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What Is a Self-Directed IRA (SDIRA)?

What Is a Self-Directed IRA
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Updated April 26, 2024

A self-directed IRA (SDIRA) is an individual retirement account (IRA) that allows a number of alternative investments in addition to more traditional holdings such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Most regular IRA custodians do not permit alternative investments to be held in IRAs on their platform. SDIRAs can be either traditional or Roth accounts.

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How do SDIRAs work?

In many respects a self-directed IRA operates in the same way as a regular IRA.

  • The same annual contribution limits apply. If contributions are made to both SDIRAs and regular IRAs, the annual contribution limits for IRAs apply to all contributions made to both types of IRA accounts in total.
  • The same income limits apply. Income limits on the ability to contribute on a pretax level for a traditional IRA and to contribute at all to a Roth IRA apply in the same way as with a regular IRA.
  • The same rules for taxes, withdrawals, and required minimum distributions (RMDs) apply. They all function just as with a traditional or Roth IRA with a conventional custodian.

However, unlike the custodian of a regular IRA, a self-directed IRA custodian cannot provide financial advice. All they can do is hold and administer the account assets. Because SDIRAs have a much broader range of potential investments, it is up to the account holder to choose the assets in which they want to invest. Hence the name, “self-directed.” All the same, account holders can engage the services of a private financial advisor if they choose.

What assets can you own in a self-directed IRA?

SDIRAs can own the same mutual funds, ETFs, individual stocks and bonds, and other assets that can be held in a regular IRA. The big additional benefit: the nonconventional assets that SDIRAs can also hold, including:

Real estate

Real estate investments can include rental property, such as an apartment building, a home used as a rental property, office buildings and commercial property, condominiums, and mortgage loans. Rental properties offer the opportunity for growth in the value of the property plus ongoing rental income. Note: You or a relative cannot live in a building you hold in a self-directed IRA. That’s a prohibited transaction.

Gold and other precious metals

Gold and other precious metals can act as an alternative asset in that their movement is often not tightly correlated with the movement of more traditional asset classes such as stocks and bonds. Other precious metals can include silver, platinum, palladium, and more. Unlike most other asset classes, these metals are a store of value.

There can be a number of scams associated with investing in precious metals, so be cautious. There are also some restrictions regarding the eligibility of precious metals. Violating these rules can trigger a costly tax situation with the Internal Revenue Service (IRS).

Private debt

Private debt offers investors a way for investors to earn interest on their IRA funds. They can negotiate lending arrangements directly with borrowers or by pooling funds with other investors and lending through a pool. Some types of private debt opportunities include:

  • Mortgage notes and trust deeds.
  • Promissory notes.
  • Timber deeds.
  • Private corporate debentures.

Cryptocurrencies

Many SDIRAs allow account holders to invest in Bitcoin and other cryptocurrencies in their accounts. If you believe in the long-term viability of cryptocurrencies, holding these assets in your IRA can make sense for tax-sheltered long-term growth.

Crowdfunding

Crowdfunding is a popular way for entrepreneurs and new businesses to raise capital. In the past many of these opportunities were only available to accredited investors. Crowdfunding has opened up more opportunities to invest in startups and private equity to nonaccredited investors.

Crowdfunding platforms allow investors to diversify, and there is usually an online platform providing direct access for them. Investing in private ventures through crowdfunding is typically lower cost than other avenues to access these types of investments.

SDIRA: Pros and cons

Self-directed IRAs offer a number of advantages to investors, including the ability to diversify their retirement investments into a number of alternative assets. Cons include some rules restricting where you can invest.

ProsCons
Increased diversification and control over options.
Risk of violating IRS rules with prohibited investments.
Tax benefits of holding certain assets in an IRA.
Risk of violating the prohibited transactions rules.
Potential for higher returns.
Lack of guidance.
Ability to invest in both conventional and alternative investments.
Potentially high fees.

