What Is a Self-Directed IRA? And How Does It Work?

Whether it’s a having a closet stuffed with a diverse wardrobe or getting to choose between dozens of flavors at your favorite ice cream shop, the average American likes lots of options.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

In the area of investing, the self-directed IRA exists to give investors that same power of choice. From real estate and livestock to promissory notes and tax lien certificates, self-directed IRAs offer regular folks access to all kinds of different investments—with the same benefits they would get from the “classic” version of an IRA.

Sounds great, right?

But hold up! As niche investments, self-directed IRAs can get complicated fast. Remember the last time you went to the grocery store for something as simple as a box of mac and cheese but had to choose between what seemed like a million varieties? It’s (kind of) the same concept here. The IRS has a long list of rules and guidelines for self-directed IRAs. Plus, they often involve high-risk investments with complicated fees—and you’ll carry the burden of more responsibility for your investment choices too. 

So, let’s put self-directed IRAs under the microscope and see how they work to find out whether they should have a place in your retirement portfolio.

What Is a Self-Directed IRA?

A self-directed IRA (SDIRA) is a tax-advantaged retirement account that’s very similar to a traditional or Roth IRA, but it allows you to invest in a wide range of “alternative” investments that regular IRAs often don’t.

How Does a Self-Directed IRA Work?

Self-directed IRAs have a lot in common with their close cousins, the regular traditional and Roth IRAs. They’re designed to offer the same kinds of tax benefits, whether that’s tax-deferred growth (traditional) or tax-free growth and withdrawals in retirement (Roth).

The biggest difference that sets the self-directed IRA apart is what you can use the funds within the account to invest in. Regular IRAs offered by most brokerage firms only allow you to invest in certain types of traditional investments—like stocks, bonds and mutual funds, for example. But with a self-directed IRA, you could potentially use retirement funds to invest in real estate, small businesses and cryptocurrencies. 

Most folks who open a self-directed IRA typically use them for long-term investments that are more difficult to buy and sell than stocks, bonds or mutual funds (which can be bought with the click of a mouse).

In investing jargon, self-directed IRAs are for investments that are “less liquid.” Here are some examples of what you can invest in with the funds inside your self-directed IRA:

• Real estate
• Undeveloped land and livestock
• Precious metals (gold, silver, etc.)
• Cryptocurrency
• Private businesses
• Energy and natural resources (water or mineral rights, oil and gas, etc.)
• Tax lien certificates
• Promissory notes

Now it’s time to talk about the “self-directed” part. Since a self-directed IRA custodian—your account's service provider—isn't allowed to give you financial advice, you're in charge of picking and managing your investments.

That’s why you usually won’t find self-directed IRAs at traditional brokerage firms and banks. Instead, specialized investment companies offer self-directed IRAs and can act as a custodian for your account.

Keep in mind that different companies might agree to handle different types of investments, so definitely do your homework before you open an account. These companies might also charge fees for creating and maintaining your account that could cut deeply into your earnings—so beware!   

And one last thing: Yes, you can have both a regular and a self-directed IRA at the same time. There’s actually no limit to the number of individual retirement accounts you can own. But no matter how many accounts you have, your total contributions for the year can’t exceed the contribution limit set by the IRS.¹

Self-Directed IRA Rules and Guidelines  

This part is very important: The IRS has strict rules about what you can and can’t do with a self-directed IRA. If you make a “prohibited transaction” or break any of the other rules, your entire account could be considered distributed to you.² That would be a bad thing, because then the assets in your account would probably be subject to taxes right away.

If you violate any of these rules, you could get hit with a huge tax bill, penalties and other consequences. So make sure you understand what the rules are for the type of investments in your account.  

Prohibited Transactions

While self-directed IRAs do offer more flexibility than a regular ol’ IRA, there are some limits to what you can invest in. The IRS says you can’t invest in collectibles, life insurance or real estate that you live in. These are all prohibited transactions. 

So, we hate to break it to you, but you can’t use your retirement funds to buy that collection of super rare first edition comic books you’ve had your eye on (that probably wasn’t a great idea anyway).

Disqualified Persons

In most cases, the IRS also frowns on buying and selling investments in a self-directed IRA with certain people who could present a conflict of interest. These people are called disqualified persons.

Here’s a list of people you can’t make transactions with:

• Family members (your spouse, your kids, your parents and others)
• The investment company that provided your IRA
• Any entity (like a company or trust) where a disqualified person owns more than 50% of that entity
• Any entity where the IRA owner (most likely you) is an important employee or is a 10%-or-more shareholder of that entity 

Self-Dealing

Some people think they can get smart and do business with themselves through their self-directed IRA. That’s called self-dealing, and it’s a big no-no with the IRS. Here’s the deal: You can’t buy or sell property to yourself, you can’t lend money to yourself from your IRA, and you can’t pay any expenses or take any money from the IRA home with you. So don’t even think about it! 

