Self-Directed IRA (SDIRA) – What This Retirement Plan Is & How It Works

Individual retirement accounts (IRAs) come with plenty of perks. You can either deduct the contribution from your taxable income in the case of traditional IRAs or let your money grow tax-free and pay no taxes on withdrawals in retirement through Roth IRAs.

But, being operated by brokerage services, IRAs typically only allow traditional paper assets like stocks, bonds, exchange-traded funds (ETFs), mutual funds, and similar securities. Which raises a question for advanced investors and free spirits: what if you want to invest in alternative assets through your IRA?

Enter: the self-directed IRA.

What Is a Self-Directed IRA (SDIRA)?

As the name suggests, a self-directed IRA allows you to pick and choose your own investments beyond those available on public stock exchanges. You get the same tax benefits as a traditional or Roth IRA, and the same contribution limits apply ($6,000 in 2022, $7,000 for taxpayers age 50 and over).

But self-directed IRAs come with a deluge of rules, stipulations, and restrictions. First among them: you have to hire a trustee or custodian to hold your IRA assets on your behalf.

Self-directed IRAs are most commonly used by experienced real estate investors looking to double down on tax benefits while earning high returns as a professional investor. But taxpayers can also use SDIRAs to invest in franchises, cryptocurrencies, precious metals, private equity, and other alternative investments like crowdfunded real estate.

How a Self-Directed IRA Works

The rules and mechanics for SDIRAs are a bit more complex than standard IRAs.  

As you decide on the best IRA option for you personally, keep the following differences in mind. 

Traditional IRA vs. SDIRA

With standard IRAs, you invest through your investment brokerage, just like a taxable brokerage account. 

But SDIRAs require you to hire a custodian or trust company to administer the account. They don’t provide investment advice or due diligence, but they do ensure you follow IRS rules and provide you with the necessary tax paperwork. That includes filing IRS Forms 5498 and 1099-R. 

And they charge for their service. Most charge a flat annual fee between $50 and $300. 

In contrast, most brokerage firms offer standard IRA accounts for free. However they limit you to the investments offered on their brokerage platform, with no room to color outside the lines.

Traditional SDIRA vs. Roth SDIRA

Like “normal” IRAs through a broker, you can open a traditional or a Roth SDIRA. 

They come with the same tax benefits as their more straight-and-narrow peers. Traditional SDIRAs let you deduct contributions from this year’s return but you pay taxes on withdrawals in retirement, whereas Roth SDIRAs don’t come with an immediate tax deduction but the money compounds tax-free and you pay no taxes on withdrawals later. 

The same rules about required minimum distributions (RMDs) apply to traditional SDIRAs as well: you have to start pulling out money by age 72. Roth accounts don’t require you to withdraw money by a certain age.

As a general rule, Roth IRAs tend to offer the better bargain unless you’re nearing retirement. 

Prohibited Investments

Even self-directed IRAs come with limits on what you can invest in however. You can’t invest in any of the following with an SDIRA:

1. Life Insurance. Although the IRS does allow annuities, you cannot purchase whole, universal, or variable universal life insurance inside any type of IRA. This rule also applies to life insurance in qualified plans, although the Incidental Benefit Rule provides an exception for very small amounts of coverage. Although you may use life insurance to fund many types of nonqualified plans, these IRA restrictions apply to all types of qualified defined-contribution plans.
2. Certain Types of Derivative Trading. Financial derivatives include futures and options contracts on securities or commodities. Many of the more aggressive self-directed IRA custodians permit the use of some derivatives inside their accounts, but the IRS does not allow any type of trade or position that has unlimited or undefined risk, such as selling naked calls. They reason that such a high level of risk is inappropriate inside an account that is designed to provide financial security during retirement.
3. Collectibles and Antiques. Unfortunately, you can’t place that priceless family heirloom inside an IRA, nor the electric train set your grandfather played with as a boy. Furniture, wine, fine art, stamps, precious stones, porcelain and pottery, silver- and dinnerware, jewelry, comic books, baseball cards, and other collectibles cannot be titled in the name of any type of IRA.
4. Your Personal Residence. You can’t hold any property that you personally use — including your primary residence, vacation house, or bachelor pad in the city — inside an IRA. Rental properties you own in your personal name are also prohibited. Other types of real estate holdings, like undeveloped land, may be permissible, but anything you use personally is off limits. This means you can’t use IRA funds to buy yourself a first or second home or investment property from which you will directly benefit in any sense. Likewise, if you manage rental or investment properties you must invest through a separate legal entity to avoid commingling personal and SDIRA funds for that property.
5. Certain Types of Coins. In general, you can’t hold any type of coin made from gold, silver, platinum, or other precious metals inside an IRA. To be allowed in an IRA, a coin’s actual currency value must exceed its value as a collector’s item. The IRS does have a list of exceptions, however, including:
   • American Eagle coins that have never been in circulation
   • Proofs of American Eagle coins
   • American Buffalo coins
   • Canadian Maple Leaf coins
   • Australian Gold Philharmonic coins

You also can’t take out a loan from your IRA for yourself or any family member, or transact business relating to any property held inside your IRA account with any “lineal descendant or ascendant,” such as renting out a house to your kids or parents.