SDIRA Benefits

Diversification and control

Because of the wider range of investment possibilities, a self-directed IRA has greater options when it comes to asset allocation. Real estate, crowdfunding, private debt, and other alternative investments, can act as portfolio diversifiers because they have a relatively low correlation with more traditional holdings, such as stocks and bonds.

Tax benefits of holding certain assets in an IRA

All types of IRAs provide the benefit of tax-deferred or tax-free growth. With a self-directed IRA these tax benefits can make a huge difference in the long-term growth of assets such as real estate and other alternatives, which can generate taxable income that reduces profits if held in a taxable account. As with any other IRA investment, holding alternatives allows you to keep your profits inside of the IRA on either a tax-deferred or tax-free basis.

Potential for higher returns

The tax benefits of holding certain alternatives in a self-directed IRA can help boost your returns. The diversification benefits from these alternatives can also boost returns.

Both conventional and alternative investments.

Many SDIRAs offer the ability to hold conventional investments, such as mutual funds and ETFs, along with many of the alternative investments discussed here.

SDIRA Disadvantages

Prohibited investments

There are assets that are not allowed in a self-directed IRA. For example, while gold and other precious metals are allowed, there are restrictions on the fineness of the metals. There are also limiting IRS rules for art and collectibles. It's important to review assets you are considering with your SDIRA custodian or financial advisor to be sure that you are not violating these rules, as it could result in a costly tax situation.

Prohibited transactions

It's important that anyone investing in alternative assets understand the concept of prohibited transactions inside SDIRAs. Engaging in a prohibited transaction can result in an unwanted and costly tax hit for the account holder. A common prohibited transaction involves self-dealing.

This rule can be easy to violate. For example, if you own a rental property inside of a self-directed IRA and decide to make a repair yourself instead of paying someone uninvolved with the SDIRA to do it, you have likely violated the rule against self-dealing. Such a mistake, even if unintentional, could cause the entire account to be considered as distributed to you, resulting in unexpected taxes and penalties.

Lack of guidance

SDIRA custodians are prohibited from offering advice on your investments, while some traditional IRA custodians may offer advice services for an extra fee. This combined with the added complexity of most alternatives can prove to be troublesome for SDIRA investors, who may not fully understand all of the implications of their investments. It can also leave them open to fraud. Consider seeking the help of a knowledgeable financial advisor.

High fees

Fees and expenses associated with SDIRA custodians can vary widely. It's important to fully understand all fees before investing. These can include a fee to establish the account, fees to transfer assets, and a fee to terminate the account, among others. This is in addition to any annual account-maintenance fees.

Types of SDIRAs

In many ways self-directed IRAs are just like regular IRAs. The same annual contribution limits of $7,000, plus an additional $1,000 in catch-up contributions if you’re 50 or older, apply (as of 2024). Income limits on the ability to contribute to a traditional IRA on a pretax basis, as well as income limits on the ability to contribute to a Roth IRA, also apply to SDIRAs.

Traditional SDIRA

A traditional self-directed IRA is one option. The account can be funded with contributions during the year or with money rolled over from another IRA custodian or from an employer-sponsored retirement account such as a 401(k). Generally, contributions are made on a pretax basis, though traditional SDIRA contributions can also be made on an after-tax basis.

Distributions from a traditional SDIRA are subject to income taxes, with the exception of the value of any after-tax contributions. Distributions may be subject to a penalty if made prior to age 59½.

Roth SDIRA

A Roth self-directed IRA works in the same way as a regular Roth IRA does. Contributions are made on an after-tax basis, and the same income restrictions limit or prohibit your ability to contribute in a given year. SDIRA Roth accounts can be funded with contributions, a rollover from another Roth account, or a Roth IRA conversion.

Self-directed SEP IRA

A SEP IRA is a self-employed or small-business retirement plan. All contributions are made by the employer; no employee contributions are allowed. The contribution limit for 2024 is the lessor of 25% of your compensation or $69,000. The Secure Act 2.0 added a Roth option for SEP IRAs starting in 2023. Not all self-directed custodians offer a SEP IRA option, but for those who do this can be a way to bump up your contributions to a self-directed retirement account.