What’s the Difference Between a Traditional and Roth Self-Directed IRA?

Just like regular IRAs, you can choose between two types of self-directed IRAs: traditional or Roth.

Both types have the same contribution limits as regular IRAs. And if you want to avoid early withdrawal penalties, you’ll need to wait until you’re at least 59 1/2 to make withdrawals.

A traditional IRA, whether it’s self-directed or not, has the same set of rules. You can get a tax break now by deducting your contributions from your income, but you’ll have to pay income tax when you take money out of your account in retirement.

With a self-directed Roth IRA, you pay taxes on the money before it goes into the account—so your investments grow tax-free and withdrawals in retirement won’t be taxed at all. If you decide to open a self-directed IRA, the Roth version is the way to go!

What Are the Pros and Cons of Self-Directed IRAs?

But before you decide to open a self-directed IRA, you have to weigh the good, the bad and the ugly. While there are some intriguing reasons to choose this option, there are plenty of potential pitfalls that could leave a gaping hole in your retirement investments.

Pros

1. They provide more investment options and flexibility.

If there’s one thing that self-directed IRAs offer, it’s more choices and greater flexibility when it comes to the investments you can have in your account. Not only that, but you still get to enjoy the same tax benefits you would get from a regular IRA.

2. They allow you to invest based on your knowledge and experience.

Self-directed IRAs also give you a chance to save for retirement by investing in things that go hand in hand with your passions, knowledge or experience. So if you really know your stuff when it comes to rental real estate, a self-directed IRA can help you put that knowledge to work. You could buy a rental property that appreciates in value over time and generate income that goes straight into your retirement account.  

3. They could potentially help you diversify your portfolio.

And finally, a self-directed IRA could serve as a nice complement to any money you already have in your other retirement accounts, further diversifying your retirement portfolio.

Cons

1. They come with higher fees and complicated recordkeeping.

Since the investments inside a self-directed IRA are more complex than traditional ones, most companies charge higher-than-average maintenance fees—which can take a bite out of your earnings. You may also have to do more work to maintain records and keep up with tax-reporting requirements.

2. There are a lot of rules to follow.

The IRS prohibits certain types of transactions that you’ll want to be aware of (we covered those already under “Prohibited Transactions”). Think of these as tax landmines that could blow up any tax benefits of a self-directed IRA. If you don’t follow the rules, you could end up owing fees and penalties to Uncle Sam once tax season rolls around.

3. They often deal with high-risk investments.

Most of the investment types that require a self-directed IRA structure in the first place tend to carry more risk. Think about it: Do you really want to bank your retirement future on something as unpredictable as cryptocurrency (heck no!) or as complicated as a “tax lien certificate”?

Should I Invest in a Self-Directed IRA?

We’re going to shoot it to you straight: You probably don’t need a self-directed IRA to invest for retirement.  

Almost 100% of the time, you’re better off sticking with a regular IRA (again, Roth is best!) and your employer-sponsored retirement account to save for retirement. Here’s what we recommend:

• Invest 15% of your gross income in good growth stock mutual funds through regular tax-advantaged retirement accounts.
• Have a 401(k) with an employer match? Start there and invest up to the match.
• After that, open up a Roth IRA and invest up to the max. That way, you can take advantage of tax-free growth and tax-free withdrawals in retirement!
• And if you still haven’t hit 15%, then go back to your 401(k) and invest the rest there.

While self-directed IRAs do open the door to adding creative types of investments, most of those options aren’t worth it because they’re either too risky or too complex to bother with. After all, just because you can invest in something doesn’t mean you should. Precious metals? Pass. The emotional rollercoaster that is cryptocurrency? Riding the Tilt-a-Whirl at the state fair after eating an entire funnel cake is probably a better idea. 

In certain circumstances, you might consider opening a self-directed IRA to purchase a real estate property that would operate within a retirement account. But you would only do this after you’ve maxed out your traditional retirement accounts and you’re completely debt-free (that means your home is paid off too).  

And remember that any rental income generated by the property doesn’t go to your bank account—it goes straight into the self-directed IRA and stays there until you’re 59 1/2 years old (unless you want to pay taxes and early withdrawal penalties). Plus, we always recommend that you only buy a rental property if you have the cash available to purchase it—no exceptions!

But even if you do open a self-directed IRA, you should still consistently invest in mutual funds inside your regular IRAs and employer-sponsored retirement accounts. Bottom line: Self-directed IRAs should complement your regular retirement accounts—not replace them.

Talk It Out With Your Financial Advisor

Self-directed IRAs can get really complicated really quick. And one wrong move could put you in hot water with the IRS. So before you make decisions that could have a huge impact on your retirement future, talk it through with a pro. They can help you figure out whether or not a self-directed IRA makes sense in your situation.

Don’t have an investment pro in your corner yet? No worries! We can connect you with experienced financial advisors through our SmartVestor program. It’s free to get connected, and there’s no obligation to commit!

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.