversification and strong growth potential. The rules governing self-directed IRAs allow you to invest in real estate, private placements, promissory notes, and tax liens. They also let you balance your portfolios with tangible assets.

However, you must follow the rules. Although these do not apply to the most popular alternative investments, you should keep them in mind to keep the tax-advantaged status of your self-directed IRA.

Avoid prohibited transactions

The IRA tax advantages in ERISA (Employee Retirement Income Security Act) are meant to motivate Americans to save for retirement. However, Congress includes rules prohibiting some transactions to ensure no one benefits from their retirement accounts before distribution.

A prohibited transaction does not restrict what you can invest in but with whom you may transact. You may only transact with third parties, not closely held entities or immediate family members.

For example, you may buy real estate through your IRA and rent it to a third party. However, you cannot lease it to your child or sibling. If you do that, the IRS will consider the IRA as distributed as it is engaged in a prohibited transaction. You would then be subject to taxes and penalties.

Do due diligence

Doing your due diligence before placing an alternative investment would be best. Many private placements do not have to be SEC-registered because their investors are “accredited.” That can make it riskier, so you should look closely into them. You should consult the appropriate legal, tax, and investment professional to review the investment proposal to check if it suits your financial situation.

Acquire necessary financing

You might not know it, but IRAs may get financing for investments. However, you should know the relevant rules for self-directed IRAs.

  • All loans to an IRA must be non-recourse. Non-recourse loans are backed by investment collateral, not a borrower’s guarantee. If you default, the lender can only collect the collateral and may not go after your assets. The rationale is that if you guarantee a loan issued to your IRA personally, you will benefit your retirement account.
  • Loans issued to an IRA must not be from a disqualified person, such as an immediate family member.
  • When an IRA invests using leverage, any earnings from the financed portion are subject to UDFI (Unrelated Debt Financed Income). If applicable, your accountant or tax preparer will determine whether such taxes are owed and report this income to the IRS on Form 990-T.

Pay applicable taxes

The profits gained from many IRA investments are not taxable. However, if your IRA earns “active income,” the profits are subject to UBIT (Unrelated Business Income Tax). That does not apply to most IRA investments, as they earn dividends, capital gains, rentals, interest, or royalties. 

However, UBIT applies to real estate development, short-term flips, or active businesses such as a store. When reviewing your IRA investments, your tax accountant will decide whether you must pay UBIT and prepare Form 990-T.

Tips for Self-Directed Traders

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Image by Anna Nekrashevich from Pexels

Whether self-directed trading for your IRA or not, less experienced investors can easily make mistakes, which include chasing trends, following hot stock tips, buying high, and selling low. Even the best tools and technical analysis have no value when you let emotions drive your actions.

When people with little to no knowledge or experience in investing start out, what are the key things they must do? What risks should they avoid?

Develop a strategy

The first thing you should do is to have a strategy. Many self-directed traders too often switch from one investment to another without a clear plan or strategy. That makes them lose money.

Investment management executive Paul Schatz agrees. He says that successful self-directed trading “begins with a time-tested and well-researched investment process” you must follow without fail. “Investing can’t be done by the seat of your pants.”

“Self-directed investing is a great way to take maybe 5% to 10% of your wealth and embark on your own decision-making,” investment expert David Biliter says. He adds that maximizing these efforts requires being detailed with your goals.

Regularly investing a set monthly amount leads to savings that compound over time. You should do that in good times and bad. Because mutual funds and ETFs are diversified, investing in them minimizes your risk, unlike individual stocks that often fluctuate wildly in price.

“Markets don’t act rationally all the time,” Biliter explains. Not planning for the downturns can lead to emotions taking over, often resulting in wrong decisions.

Investing in different asset classes to diversify your portfolio is crucial for mitigating risk. For example, have a healthy mix of domestic, international, and bond funds.

Avoid emotional trading

Many self-directed traders approach investing like a kid in a candy shop. They rush to scoop up gold stocks one week, then gravitate to tech stocks the next, and energy stocks the following week. “Investing on emotion destroys returns. People buy high and sell low,” Schatz says. The goal is to do the opposite.

