What Is a Self-Directed IRA? What You Should Know Before Signing Up

The term “self-directed” gets a lot of mileage in the investment realm. But the one area where it requires special handling is in regard to a self-directed IRA. 

There are plenty of investment accounts that are self-directed. For example, you can make your own trades inside a discount brokerage account.

But a self-directed IRA is something completely unique. It’s self-directed because you choose the investments held in the account. But that’s where the similarities end. A self-directed IRA is much more specialized and holds greater potential for both risk and reward.

Table of Contents
  1. What Is a Self-Directed IRA?
  2. Where Can You Find a Self-Directed IRA?
  3. What Can You Hold In a Self-Directed IRA?
  4. How Does a Self-Directed IRA Work?
  5. What’s the Difference Between a Self-Directed IRA and a Regular IRA?
  6. Advantages of a Self-Directed IRA
  7. Disadvantages of a Self-Directed IRA
  8. The Bottom Line on Self-Directed IRAs

What Is a Self-Directed IRA?

A self-directed IRA is a highly specialized brokerage account that will enable you to invest in assets and asset classes that are not available in conventional IRAs, let alone other types of retirement accounts and taxable brokerage accounts.

The most distinguishing characteristic of a self-directed IRA is that it gives you the ability to hold physical assets. For example, it’s possible to have a self-directed IRA that lets you hold investment real estate.

It will work the same way as a traditional or Roth IRA, in that you can make tax-deductible contributions of up to $6,000 per year, or $7,000 if you are 50 or older. A self-directed IRA can be set up as either a traditional or a Roth IRA.

The investments held in the account earn income on a tax-deferred basis. That means you won’t have to pay tax on the gains until you begin taking distributions from the plan.

As is the case with a regular IRA, if you withdraw funds from the account before reaching age 59 ½, you’ll owe a 10% penalty in addition to ordinary income tax.

Where Can You Find a Self-Directed IRA?

This is one of the biggest dilemmas for anyone interested in opening a self-directed IRA. You won’t find one offered by the big investment firms, like Fidelity or Schwab. And robo-advisors, like Betterment, Wealthfront, or M1 Finance, don’t provide them either.

Instead, you’ll need to conduct a web search. Start by googling “self-directed IRA” with the name of the asset class you want to invest in. For example, if you want to hold physical precious metals in your IRA, you’ll enter “self-directed IRA precious metals.”

We can’t even give examples of self-directed IRA custodians in part because the field is so diverse and because we can’t vouch for the integrity of any providers. They’re generally small, highly specialized, and anything but household names.

Just be careful to do your due diligence on any custodian you’re considering. Though many are completely legitimate, some are something less. And nearly all have complicated provisions and high fees that will cut into your investment gains.

Start with a FINRA broker check, paying particular attention to any complaints filed or disciplinary actions taken against the company. Then, check with the Secretary of State in the custodian’s state and your own to see what their standing is. There may also be a list of complaints and disciplinary actions listed with those agencies.

Finally, check the company’s standing with the Better Business Bureau. It’s not a regulatory agency, but they give companies a rating ranging between A+ and F to provide you with a good idea of general consumer sentiment about a company. They also list complaints. If there are many, pay attention to consistent complaints.

Finding a reputable self-directed IRA custodian is very much like panning for gold.

What Can You Hold In a Self-Directed IRA?

Just as is the case with regular IRAs, there’s a very long list of investments you can hold in a self-directed IRA. In fact, the list of prohibited investments is limited to just two – collectibles and life insurance.

With just about any other asset class, it’s game on. Even with regular IRA accounts, you’re free to invest in all kinds of individual stocks, bonds, mutual funds, exchange-traded funds, real estate investment trusts, precious metals, commodities, and options.

But a self-directed IRA focuses on holding physical assets within your plan. Examples include cryptocurrency, physical precious metals, real estate, tax liens and deeds on a foreclosed property, foreign currency, and other exotic investments.

Two of the most common investments held are real estate and precious metals. There are custodians established specifically for each purpose, and a few that handle both. 

In the case of real estate, you can actually hold property in the account. The same is true of precious metals, though these are limited to recognized bullion coins that meet certain purity standards. Examples include American Eagles, Canadian Maple Leafs, and South African Krugerrands (but not numismatic coins).

Some self-directed IRA custodians can also accommodate traditional paper investments, though they may do it through an affiliate relationship with a traditional investment broker.

How Does a Self-Directed IRA Work?

Self-directed IRA accounts are subject to the same limits and tax treatment status as traditional and Roth IRA accounts. But beyond the basics, they’re much more complicated in their structure and how you need to handle them. 

First, you’ll need to be an experienced investor in whatever asset class you want to establish the self-directed IRA for. For example, if you want to set up a self-directed IRA for real estate, you should be an experienced real estate investor. That experience will help you understand the nuances of the self-directed IRA and the requirements needed to set up and manage the plan.

Second, self-directed IRA custodians don’t offer the investments they allow you to hold in your plan. Those need to be purchased from third-party brokers. For example, if you plan to hold gold bullion coins in your self-directed IRA, the coins will need to be purchased from a coin dealer.

