What Is a Self-Directed IRA and How Does It Work?
Written by
Rudri Patel
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Melanie Grafil
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There’s a different type of IRA that most investors don’t even know about called the self-directed IRA. Although a self-directed IRA shares many of the same overall characteristics of a traditional IRA, it has some differences.
If you’ve heard about a self-directed IRA — or even if you haven’t — here are some of the most important benefits, tips and frequently asked questions to bring you up to speed.
An Overview of Self-Directed IRAs: What They Are
Most are familiar with traditional retirement accounts that include IRAs and Roth IRAs. These vehicles allow investments in mutual funds, stocks and ETFs. If you’re looking to invest in alternative assets, a traditional IRA or Roth IRA will not allow those investments.
Instead, you may want to consider a self-directed IRA, which is an IRA that you have complete control over. While you do technically “control” a traditional IRA that you can open at any bank or brokerage firm, a self-directed IRA is completely in your hands. You can invest in assets like precious metals, real estate, cryptocurrency and tax liens.
Since you’re the one in charge of your self-directed IRA, you are responsible for choosing all of your investments. A self-directed IRA is for those who are more experienced investors and who seek alternative investments.
How Does a Self-Directed IRA Work?
A self-directed IRA is a type of IRA that allows you to invest in alternative investments, but it also requires the oversight of a custodian or trustee. The custodian executes the investment purchases, sales and recordkeeping on behalf of the investment owner. Keep in mind that custodians do not offer investment advice.
Investors are allowed to participate in a broader range of investments including real estate, precious metals, cryptocurrency and tax liens.
In terms of compliance, investors cannot invest in collectibles, real estate owned by the IRA, or buy or sell assets to themselves, family members, or businesses they control. Traditional self-directed IRAs require a minimum distribution at age 73, and withdrawals are taxed. Roth self-directed IRAs do not require a minimum distribution, and withdrawals are not taxed in retirement.
Types of Self-Directed IRAs
A traditional self-directed IRA and a Roth self-directed IRA are the two options you have for investments. The key difference is that the traditional self-directed IRA’s contributions are tax-deductible, while self-directed Roth’s contributions are post-tax. Here’s an overview of the differences:
| Feature | Roth Self-Directed IRAs | Traditional Self-Directed IRAs |
|---|---|---|
| Tax treatment | -Contributions are after-tax -Withdrawals are tax-free in retirement. |
-Contributions may be tax-deductible -Withdrawals are taxed as income in retirement. |
| Eligibility | -Income limits apply for contributions and phases out at higher incomes | No income limits for contributions, but deductions may be limited based on income. |
| Withdrawal rules | -Contributions can be withdrawn anytime tax-free -Earnings can be withdrawn tax-free after age 59 1⁄2, if the account is more than five years old |
Withdrawals before age 59 ½ may face taxes and penalties unless an exception applies. |
| Required Minimum Distributions | -No RMDs -No mandatory withdrawals at any age. |
Yes. Must start withdrawals at age 73. |
| Penalty for early withdrawal | Earnings withdrawn before age 59½ may face a 10% penalty unless an exception applies. | Withdrawals before age 59½ are subject to income tax and a 10% penalty unless an exception applies. |
Key Differences Between Self-Directed IRAs and Traditional IRAs
Self-directed IRAs permit investment in assets like precious metals, real estate, cryptocurrency and tax liens, while a traditional IRA involves traditional investments in stocks, bonds, mutual funds and ETFs. The assets in a self-directed IRA are more volatile and so requires an investor who is comfortable with risk.
A self-directed IRA is managed by a custodian and requires more hands-on management. A traditional IRA is handled by a bank or brokerage firm.
What Can You Invest in With a Self-Directed IRA?
A self-directed IRA allows you to invest in several types of investments. Those investments include:
- Real estate. This includes raw land, commercial and rental buildings.
- Precious metals. This includes gold, silver, palladium and platinum. The precious metals must meet IRS standards and cannot be stored at home.
- Cryptocurrencies. The cryptocurrencies must be held by an IRS-approved custodian.
- Private equity and startups. Hedge funds, venture capital and private businesses are approved investments.
- Tax lien certificates. You can earn interest on unpaid property taxes.
Som investments are prohibited from a self-directed IRA. These include collectibles, personal use property, life insurance policies and self-dealing transactions.
How To Open a Self-Directed IRA
The process for opening a self-directed IRA is essentially the same as opening any other type of IRA. The trick is finding a financial firm that actually offers a self-directed IRA. Here are the steps to set up a self-directed IRA:
1. Choose a Qualified Custodian
You will need to select a custodian for your self-directed IRA. You can look for IRS-approved custodians and also find out information on fees, customer service and investment options. Make sure the custodian can handle the type of investments you prefer.
2. Understand and Adhere to IRS Rules
Have a clear understanding of prohibited transactions like collectibles and IRA-property owned by you for personal use. Also, understand that you have to take a required minimum distribution at age 73 if you have a traditional self-directed IRA.
3. Identify Your Investment Goals
Identify the type of investments you want to make, and ensure these fit with your long-term financial strategy.
4. Fund the Account
You can fund the account with a rollover from a traditional IRA or directly contribute to your self-directed account.
5. Begin Selecting Investments
Research investment opportunities and work with your custodian to purchase the assets you selected.
Tips for Selecting a Reliable Custodian
There are key features you should look for in a custodian. Be sure the custodian is IRS-approved and you understand their fees. Also, make sure they support the assets you’d like to invest in. Read their reviews to see if they have received positive customer support ratings.
Who Should Consider a Self-Directed IRA?
Self-directed IRAs aren’t for everyone. You have to evaluate your investment style before diving into the self-directed IRA market.
A self-directed IRA allows you to spread out your investments among different types, so if you’re the type who likes to pick and choose the investments in your retirement portfolio, and are willing to take on some of that additional risk, then this might be the right choice for you.
Additionally, self-directed IRAs are ideal for those investors who are familiar with alternative markets of precious metals, cryptocurrency, tax liens and real estate. Those who want to diversify their portfolio, because it’s heavily funded in traditional assets, may also want to consider a self-directed IRA to add balance to their retirement strategy.
John Csiszar contributed to the reporting for this article.
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