While not a form of SDIRA, some self-directed custodians may also offer a self-directed solo 401(k) as a retirement plan option. This can be another good option for those who are self-employed to put away higher amounts in a self-directed retirement plan option.

How to set up a self-directed IRA

Once you’ve made the decision to invest via a self-directed IRA, there are several steps to follow in opening one.

Select a custodian

Typically, a custodian for a self-directed IRA will be a different entity than the broker firm or bank where you might hold conventional IRAs or other investment accounts. You will want to check out the prospective custodian’s rules, any limitations on the types of alternative investments that it might accept in SDIRAs, and any fees and expenses associated with the platform. You’ll also want to vet the custodian platform for any regulatory issues, violations, or investor complaints made against it.

Be sure to understand the process of investing

Both in general and specific to the custodian you’ve chosen, be sure to understand all aspects of making alternative investments inside a self-directed IRA. This includes knowledge of all prohibited investments and transactions, in order to avoid an unwanted tax surprise.

Some custodians may have specific rules regarding assets that can be held, and you should understand these. Ideally, this should be uncovered as you vet the custodian.

If you are rolling over money from another IRA or other type of retirement account, be sure to work closely with both the old account custodian and the new SDIRA custodian to ensure a seamless transaction.

Choose your investments

Once you have chosen a custodian and fully understand the investment process for a self-directed IRA, it's time to select your investments for the account. Be sure that you have looked at all aspects of the investments you are considering. This may be a good time to consult with a knowledgeable financial advisor.

Is a self-directed IRA the right choice for you?

The answer to this question is, “It depends.” This is the same answer to most questions asking if a particular investment strategy or account type is right for you. The answer always depends on your particular situation, financial goals, investing savvy, and risk tolerance, among other factors.

A self-directed IRA might be the right choice for you if you want to diversify your IRA investments by holding alternative ones—including gold and precious metals, real estate, cryptocurrencies, and crowdfunding—and reap their tax advantages.

It also may be the right choice if you are comfortable with the level of involvement it requires. You need to understand the potential risks and returns of your chosen investments, as well as fully comprehend the operating rules and the consequences of violating them.

TIME Stamp: SDIRAs can diversify investments and raise earnings, but need hands-on attention

Self-directed IRAs can be a valuable investing tool. The ability to hold a number of alternative investment types not typically allowed with conventional IRAs offers the chance for investors to diversify their retirement account holdings, as well as their overall portfolio allocation, and increase their returns.

However, it’s important to fully understand all aspects of these complicated accounts before moving forward. For many investors a standard IRA will suffice to serve their needs.

Frequently asked questions (FAQs)

How do I set up a self-directed IRA for real estate?

There are a number of ways to invest in real estate through SDIRAs. One is a direct investment into a rental or commercial property. If going this route, it's important to avoid violating the rules against self-dealing. This includes ensuring that all revenues are paid to the SDIRA, all expenses are paid on an arm’s length basis from the SDIRA, and the property is not rented to family members. The SDIRA is the real estate owner, not the SDIRA account holder.

Another route investors can take is to invest in a real estate investment trust (REIT). Realty Mogul is a REIT provider that accepts funds from SDIRAs for its REIT offerings.

What are the best investment tools for alternative investments?

The best tools can vary based on the types of investments you are looking to hold in your SDIRA. For example, if you are interested in investing in start-ups via crowdfunding, you would want to research the best tools and sources of information on crowdfunding.

For investors interested in private investing, YieldStreet is a top platform to consider. It allows accredited investors to invest in private market investments for their SDIRAs.

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Why is it important to diversify your stock portfolio?

Stocks make up a significant portion of many investment portfolios, whether in the form of individual stocks or of mutual funds and ETFs that focus on stocks. While there are a variety of asset classes and sectors within stocks, they tend to move in the same direction during both bull and bear markets. Holding investments that are not highly correlated with stocks and bonds can help reduce downside risk in your portfolio during market pullbacks.

The information presented here is created independently from the TIME editorial staff. To learn more, see our About page.

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