- A self-directed IRA (SDIRA) is a kind of retirement account that allows you to invest in assets that are off-limits to regular IRAs.
- You directly manage your self-directed IRA, and so are responsible for researching your investments and their tax consequences.
- In general, self-directed IRAs are available only through a custodial service that specializes in them.
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When it comes to IRA investments, stocks, bonds, and mutual funds/exchange-traded funds (ETFs) are traditionally the assets of choice. After all, these securities are easy to buy and sell, and in the case of mutual funds, offer other benefits: professional management and instant diversification for your portfolio.
Still, some IRA investors may want more control over their holdings, the opportunity to earn higher returns, or the option to move their money out of the usual suspects — and into more exotic assets. If that sounds like you, a self-directed IRA (SDIRA) might be worth a closer look.
Be warned, though: It also involves extra effort and definitely complicates your financial affairs.
What is a self-directed IRA?
An individual retirement account (IRA) is a tax-advantaged retirement savings account: The money within it grows tax-free. You take a tax deduction when you put funds into it and pay taxes on the sums when you start withdrawing, which you must do after age 72½.
Self-directed IRAs (SDIRAs) are structured like standard IRAs, with the same contribution limits, distribution rules, and tax advantages. What sets SDIRAs apart are two things:
- The wide variety of investment options they offer
- Who makes the investment decisions about them
Self-directed IRA alternative investment options
The IRS regulates what sort of investments regular IRAs can hold: stocks, bonds, mutual funds, ETFs, CDs, and other traditional assets. SDIRAs can own these too. But only self-directed IRAs let you hold alternative investments, such as:
- Real estate (the most popular SDIRA asset)
- Gold and other precious metals
- Tax liens
- Private mortgages
- Horses, livestock, and farmland
- Intellectual property
- Promissory notes
- Private equity
How self-directed IRAs are managed
All IRAs have to be held at some sort of financial institution, which acts as their custodian or trustee. Someone at or affiliated with that institution — a broker, wealth manager, or financial planner — might advise you on investments, or even make trades in it on your behalf.
An SDIRA also has a custodian or trustee to administer it, but the account owner directly manages it (that’s why they’re called “self-directed”). The IRS prohibits SDIRA custodians from giving financial advice. As a result, many traditional brokerages, banks, and investment companies don’t offer self-directed IRAs; you have to go to a different custodian who specializes in them.
How to set up a self-directed IRA
To open an SDIRA, you’ll need an IRA custodian that handles these accounts (do an online search for “SDIRA custodian” to find one). The custodian might be a bank, credit union, broker, savings and loan association, or firm approved by the IRS to act as a trustee.
SDIRA custodians offer different investment options. So, if you’re interested in a particular asset — say, Bitcoin — make sure it’s part of the custodian’s lineup.
You can set up an SDIRA as either a traditional IRA (tax-deductible contributions) or Roth IRA (tax-free distributions). SDIRA funding options include direct contributions (observing annual contribution limits, of course), transfers from other investment or bank accounts, and rollovers from other IRAs or 401(k) plans.
Benefits of self-directed IRAs
All IRAs offer a tax-advantaged way to save for retirement. But the self-directed version boasts a few extra perks that can turbocharge a nest egg:
Because they can invest across asset classes, SDIRAs can diversify your portfolio in much more effective ways. In fact, they can hold just about anything that’s not specifically prohibited by IRS rules (mainly, life insurance, S-corps, and collectibles like art and antiques, stamps, or other tangibles).
Higher potential returns
The average annual return for the S&P 500 is about 8% — about the same you would expect in a standard IRA. Many alternative investments, such as real estate, offer higher potential returns, without necessarily adding significant risk or volatility.
Flexibility with your investments
In general, you have to wait until you’re at least age 59½ to take penalty-free withdrawals from either type of IRA (in the case of a Roth IRA, you can withdraw your contributions at any time without penalty) to invest in something else. However, you can access the capital in your SDIRA anytime and direct how it will be put to work — whether that’s buying an office building or a racehorse. And because you’re not withdrawing the money, doing so won’t trigger penalties or taxes.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provides bankruptcy protection for IRAs. That means the investments you hold in an SDIRA — including valuable assets like real estate — would remain untouched in the event of bankruptcy or legal action.
Risks of self-directed IRAs
Of course, SDIRAs have their downsides, as well:
Even though SDIRAs are “self-directed,” the IRS requires a certified custodian or trustee to oversee your investments — and they don’t work for free. Expect to pay a fee to establish the account, plus annual fees and service fees for any tasks the custodian handles, such as bill paying.
It’s easy to buy and sell stocks, bonds, mutual funds. That’s not always the case with SDIRA assets, and your capital could be tied up in assets you no longer want. Poor liquidity also means you may not get the price you anticipated when it’s time to sell.
A prohibited transaction happens when you, your beneficiary, or a disqualified person misuses your SDIRA. Self-dealing is one such prohibited transaction: Under IRS rules, you can’t immediately or directly benefit from the assets in your account. Doing so could trigger a penalty or the immediate disqualification of the IRA, and its tax breaks.
For example, you could invest in a rental property like a vacation home, but you better not spend any time there.
SDIRA account owners can’t participate in transactions with certain other people (this directly relates to the self-dealing rule that prevents personal gain). According to the IRS, disqualified persons include:
- Any fiduciary to the account (including the account owner)
- A family member, including a spouse, parent, descendent, or the spouse of a descendent
- A corporation, estate, partnership, or trust where a disqualified person owns 50% or more of the interests
- A director, an officer, or a 10%-or-greater partner or shareholder of any of the above entities
Lack of counsel
While they can (and do) make certain investments available, SDIRA custodians aren’t allowed to give financial advice or make recommendations. In fact, the Securities and Exchange Commission (SEC) warns that custodians “generally do not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters.”
You could certainly work with an outside advisor (but not the custodian) to help you pick investments and develop a strategy. But you have to make all the decisions and direct the custodian to execute them.
The bottom line: You’re on your own in evaluating the soundness of any investment, and in understanding the tax consequences of your investment picks.
The financial takeaway
Self-directed IRAs allow you to invest beyond the basics, diversifying your holdings for potentially higher returns. But while they offer more flexibility and options than standard IRAs, they involve more work, rules, and risks — and a steeper learning curve.
Consequently, SDIRAs are most appropriate for people who already have experience with alternative investments and want to hold those assets in a tax-advantaged account.