Self-Directed IRA (SDIRA): Rules, Investments, and FAQs

What Is a Self-Directed IRA (SDIRA)?

A self-directed individual retirement account (SDIRA) is a type of individual retirement account (IRA) that can hold various alternative investments normally prohibited from regular IRAs. Although a custodian or trustee administers the account, it’s directly managed by the account holder, which is why it’s called self-directed.

Available as either a traditional IRA (to which you make tax-deductible contributions) or a Roth IRA (from which you take tax-free distributions), self-directed IRAs are best suited for savvy investors who already understand alternative investments and want to diversify in a tax-advantaged account.

Understanding a Self-Directed IRA (SDIRA)

The main difference between an SDIRA and other IRAs is the types of investments that you can hold in the account. In general, regular IRAs are limited to common securities like stocks, bonds, certificates of deposit (CDs), and mutual or exchange-traded funds (ETFs).

But SDIRAs allow the owner to invest in a much broader array of assets. With an SDIRA, you can hold precious metals, commodities, private placements, limited partnerships, tax lien certificates, real estate, and other alternative investments.

As such, an SDIRA requires greater initiative and due diligence by the account owner.

Taxes, Withdrawals, and Contributions

Contributions to a self-directed IRA are limited to annual amounts. In 2023, this is $6,500 for those under age 50, with a $1,000 catch-up contribution for those over 50. In 2024, the amount increases to $7,000 with the catch-up contribution remaining the same.

When you begin making withdrawals, you'll pay regular income taxes based on your income level if you start withdrawing before you're 59½. If you make any withdrawals before you reach this age, you'll owe a 10% penalty and pay income tax on the withdrawal.

When you turn 73, the IRS requires you to begin taking withdrawals. The amount you withdraw must meet minimum requirements based on your account balance and life expectancy.

How to Open an SDIRA

With most IRA providers, you can only open a regular IRA (traditional or Roth) and only invest in the usual suspects: stocks, bonds, and mutual funds/ETFs. To open an SDIRA, you'll need to:

1. Find a qualified IRA custodian that specializes in SDIRAs.
2. Determine whether they offer the range of investments you want.
3. Set up the account and pay any fees.
4. Begin contributing to your account.

Remember that SDIRAs are self-directed, so custodians aren’t allowed to give financial advice. As such, traditional brokerages, banks, and investment companies usually don’t offer them to their clients. This means that you need to do your homework. If you need help picking or managing your investments, you should plan on working with a financial advisor.

Traditional vs. Roth SDIRA

Self-directed IRAs can be set up as traditional or Roth IRAs. But keep in mind that the two account types have different tax treatments, eligibility requirements, contribution guidelines, and distribution rules.

A key difference between a traditional and a Roth IRA is when you pay the taxes. With traditional IRAs, you get an up-front tax break, but you pay taxes on your contributions and earnings as you withdraw them during retirement. When you contribute to a Roth IRA, you don’t get a tax break, but your contributions and earnings grow tax-free, and qualified distributions are also tax-free.

Of course, there are other differences to consider. Here’s a quick rundown:

• Income limits: Traditional IRAs have no income limits, but you must make less than a certain amount to open or contribute to a Roth.
• Required minimum distributions (RMDs): You must start taking RMDs at age 73 if you have a traditional IRA. Roth IRAs have no RMDs during your lifetime.
• Early withdrawals: With Roth IRAs, you can withdraw your contributions (but not your earnings) at any time, for any reason, with no tax or penalty. Withdrawals are tax and penalty-free after age 59½, provided the account is at least five years old. With traditional IRAs, withdrawals are penalty free starting at age 59½. Remember, you have to pay taxes on traditional IRA withdrawals.

These same rules apply to whichever version of an SDIRA you have.

Investing in an SDIRA

Self-directed Roth IRAs open up a large universe of potential investments. In addition to the standard investments (stocks, bonds, cash, money market funds, and mutual funds), you can hold assets that aren’t typically part of a retirement portfolio.

For example, you can buy investment real estate to hold in your SDIRA account. You can also hold partnerships and tax liens—even a franchise business.

The Internal Revenue Service (IRS) forbids a few specified investments in SDIRAs, whether it’s the Roth or traditional version. For example, you can’t hold life insurance, S corporation stocks, any investment that constitutes a prohibited transaction (such as one that involves self-dealing), and collectibles.

Collectibles include a wide range of items, among them antiques, artwork, alcoholic beverages, baseball cards, memorabilia, jewelry, stamps, and rare coins (note that this affects the kind of gold that a self-directed Roth IRA can hold).

Advantages and Disadvantages of SDIRAs

SDIRAs have lots of benefits, but there are a few things to watch out for.

Advantages Explained

• You can choose the assets you place in the account: An SDIRA allows you to select the investments you want, so if you prefer specific types of assets, sectors, or industries, you can build your portfolio to match.
• Tax breaks on earnings: Earnings grow in the account, so you pay taxes on earnings only when you make withdrawals.
• Personalized diversity: Choice allows you to diversify holdings within your IRA and use your IRA in your overall investing strategy to diversify your portfolio further.

Disadvantages Explained

• Easy to accidentally violate a rule and distribute the entire account: If you break a rule, the entire account could be considered distributed to you. And you’ll be on the hook for all the taxes plus a penalty. Make sure you understand and follow the rules for the specific assets that you hold in the account.
• You can't get help from a custodian: Again, SDIRA custodians can’t offer financial advice. You’re on your own. Make sure you do your homework and find a good financial advisor if you need help.
• Complicated fee structure: SDIRAs have a complex fee structure. Typical charges include a one-time establishment fee, a first-year annual fee, an annual renewal fee, and fees for investment bill paying. These costs add up and can certainly cut into your earnings.
• Some investments are not very liquid: It’s easy to get out of stocks, bonds, and mutual funds. Just place a sell order with your broker, and the market takes care of the rest. Not so with some SDIRA investments. For example, if your SDIRA owns an apartment building, it will take some time to find the right buyer. That can be especially problematic if you have a traditional SDIRA and need to start taking distributions.
• Easy to become a victim of fraud: Even though SDIRA custodians can’t offer financial advice, they will make certain investments available. The U.S. Securities and Exchange Commission (SEC) notes that SDIRA custodians don’t typically evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”

The Bottom Line

Self-directed IRAs are retirement accounts that allow you to choose how your retirement funds are invested. These IRAs differ from traditional IRAs in that you must monitor and maintain them to ensure they perform as you want them to.

SDIRAs can be an excellent choice for investors with more knowledge of and experience in the financial markets. However, they may be too advanced for the novice or intermediate retail investor because owning an SDIRA is similar to managing your own retirement fund.