Self-directed IRAs (SDIRAs) offer the flexibility to invest in a broad range of assets beyond traditional options like stocks and bonds. This includes various alternative investments that many financial institutions don’t typically manage.

Here are some important points to understand about self-directed IRAs and potential pitfalls for investors.

What is a self-directed IRA?

A self-directed IRA functions similarly to a traditional IRA, with the key distinction being the range of investment options available. Investors can choose between two main types:

  1. Traditional IRA: This allows you to invest pre-tax dollars, potentially deferring taxes on contributions. Your investments grow tax-deferred, and you’ll pay taxes on withdrawals during retirement (after age 59½) at ordinary income rates.
  2. Roth IRA: This option involves investing after-tax dollars, meaning you pay taxes on contributions upfront. Your investments grow tax-free, and withdrawals in retirement are also tax-free.

Regardless of the type, there’s an annual contribution limit. For 2024, the maximum contribution to your IRA is $7,000.

If you prefer not to manage your IRA yourself, you can opt for a financial advisor or a robo-advisor, who will create a portfolio strategy focused on traditional assets like stocks, bonds, mutual funds, and ETFs for diversification and long-term growth.

However, with a self-directed IRA, you have the freedom to make your own investment decisions, opening the door to a wide array of alternative assets.

Self-directed IRA investment options

A self-directed IRA offers the flexibility to invest in a wide range of assets beyond traditional stocks, bonds, and funds available at typical online brokerages. This flexibility is a significant advantage for investors looking to diversify their portfolios.

In addition to standard financial investments, a self-directed IRA can also invest in alternative assets such as:

  • Private stock
  • Real estate (e.g., residential properties)
  • Limited partnerships
  • Cryptocurrency
  • Commodities
  • Precious metals (e.g., gold)
  • Crowdfunded assets like loans

The list of acceptable investments may be even broader, depending on the willingness of your IRA custodian to work with you.

However, it’s important to note that the IRS imposes restrictions on self-directed IRAs. Specifically, you cannot invest in life insurance or collectibles, which include items such as art, antiques, rugs, gems, coins, stamps, and alcoholic beverages.

How to set up a self-directed IRA

If you’re interested in establishing a “go anywhere” self-directed IRA, you’ll need to find a custodian that specializes in these types of accounts. Most traditional IRA brokers typically do not offer options for alternative investments.

Here’s how to set up a self-directed IRA:

  1. Research Custodians: Look for custodians that support “go anywhere” self-directed IRAs, allowing you to invest in the assets you’re interested in. Pay attention to any fees associated with the custodian, as they may charge setup fees and annual maintenance fees, unlike many brokers for traditional investments that may have no fees.
  2. Open an Account and Pay Fees: After selecting a suitable custodian, set up your account and pay any required fees for account establishment.
  3. Make Your Contribution: Once your account is active, deposit funds to enable your investments.

It’s important to weigh the additional fees charged by custodians against your investment strategy, especially if you’re starting with a smaller amount. For those rolling over a larger account, these fees can be more manageable due to the larger asset base.

Pros and cons of a self-directed IRA

A self-directed IRA can offer extensive investment opportunities, but it also comes with notable risks and drawbacks. Here’s a look at the pros and cons of utilizing a self-directed IRA.

Advantages of a self-directed IRA

  • Full control: Your investment success is directly tied to the choices you make.
  • Potential for higher returns: If you have insights into unique opportunities that others may overlook, you can capitalize on them for potentially greater rewards than traditional investments.
  • Increased diversification: Investing in alternative assets can diversify your portfolio, potentially lowering risk while enhancing returns.
  • Greater enjoyment: With a wider array of investment options, you may find opportunities that align with your interests or expertise.

Disadvantages of a self-directed IRA

  • Complete control: While having full control over your investments can be empowering, it also means your success hinges entirely on your decisions, so you need to be well-informed.
  • Fees: Custodians that facilitate alternative investments often charge substantial fees, which may make it impractical for smaller accounts to use these options.
  • Liquidity: Traditional assets can typically be sold at any time the market is open, but alternative investments, like real estate, may take months or years to sell, if at all.
  • Distribution requirements: The lack of liquidity can pose challenges if you need to take distributions in retirement. You might be forced to sell an asset at a loss to meet minimum distribution requirements.
  • Prohibited transactions: It’s crucial to adhere strictly to IRA regulations to avoid IRS penalties. For instance, if you invest in real estate, you cannot use that property for personal enjoyment; it’s strictly an investment. Performing maintenance on your IRA-owned property yourself could also violate these rules. The IRS provides a list of additional prohibited transactions.

In Conclusion

Self-directed IRAs can be an excellent choice for investors willing to put in the effort to manage their own retirement accounts. However, the additional fees and complexities involved may deter others, making traditional financial investments a more suitable option for those seeking reliable returns at lower costs.