What is a self-directed IRA and how does it work?

A self-directed individual retirement account (IRA) is a variety of traditional or Roth IRAs that allows you to invest in assets that are not available to holders of conventional IRAs. In other words, this is a tax-advantaged retirement account that you control. Despite the fact that the account is administered by a custodian or trustee, you get to manage the account directly – hence the name “self-directed.” Even though self-directed IRAs can be an attractive investment option, they are not recommended for the average investor. Read our article to find out why. 

Self-directed IRA

How does a self-directed IRA work?

In many ways, a self-directed IRA works just as a regular IRA. You have to have an income to be eligible to open one and the Internal Revenue Service (IRS) sets the same annual contribution limits ($6,000 per year per person or $7,000 if you are 50 or older). You can open a self-directed IRA either as a traditional or as a Roth IRA with the same deduction and income limits.

The main difference between conventional IRAs and the self-directed variety lies in the type of investments you can hold. If you open a self-directed IRA, you’ll be able to invest in alternative assets like commodities, real estate, limited partnerships, tax lien certificates, private placements and even cryptocurrencies. Meanwhile, holders of regular IRA accounts are limited to stocks, bonds, certificates of deposit, and mutual or exchange-traded funds (ETFs).

However, there are forbidden investments even with self-directed IRAs. You can’t hold life insurance, S Corporation stocks and collectibles, which include antiques, artwork, jewelry, stamps, and rare coins.

Even though you can only withdraw your money penalty-free from a self-directed IRA once you reach the retirement age, you can access the capital in your account anytime and decide how it will be invested.

Not every IRA service provider offers self-directed IRAs, so if you want to set up such an account, you’ll need to find a qualified IRA custodian that specializes in that type of account. Also, self-directed IRA custodians provide different investment options; we recommend that you check their portfolio of services before committing yourself to one. Note that you are not allowed to buy alternative assets from your self-directed IRA custodian, you’ll have to purchase them from another entity.

Finally, bear in mind that the IRS prohibits self-directed IRA custodians from giving financial advice. This means that you’re on your own in assessing the risks of your investment choices. Naturally, you can work with a good financial advisor if you need help.

Self-directed IRA

Risks of a self-directed IRA

While building a more diversified portfolio can lead to more lucrative returns, investing in alternative assets also involves much higher risks. Unless you are a financially savvy investor who understands the nature of such investments, there is a risk that your investments will underperform benchmark indexes.

Expect limited liquidity with some of your investments as selling alternative assets like real estate can take much longer than selling a stock. If you need to liquidate an investment, you may end up selling for much less than market value or the purchase price.

Fees are one of the key drawbacks of having a self-directed IRA. Your custodian will most likely charge you for establishing the account, on top of annual fees and service fees for any tasks they handle.

You may also want to familiarize yourself with the IRS rules on self-directed IRAs, the most important of which relate to disqualified individuals and prohibited transactions. The IRS prohibits purchasing assets or selling assets to disqualified persons. In addition to yourself as the owner of the account, each ascendant and descendant in your family and their spouses are also disqualified persons. The list includes any corporation, estate, partnership, or trust where a disqualified person owns 50% or more of the interests as well as a director, an officer, or a 10%-or-greater shareholder of any of these entities.

IRS rules also prohibit you from immediately or directly benefiting from the assets in your account. There are several prohibited transactions, like self-dealing or investing in a business owned by a family member. 

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