Self-Directed IRA Pros & Cons

These more nimble IRAs come with their own upsides and drawbacks. Before you take on the extra responsibilities and expenses, make sure you understand both clearly.

Pros

Beyond all the normal advantages of IRAs, self-directed IRAs bring a few extra perks to the table.

Keep these pros in mind as you explore SDIRAs as a versatile tax-sheltered account option.

1. Flexibility. You can invest in almost anything you like through an SDIRA. For professional investors who know they can earn higher, more predictable returns in their own area of expertise, SDIRAs make a perfect retirement investment vehicle. After all, if you know you can predictably earn 15% on real estate investments, you may be loath to accept the volatility and 10% long-term average returns of the stock market.
2. Managerial Control. When you buy a stock or corporate bond, you hope for the best. The company could continue growing — or a CEO sex scandal could send the company into bankruptcy. With SDIRAs, you play the role of CEO. You choose the investment and you can manage it yourself. Say you invest in a four-unit rental property through your SDIRA. You can renovate the property to boost asking rents and force equity and appreciation, or leave it as is. You can hire a property manager or not, screen tenants aggressively to ensure timely rents and minimal wear and tear, even buy rent default insurance to protect against the risk of lost rents.
3. Checkbook Control. The traditional model of SDIRAs involves the custodian approving all financial transactions, which gets tedious quickly. But many account holders set up a legal entity such as an LLC, and then direct the custodian to invest their retirement funds in that LLC. You, as the owner of the LLC, can then operate your investing business day in and day out without constant interference from the custodian. You can send and receive payments such as rents and repair bills on your own.
4. Potential for Higher Returns. You can take advantage of your specialty knowledge and investing expertise if you have it to earn higher returns through an SDIRA than you could in a typical brokerage account. The classic example is real estate, but it’s far from the only example. If you’ve built a business around franchises, you can open a franchise specifically to invest in through your SDIRA. If you vet private equity funds for a living, you can undoubtedly earn more by investing in them than in an index fund. 
5. Asset Protection. Your assets held in a self-directed IRA get better protection against lawsuits, judgments, collections, and bankruptcy losses than most other assets. The rules vary by creditor and state laws; for example, little can protect you from IRS tax liens. But as asset protection strategies go, an SDIRA creates a better barrier than most. The Bankruptcy Abuse Prevention and Consumer Protection Act allows you to exempt up to $1 million of your SDIRA’s assets from creditors.

Cons

For all those advantages, self-directed IRAs come with their fair share of downsides too.

Before you rush out to open an SDIRA, consider the following drawbacks carefully, and speak with an investment advisor to weigh the pros and cons.

1. Administrative Hurdles. To begin with, you have to hire a custodian licensed by the IRS to oversee and approve your investments. That adds an extra layer of complexity to your IRA investments, compared with simply opening an IRA through a broker and buying a handful of index funds. Your SDIRA custodian must countersign all the contracts you sign, for example, and they may ask plenty of probing questions. That could slow your deals enough to eliminate your competitive advantage.
2. Cost. Custodians don’t offer their services out of the kindness of their hearts. Watch out for initial setup fees, ongoing annual fees, and sometimes even transaction fees. For example, real estate investors could end up having to pay fees when they issue an earnest money deposit, when they settle, or when they need to make monthly mortgage payments, pay a homeowners association, pay utility bills, or any other transaction.
3. Complex Regulation. Uncle Sam can disqualify your investments in a self-directed IRA if they don’t meet IRS standards. If that happens, the assets held in your SDIRA suddenly become subject to taxes and penalties, which can add up quickly. For example, you can’t gain “indirect benefits” from your SDIRA investments, such as moving into the basement apartment in a rental property owned by your SDIRA. You must hold any properties you own through an SDIRA in a unique title, such as an LLC specific to the SDIRA, rather than your personal name. All income and expenses must go in and out of your SDIRA funds, not your own personal funds. And so it goes.
4. Financing Hassles. You can use financing to partially pay for assets held in a self-directed IRA. But that portion of the asset falls outside of the tax protections provided by the SDIRA. Say you buy a rental property for $200,000, make a down payment of $50,000 through your SDIRA, and finance the other $150,000 with a mortgage. Only 25% of the asset qualifies for the tax benefits, while the other 75% gets taxed regularly. The same goes for a business loan to get a franchise off the ground, for instance.
5. Limited Upside for Real Estate. Self-directed IRAs attract many real estate investors looking to capitalize on their expertise. But real estate already comes with many tax advantages, which limits the usefulness of an SDIRA. For example, real estate investors can defer paying capital gains taxes when they sell a property by using a 1031 exchange. Investors can deduct every conceivable expense, including some paper expenses like depreciation.
6. Low Contribution Limits Make It Hard to Buy Large Assets. The kinds of assets investors most often use SDIRAs for, such as real estate and franchises, tend to cost a pretty penny. Yet the same low contribution limits apply to SDIRAs as regular IRAs, with most taxpayers capped at $6,000 in 2022. How many years would it take you to save up even a down payment for a property at $6,000 per year?
7. Diversification Challenges. Large, expensive assets make it harder to diversify because each individual asset costs so much money. In contrast, you can spread $100 over hundreds of companies simply by buying shares in an index fund.
8. More Management Required. No one sets up an SDIRA to invest completely passively, such as through a robo-advisor. The alternative investments people set up SDIRAs for require work. Landlords have to deal with bad tenants, maintenance and repairs, turnovers, screening applicants, and angry neighbors. Franchisees have to build a business with every cog in place, from marketing to managing personnel, overhead expenses to inventory. You’re starting a business, not investing passively.

