What is a Self-Directed IRA?

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Self-Directed IRAs (SDIRAs) are more flexible accounts for savvy investors who want to make complex investments outside the traditional categories of stocks, bonds, and funds. Learning more about the details of SDIRA rules, the benefits of these accounts, and some of the risks investors incur with them can help you decide if this is a worthy investment for you.

What Is a Self-Directed IRA (SDIRA)?

Self-directed IRAs are types of IRAs, or Individual Retirement Accounts, that allow for alternative types of investments. Traditional and Roth IRAs place restrictions on the types of investments individuals can make, but self-directed IRAs offer knowledgeable investors opportunities to tap into the tax advantages IRAs create. While custodians and/or trustees administer these accounts, individual account owners can manage the accounts and their investments.

SDIRAs allow investors to expand their investment choices beyond stocks, bonds, ETFs, and certificates of deposit (CDs). However, you cannot invest in collectibles or life insurance. They also have more complex rules regarding distribution rules and prohibited transactions. Even the contribution limits are slightly different: individuals can contribute up to $7,000 in 2024 (or up to $8,000 if you’re an individual over 50).

How to Open a Self-Directed IRA (SDIRA)

To open an SDIRA, you need a qualified IRA custodian who can administer the account, and different custodians offer different options. Since these accounts are self-directed, the custodian can’t offer you financial advice. Instead, you’ll need to know enough to manage the account or have a financial advisor. Follow these four steps to open your self-directed IRA:

  1. Know the basics of the rules and investment options before you choose to open an account.

  2. Invest in a wider array of options, including private businesses, metals and commodities, and real estate to diversify your total holdings.

  3. Decide if you want a self-directed traditional IRA (a pre-tax investment option) or a self-directed Roth IRA (a post-tax investment option).

  4. Open your account and fund it through IRA transfers, rollovers, or new contributions.

Traditional vs. Roth Self-Directed IRA (SDIRA)

Self-directed traditional and Roth IRAs are much like regular IRAs. Traditional SDIRAs allow for pre-tax investments, but the withdrawals are taxed. Roth SDIRA contributions are taxed upfront, but you can make tax-free withdrawals. Also, individuals must make below a certain income level to contribute to a Roth SDIRA, just like with Roth IRAs.

However, individuals don’t have to take Required Minimum Withdrawals (RMDs) from Roth SDIRAs at any age, and individuals can make withdrawals at any age after 59 1/2.

Difference Between an SDIRA and Other Retirement Accounts

The main difference between SDIRAs and other types of tax-advantaged retirement accounts — and the main reason why many investors prefer this option — is the flexibility that SDIRAs offer. Most tax-advantaged accounts place strict limitations on the investment types custodians can offer, and many custodians offer only a limited array of those choices and funds. While SDIRA custodians also tend to specialize in select types of investments, individuals have much more freedom to find custodians that offer the more diverse investment types they’re interested in. 

One example that illustrates the greater freedom SDIRAs have is in real estate. Individuals who purchase investment properties through an SDIRA can sell those properties and have any profit funnel directly into their SDIRA. With a self-directed traditional IRA, those profits grow untaxed. 

Investing in a Self-Directed IRA (SDIRA)

Knowledgeable investors can make more profitable and less volatile investments through SDIRAs with fewer restrictions. Real estate investors, in particular, can use existing funds in their SDIRA to put a down payment on a property without withdrawing those funds. This allows the investor to make a profit off the investment without it being considered a contribution or applying to the $7,000 annual contribution cap.

Some of the investments that individuals can make through an SDIRA include:

  • Traditional investment options, such as stocks, bonds, ETFs, and CDs

  • Real estate properties (including rental properties and flips)

  • Precious metals

  • Partnerships

  • Tax liens

  • Private business investments

Some investments that cannot be made through an SDIRA include:

  • Life insurance

  • “Self-dealing” investments

  • S Corporation stocks

  • Prohibited transactions

  • Collectibles: This list includes alcoholic beverages, antiques, art, baseball cards, jewelry memorabilia, rare coins (even if they’re a precious metal), and stamps.

What Are the Benefits of a Self-Directed IRA?

Self-directed IRAs offer many benefits to investors who either know enough investing information to use them or who have experienced financial advisors. Alongside the overall core advantage of flexibility, SDIRAs offer these four benefits:

  1. Investing opportunities in a tax-advantaged account

  2. Increased growth potential

  3. Potential protection from economic fluctuations

  4. Control over personal finances and investments

Investors who like the freedom of SDIRAs may also be interested in self-directed 401(k)s.

Self-Directed IRA (SDIRA) Risks

However, because self-directed IRAs are self-directed and have complex rules, there are many risks involved. We recommend you work with a knowledgeable financial advisor who can help you navigate the investment rules. Eight of the most noteworthy risks of SDIRAs are:

  1. Prohibited Transactions. The “self-dealing” restriction is particularly hazardous, so it’s important to maintain a clear distinction between assets that belong to you and assets that belong to your SDIRA. Self-dealing restrictions also govern the extent to which you can make investments or deal with family members, which the IRS details here.

  2. The Need for Due Diligence. Because SDIRA custodians cannot offer advice, investors must have adequate resources to make their own informed decisions.

  3. Fees. Some SDIRA fees include establishment fees, annual fees, investment bill pay fees, and more.

  4. Exit Plan Considerations and Liquidity. Unlike traditional investment types, it can be difficult to sell assets held under an SDIRA. This is especially challenging if you need emergency cash or have to take RMDs from a traditional SDIRA.

  5. Fraud. SDIRA custodians often don’t assess the quality of the investments it offers, so investors are vulnerable to potentially fraudulent investment schemes.

  6. No Transparency. Some investment opportunity listings just post the purchase price and expected returns rather than any other details or asset amounts.

  7. Overly Concentrated Portfolios. While SDIRAs open the doors to multiple different types of investments, investors still run the risk of investing too heavily in one type of market. Investing in ETFs and index funds remains one of the easiest ways for investors to diversity.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.

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