Self-Directed IRA (SDIRA): Benefits, Tips and FAQs

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When you open an IRA at a bank or brokerage firm, it is usually a simple traditional or Roth IRA. The firm you open the account with typically acts as custodian, ensuring the account meets with all IRS and government guidelines and safeguarding the actual assets.

But there’s a special type of IRA that most investors don’t even know about called the self-directed IRA. Although a self-directed shares many of the same overall characteristics of a traditional IRA, it has some differences. If you’ve heard about a self-directed IRA — or even if you haven’t — here are some of the most important benefits, tips and frequently asked questions to bring you up to speed on this intriguing type of investment account.

What Is a Self-Directed IRA?

A self-directed IRA, as the name implies, is just an IRA that you have complete control over. While you do technically “control” a traditional IRA that you can open at any bank or brokerage firm, a self-directed IRA is completely in your hands. With a traditional IRA, a custodian is required to oversee the assets, and they traditionally limit the types of investments you can hold. While you can usually buy stocks, bonds, mutual funds, ETFs and investments that average investors are generally familiar with, you can’t simply buy anything you want and put it into a traditional IRA.

However, these limitations don’t apply to self-directed IRAs. Since you’re the one in charge of your SDIRA, you are responsible for choosing all of your investments and ensuring that they comply with legal and governmental regulations. While this can be cumbersome for someone not familiar with the process, there are some upsides to an SDIRA that allow you to trade off some of that burden for more investment freedom and the chance for greater potential upside.

How Is a Self-Directed IRA Different From a Traditional IRA?

In a nutshell, a self-directed IRA is different from a traditional IRA because the account holder has essentially free reign over the types of investments they can put into it. A custodian limits the investments in a traditional IRA because without those limitations, an account holder can potentially take on too much risk. But for investors who can manage their own accounts and handle additional risk, a self-directed IRA is far less restrictive.

For example, in a self-directed IRA, you have the capability to own alternative investments such as precious metals, real estate, cryptocurrencies, and even shares of a private company. Those types of investments are prohibited in traditional IRAs.

While this broadens the investment playing field for advanced investors, it also requires additional due diligence. Without following the proper guidelines, there can be negative tax implications for investors using a self-directed IRA. With no custodian to guide you, it’s usually best to open a self-directed IRA only in consultation with tax and financial advisors.

What Are the Advantages of a Self-Directed IRA?

The biggest single advantage of a self-directed IRA is that it has more available investment options. This means you can buy nearly any type of investment you want and put it into your IRA, enjoying the tax benefits along the way.

The other benefits of a self-directed IRA all flow from this primary one. For example, if you can buy more types of investments in your self-directed IRA, it by definition means you have more control over your portfolio. This is always an advantage. Buying additional types of investments also means that you have the potential for greater returns.

Of course, you’ll have to know what you’re doing if you’re 100% in control of your investment portfolio, particularly if you are dabbling in alternative or even obscure investments like private equity or cryptocurrency. This is why self-directed IRAs are not for everyone, and it can be a serious decision to open one. While an SDIRA can offer potential additional upside for sophisticated investors, it also comes with extra risk.

What Are the Disadvantages of a Self-Directed IRA?

The freedom that a self-directed IRA offers can be of great value to a savvy investor, but for the average one, it can invite an additional level of risk that is simply unnecessary. While it can be an advantage to have the ability to own private equity or real estate in an IRA, those types of investments are much more “hands on” than a simple S&P 500 index ETF, for example. If you own alternative investments and don’t know how to handle them, they can torpedo your portfolio much faster than more traditional investments.

Some options, such as real estate, are also relatively illiquid, meaning they can be difficult to get out of in a short period of time. This can drag down returns if there’s a crisis and you need to sell fast, as you’ll never get the best price when you need to move real estate quickly.

There are also regulatory pitfalls you’ll need to be aware of in a self-directed IRA. If you want to own gold or silver coins, for example, you can lose the tax benefits on those investments if the IRS deems them to be collectibles, which are prohibited in any IRA, including a self-directed one. If you fall into this trap, those investments could be treated as taxable withdrawals, potentially creating a huge tax headache. To avoid this problem, you’ll have to buy only coins considered bullion coins, not those with added numismatic value.

How Can You Open a Self-Directed IRA?

The process for opening a self-directed IRA is essentially the same as opening any other type of IRA. The trick is finding a financial firm that actually offers a self-directed IRA. Most banks and brokerages don’t offer self-directed IRAs because custodians aren’t allowed to give financial advice, and most financial services firms are in the business of giving advice. However, times are slowly changing.