Is a Self-Directed IRA Right for You?

The short answer: SDIRAs work best for professional investors or investment experts with a specific type of alternative investment in mind.

For most Americans, self-directed IRAs add more complications and wrinkles than they’re worth. Most people are better off opening a regular IRA, potentially through a robo-advisor to automate their investments and asset allocation based on their age, retirement plans, and risk tolerance.

But expert investors, such as experienced real estate investors who can reliably earn high returns from their investments, can accelerate those returns through the tax advantages of an SDIRA. Even so, start with a regular IRA and only consider moving funds to an SDIRA after you’ve established a reliable track record with alternative investments.

Self-Directed IRA FAQs

What Can You Invest In With a Self-Directed IRA?

Technically, you can invest in anything other than the prohibited investments outlined above. But most people who set up SDIRAs invest in income properties such as long-term rentals or vacation rentals, real estate crowdfunding platforms, franchises, precious metals, or private equity.

What Is a Self-Directed IRA for Real Estate?

You can invest in real estate through an SDIRA, both through direct ownership or indirectly such as real estate crowdfunding. 

Beyond income properties, some investors go so far as to flip houses within their SDIRA. It’s a quick way to build your IRA balance, which lets you then invest more passively if you like, or even liquidate it and roll the balance over to a standard IRA with a brokerage. Or a quick way to lose your retirement savings if you don’t know what you’re doing. 

What Do I Need to Open a Self-Directed IRA?

First, you need to find an SDIRA custodian you like, with modest fees and maximum flexibility. You can then create an account with them, which will require you to fill out a form with your tax details such as your name, address, and Social Security number. You’ll also need to provide proof of identity in the form of a government-issued photo ID.

What’s an SDIRA LLC?

Often investors create an LLC specifically to own the assets held in their SDIRA. You then direct the SDIRA custodian to invest your account balance in that LLC, and then you use that LLC to buy and sell properties, franchises, precious metals, cryptocurrencies, or whatever else you want to invest in. It gives you complete control over your IRA investments, and circumvents having to get approval from the custodian for every transaction. 

Can I Pay Myself a Salary to Manage My SDIRA LLC?

You can’t pay yourself a salary for managing investments owned within your SDIRA — that counts as self-dealing, a naughty no-no according to the IRS. Also, all revenue earned by assets owned under your SDIRA must stay within the SDIRA. If you pull it out, it counts as a distribution. 

Final Word

As a real estate investor myself, I understand the temptation to use your IRA to invest in what you know. Yet I resist that temptation for several reasons.

First, I believe every investor should own stocks as part of their portfolio. You may love real estate and earn spectacular returns from it, but that doesn’t mean you should ignore every other asset class. Doing so leaves you vulnerable to shocks in the real estate sector, not to mention poor liquidity and diversification.

So if you’re going to invest in stocks anyway for long-term wealth building, why not use a regular IRA? You save yourself a slew of headaches and expenses by skipping the SDIRA and leaving your IRA to equities. 

Besides, you already get plenty of tax advantages inherent to real estate. I’d just as soon apply the tax advantages of an IRA to my stock investments, where I don’t have the same built-in tax benefits.

I automate my stock investments and retirement accounts, so I don’t have to spare them a thought. Which works out well, because my real estate investments require far more labor — labor that doesn’t need compounding with all the added wrinkles of an SDIRA.