Third, and most importantly, there are restrictions on how assets are held within the account. Make a mistake here, and the penalties from the IRS can be severe.

Let’s use a self-directed real estate IRA. Under IRS rules, the property cannot be used by you personally for even one day. You also can’t be involved in the purchase of the property or the ongoing management. The property must be titled within the IRA and managed from there as well.

Violate the rules, and the IRS can invalidate the IRA.

There’ll be a 15% penalty for the violation, but if it’s is not corrected, and the plan is invalidated, the IRS can also impose a penalty equal to 100% of the amount involved in the violation.

The IRS risks alone keep the number of self-directed IRA plans to an absolute minimum.

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

Interestingly enough, there are actually more similarities between a self-directed IRA and a regular IRA than there are differences.

Contribution amounts, tax-deductibility, and withdrawal rules are all the same. And with either type of IRA, it can be established as either a traditional or a Roth IRA.

The first major difference between the two is in the type of asset you can hold in either account, which we’ve already covered above.

The other major difference is in the way investments are handled within the plan. With a regular IRA, you will not only select the investments in the account, but you can also manage them. That is, you can make the purchases and sales of securities on your own.

But with a self-directed IRA, there’s an arms-length feature.

You can direct the custodian to purchase certain investments, but you cannot participate in those activities in any way.

For example, if you set up a self-directed real estate IRA, not only must the property held in the account be purchased and managed by the custodian, but all revenues must be retained in the plan, with expenses paid out of the plan as well. You may own the IRA, but the self-directed IRA custodian owns and manages the assets within the plan.

Certain real estate investors may think that by holding real estate in a self-directed IRA, they can gain the tax benefits of the IRA while still enjoying the benefits of property ownership. This isn’t true. Any significant involvement in the property management or accessing the revenues it generates will lead to an IRS violation.

And finally, since self-directed IRAs are nonstandard plans, they contain more provisions and higher fees.

Advantages of a Self-Directed IRA

The main advantage of a self-directed IRA is the ability to hold unconventional investments in a tax-sheltered retirement plan. It’s an ideal scenario for someone who is not satisfied with holding real estate through a real estate investment trust and prefers to hold individual properties.

The same is true of precious metals. Yes, you can invest in a gold ETF or in gold stocks in a regular IRA. But if you want to hold the physical metal in your IRA, you’ll need to do that through a self-directed IRA. Self-directed IRAs are set up to do that, whereas a traditional broker has no capacity to hold and manage physical assets.

It’s also an opportunity to hold more exotic investments, like tax liens or investment positions in startups. These will allow you to achieve a greater level of diversification than you can with a traditional IRA.

Disadvantages of a Self-Directed IRA

Unfortunately, there are more disadvantages than advantages when it comes to self-directed IRAs. As already noted in this article, reputable brokers are more difficult to find, plans are more complicated, and fees are many times higher than they are with traditional IRAs.

It’s not possible to even give an estimate on the fees associated with self-directed IRAs. It all depends on the specific type of investment class the custodian specializes in and the level of competition in that field. If there aren’t many providers, the ones that are available are free to charge whatever they want.

Other issues include:

A lack of liquidity. Because a self-directed IRA holds specialized investments, it will be virtually impossible to do a rollover of the plan into a regular IRA. That’s because regular IRA custodians don’t handle those assets.

IRS violation risk. You can be on the wrong side of the IRS with a regular IRA. But the nature of traditional IRAs and the structure imposed by the custodians make it extremely unlikely. The opposite is true with self-directed IRAs. Their complexity, along with the direct involvement of investors, increases the potential for violations.

Lack of investor protection. Unlike traditional investments, there may be no insurance provided from either FDIC or SIPC to protect you from default by the custodian. There’s also the possibility of fraud. Because self-directed IRA custodians are small and obscure, the possibility of mismanagement is real. You may lose your entire investment to an unscrupulous broker. Since self-directed IRA custodians are hardly recognizable names, you may be completely unaware that the one you’re dealing with is less than reputable.

The Bottom Line on Self-Directed IRAs

Self-directed IRAs are not suitable to the average investor, or even most investors. They’re highly specialized accounts designed for unique asset classes. Not only do you need to be experienced in whatever asset class you plan on holding in your self-directed IRA account, but you also need to be fully aware of the risks. There are risks with the investments themselves because they are nonstandard, but also within the self-directed IRAs.

Even if you are an experienced investor interested in holding an asset class in an IRA account that you can’t keep in a regular IRA account, you’ll still need to exercise a healthy amount of caution. You should hold only a small amount of your investment portfolio with one custodian. Lastly, a self-directed IRA should never be the account where you hold the majority of your retirement assets.

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About Kevin Mercadante

Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed "slash worker" – accountant/blogger/freelance blog writer – on OutofYourRut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides "Alt-retirement strategies" for the vast majority who won’t retire to the beach as millionaires.

He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering workarounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the "savings barrier" and transitioning from debtor to saver.

Kevin has a B.S. in Accounting and Finance from Montclair State University.

Opinions expressed here are the author's alone, not those of any bank or financial institution. This content has not been reviewed, approved or otherwise endorsed by any of these entities.

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