Fear and greed undermine the goals of investors. Fear drove investors to abandon the equity markets during the financial crisis. As a result, they missed the opportunity to benefit when they eventually rebounded.

Establishing a plan is tricky, but maintaining it through perilous times is twice as difficult. The key to sustaining it is by being clear about what you are trying to accomplish, determining your risk tolerance, and setting a time horizon. 

The more well-defined your goals are, the easier it will be to create a strategy you can stick to when emotions run amuck and markets go up and down. Whether aiming to fund a dream vacation or saving for retirement, the more detailed you are, the more you can refine your plan.

Assess risk tolerance

Time and money go hand in hand. Once you have an idea of the former, you must address the latter. The dollars-and-cents figures that lead to successful self-directed investing aren’t how much you could gain but how much you’re willing to spend and how much you’re prepared to lose.

A precise evaluation of these factors will provide you with your level of risk tolerance. That alone will define the rules that allow you to follow them through fluctuating markets.

Your risk tolerance dictates how much you’re willing to invest and where and how. Lane says the most critical factor in determining your risk tolerance is why you are investing. You are more willing to take risks if your purpose is to buy a boat than if it’s for your child’s college fund.

Funding a last-minute vacation might mean you’re more willing to gamble on a medium-sized investment in a couple of stocks. You might be more inclined to aim for a more stable asset when creating savings for your retirement. However, remember that no investment is without risk, so diversify.


Thoughtful investing requires “research and more research,” says wealth management executive Allan Katz. Many do-it-yourself investors see things from a limited viewpoint. They look to see how the stock market is performing and whether it’s up or down, but that doesn’t constitute sufficient research.

Self-directed traders can quickly identify the top-performing mutual funds in the last year and look at their fees when researching funds. However, limited information is not enough to make good decisions. “Past performance offers no guarantees of future performance,” Katz says. A five-star mutual fund that excelled in 2023 may suffer a setback in 2024.

With a clear understanding of your goals, timeline, and level of risk exposure, you can now set clear and easy rules you can follow. They will help check your emotions and secure your investments.

“There’s so much noise out there, and in my experience, the only way to cut through it is to stick to your rules,” Biliter adds. People will have different rules, but that doesn’t matter as long as they follow them.

Stick to the plan

Devising a well-thought-out financial plan is complicated, but sustaining it is challenging, too. “Everyone needs a roadmap to get to destinations,” says financial planner Clayton Shearer. Self-directed traders must know “how much to invest, a reasonable rate of return to expect, and a time frame for the investment.”

Devising a written plan that details one’s personal investment strategy keeps investors on track. That plan should include how to diversify investments and the allocation percentage for each one. Since investments will dip or spike at different rates over time, rebalancing the portfolio annually to conform to the original plan is crucial.

Developing written exit strategies helps you stay focused. If one investment hits your target, consider selling it and finding another growth stock.

Shearer advises taking a step back when the market plunges and maintaining the plan. Investors who don’t let their emotions overrule can thrive. “Leave your portfolio alone and let time do its job.”

Consider consulting the pros

Too many investors buy, go to investment sites, read articles on financial trends, and think they know everything. However, these articles are not customized to address your goals, schedule, and risk tolerance.

If you react to market fluctuations or make decisions based on the news, consider hiring a financial planner to review your plan, offer feedback, and make suggestions. Schatz says that most financial advisers have honed their strategy, learned what works and what doesn’t work, and know how to establish a well-thought-out investment plan.

You don’t have to relinquish control of your assets. You can pay a professional by the hour or on a per-project basis. For instance, you might want someone to review your investment plan to see if it suits your situation.

Proceed With Caution

Self-directed trading offers investors the unique opportunity to take complete control of their financial portfolios. You can explore various investment options, opening the door to potential growth and diversification.

However, self-directed traders must remain informed and diligent. You must follow regulations and do your due diligence to maximize the benefits while safeguarding your investments.

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