Along with the rise of online brokerages and zero-commission trading, self-directed IRAs are gaining prominence, even at such mainstream firms as JPMorgan Wealth Management, a division of Chase. Here are the things you’ll need to do to open a self-directed IRA at most firms:

• Your Social Security Number
• Your date of birth
• Your address
• Bank information to fund your account
• Your beneficiary’s name and Social Security Number

This is the type of standard personal and financial information that you’ll have to provide when opening any IRA, including a self-directed one.

It can’t be stressed enough, however, that not all brokerages will even offer a self-directed IRA. Some customer service reps might not even fully understand what the difference is. So it’s imperative that you do your research and seek out firms that do offer a self-directed IRA. And although you can open an SDIRA at firms like JPMorgan Wealth Management, many of the other firms offering a self-directed IRA are lesser-known. Here is a partial list of some of the other banks and brokerages that currently offer SDIRAs:

• RocketDollar
• Alto
• UDirect
• IRA Financial
• Equity Trust Financial
• Midland Trust
• American IRA
• Chicago Trust Administration Services
• Entrust Group
• IRA Innovations
• IRA Resources
• Mountain West IRA
• Quest IRA
• Specialized IRA Services
• uDirect IRA
• Vantage IRA

Many other firms offer self-directed IRAs, but they’re often not well-advertised. You’ll usually have to inquire as to whether or not a self-directed IRA is available.

What Are the Risks Associated With Self-Directed IRAs?

The primary risk associated with a self-directed IRA is that you’ll get in over your head. As you have a nearly unlimited universe of investments to choose from, you could potentially buy some that you don’t fully understand.

For example, although you can technically invest in private equity in a self-directed IRA, traditional private equity investments are only open to accredited investors. These are investors with significant assets and investment experience. But there’s a reason for this. Private equity investments can have significant restrictions on withdrawal and may be extremely risky investments. Although the upside can be high, there’s often a risk that you will lose all your money as well. This makes them inappropriate for the average investor, even if he or she has substantial assets. Since a self-directed IRA allows access to private equity, you may be tempted to take on more risk than you really want.

The same is true with real estate investments within a self-directed IRA. Although this type of structure can provide tax benefits, some investors may not fully understand the liquidity risk involved in real estate, or the risk of capital loss.

While a traditional IRA can certainly lose money through more conventional investments like stocks and bonds, those are the types of risks that most investors are more familiar with. The expanded investment world of the SDIRA, while beneficial for some, can be too risky for others.

Are There Contribution Limits for Self-Directed IRAs?

In terms of contribution limits, self-directed IRAs are indistinguishable from traditional IRAs. Specifically, for tax year 2024, the contribution limits for self-directed IRAs are as follows:

• Under age 50: $7,000
• Age 50 and over: $8,000

The same limits apply to a self-directed Roth IRA. However, with all Roth IRAs, if you earn too much income, you’re prevented from making a contribution. For tax year 2024, these are the limitations:

As with traditional IRAs, Roth IRA account holders aged 50 and older can contribute an additional $1,000 to their accounts, including in a self-directed Roth.

FAQ

• Can you withdraw money from a self-directed IRA?
  • You can withdraw money from a self-directed IRA the same way that you can from any other type of IRA. In other words, if you have a traditional self-directed IRA, your money is tied up until age 59 ½, unless you want to pay a 10% early withdrawal penalty on top of the usual ordinary income taxation. With a self-directed Roth, you can withdraw your contributions at any time, but your earnings face the same restriction in terms of the early distribution penalty. However, any qualified Roth distribution — generally, those taken out after age 59 ½ from a Roth that has been open for at least five years — is tax-free.
  • It goes without saying, however, that taking money out of any IRA, including a self-directed IRA, can ruin your long-term financial plan. Although distributions after retirement are expected, if you plan on taking money out of your IRA before 59 ½, you should consider investing in a regular taxable account instead. For one thing, the tax benefits that you derive from your SDIRA can be neutralized by the 10% early withdrawal penalty you’ll have to pay. You’ll also lose years of tax-deferred compound interest in your account by taking the money out early.
• Are there any prohibited investments within a Self-Directed IRA?
  • Although there are fewer restrictions on investments within a self-directed IRA, there are still some things that you can’t buy in these types of accounts. Collectibles, for example, are not allowed, including art, coins, alcoholic beverages, gems, antiques and certain precious metals. You also can’t invest in life insurance or S-corporations in a self-directed IRA. Specific firms may also have their own in-house restrictions.

This article originally appeared on GOBankingRates.com: Self-Directed IRA (SDIRA): Benefits, Tips and FAQs