A self-directed IRA is a type of individual retirement savings account. It is offered in both traditional and Roth variations and works primarily the same way: you’ll contribute to the IRA and make investment choices that grow your retirement funds.
What distinguishes a self-directed IRA from other types of IRAs is that it allows you to hold alternative investments.
The investment options of a self-directed IRA go beyond the typical array of stocks, bonds, and mutual funds. Here are just some of the things you can invest in with a self-directed IRA:
Tax lien certificates
Commodities, like oil or gas
These alternative assets can help you diversify your portfolio and potentially save more money for retirement, but they also come with high risk. Through 2022, you can invest up to $6,000 (plus a $1,000 catchup contribution if you're at least 50 years old) per year across all your IRAs.
How a self-directed IRA works
If you have an IRA account, it is managed by an IRA custodian. With popular IRA types, including traditional and Roth IRAs, the custodian is generally whoever provides your IRA — usually a financial institution or brokerage firm.
However, traditional IRA providers, like Fidelity or a bank or credit union, might not offer a self-directed IRA. In that case you’ll need to find a special trust company to act as your IRA custodian.
Every year, you’ll have to assess and report the value of your investments to the custodian, which makes sure you’re following the regulations set by the IRS. The custodian does not provide financial advice; it only administers your retirement plan assets, so it’s wise to enlist the help of a financial advisor who can help you properly evaluate your holdings.
(Read more about the various types of assets.)
Self-directed IRAs come in traditional and Roth variations. This is a distinction between the type of tax advantage you prefer. A traditional IRA offers tax-deferred growth, while the Roth IRA offers tax-free growth.
The contribution limits for a self-directed IRA or self-directed Roth are the same as other IRAs. The annual contribution limit for a self-directed IRA is $6,000 for those under 50. If you’re age 50 or above, you can contribute up to $7,000. The contribution limit applies across all IRA accounts. So if you own another IRA account, any contributions to it will decrease how much you can contribute to your self-directed IRA that year.
You can use your IRA investments to purchase real estate or undeveloped land. Any money you make from the investment, either from a sale or rental income, must be directed back into the IRA.
There are also other guidelines and prohibited transactions that you must avoid as to not violate IRS rules. For example, you and your family members are considered disqualified persons and can’t live on the property. So it would be inadvisable for you to purchase a rental property with the hopes of leasing a unit to your son. We’ll talk more about prohibited transactions and disqualified persons later.
If you want to make renovations or need to do maintenance to the property, you must use the IRA funds. For example, if you're adding a fence or fixing the plumbing, you can’t make these improvements yourself or you’ll end up a disqualified owner.
The main caution to take here is not to invest in companies that you already have a stake in or are associated with. An example of an alternative investment could be a startup that you want to fund.
Acceptable metals include gold, silver, palladium, and platinum and they must adhere to standards regarding fineness and pureness.
The IRS prohibits you from using the IRA funds for certain transactions regarding disqualified persons.
Disqualified persons are
Your spouse or family member
A beneficiary of the IRA
Fiduciaries, or someone related to the administration of your self-directed IRA
Company in which you own 50% stock
In general you cannot use IRA funds to engage in business with the people or entities listed above. You also cannot lease them property or loan them money that comes from your IRA.
The following assets are prohibited:
Coins (excluding US Treasury-minted gold and silver)
Should I open a self-directed IRA?
Whether or not a self-directed IRA is right for you depends on your financial goals and appetite for risk. Remember that typically you can still invest in a traditional assets like stocks and bonds depending on your custodian.
Investing in alternative assets can be helpful for diversification. Alternative investments also have the potential for high returns. For instance, the start up that you fund might turn out to be a big success in the future. Volatile assets often experience huge spikes in growth, where as traditional assets, like a certificate of deposit (CD) earn money at a steadier rate.
On the other hand, you could lose a lot of money from your investments, too. The market is volatile for many alternative assets, and the rates of return are of course not guaranteed. This is especially true for digital assets, where the price swings can occur in a very short amount of time. It’s important to consider these fluctuations and how much risk you’re willing to take on if you’re saving for retirement.
Self-directed IRAs also pose the risk of fraud. The U.S. Securities and Exchange Commission (SEC) warns investors of the risks associated with a self-directed IRA, including lack of transparency. It cautions against cryptocurrency and any initial coin offerings (ICOs) in particular, which might deceive investors by promising a high rate of return. While some cryptocurrency exchanges might be regulated by local governments, others may give the false impression that they adhere to SEC or CFTC (Commodity Futures Trading Commission) standards or are even endorsed by these government agencies. To avoid fraud, make sure you are trading on a reputable cryptocurrency exchange, and check the government website for any authorized official releases.
While there are financial records available for publicly traded stocks, alternative investments may not have the same level of transparency when it comes to disclosing information about their financial history.
Some alternative investments might also be more illiquid than others. This means it’s difficult to sell your assets quickly when you need money. While cryptocurrencies can be sold as easily as stocks, it might take a bit longer to sell off your rental property and collect the money.