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What is a self-directed IRA?
A self-directed IRA is a type of traditional or Roth IRA, which means it allows you to save for retirement on a tax-advantaged basis and has the same IRA contribution limits. The difference between self-directed and other IRAs is solely the types of assets you own in the account.
Understanding a self-directed IRA (SDIRA)
Regular IRAs typically house only stocks, bonds, mutual funds and other relatively common investments. Self-directed IRAs offer many more possibilities. For example, you could invest in real estate or a privately held company. If you can find a custodian to agree to the deal, you’re good to go. (With any IRA, you need a custodian or trustee to hold the account for you.)
How to open a self-directed IRA
Brokerage firms act as custodians for many types of IRAs, but most household-name brokers don't offer self-directed IRAs.
Custodians of self-directed IRAs are often companies that specialize in them, including some banks and trust companies. They can differ from each other in the types of investments they'll agree to handle, so you'll have to shop around. (If that sounds like too much of a hassle, here are our picks for the best regular IRA brokers.)
Given the complexity of self-directed IRAs — more on this below — you might want a financial advisor with experience managing investment deals for self-directed IRAs to help you with due diligence on the investments. A custodian generally won't offer this.
Also, keep in mind that the IRS still forbids some types of investments in self-directed IRAs, including collectibles and life insurance.
Once you find a custodian, you'll open an account and contribute money to it, just as you would with any other IRA.
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Advantages of a self-directed IRA
The two main reasons investors take on the risks of self-directed IRAs are to seek higher returns and greater diversification.
“If you understand investments, particularly in certain segments, you can take advantage of higher yields and maybe less volatility,” says John O. McManus, who has invested in real estate and other assets through a self-directed IRA for about 15 years. McManus founded the estate-planning firm McManus & Associates in New York and New Providence, New Jersey.
“You can take advantage of higher yields and maybe less volatility.”John O. McManus, founder, McManus & Associates
His self-directed IRA also lets McManus invest in companies that aren’t publicly traded, which “a mutual fund will not allow you to do,” he says. But, he warns, “This is not a game for the unsophisticated.”
Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, an investment advisory firm that specializes in self-directed IRAs, says he met an experienced real-estate investor who'd been buying properties with his IRA. He’d find underpriced properties with potential, have his IRA put, say, a $5,000 down payment on the property, then sell or assign the contract to a real-estate investor, in a process some call “bird dogging.”
“You’re using $5,000 to make $20,000 to $40,000," Chisholm says. "You may not be able to do that at scale but certainly some people have done things like that. There are ways to make quite sizable returns if you’re creative and knowledgeable enough to use self-directed IRAs in the right way. That’s not to say that everybody should do this."
Risks of self-directed IRAs
The benefits are well and good. But it’s important to consider the substantial risks:
The IRA tax benefit evaporates if you don’t follow the rules, and you might end up owing penalties and interest, too.
One potential blunder is neglecting the “no self-dealing” rule, which prohibits you from borrowing money from your IRA, selling property to it, and other interactions. Say you invest in a rental property through your IRA, and then the unit’s kitchen faucet breaks. You say to yourself: “I can fix that myself and save a bunch of money!” Now you’ve broken the rules, because you’ve “furnished services” to the IRA, which the IRS prohibits. If the IRS finds out, the entire account will be considered distributed to you, and thus taxable, plus you’ll owe a penalty — all because you tried to save a little money.
“Don’t ever spend the night in your IRA-owned rental property.”
To avoid violating the “self-dealing” rule, think of your IRA as owning and operating the assets within it. In other words, in the example above, your IRA, rather than you, must pay someone else to do the work. And don’t ever spend the night in your IRA-owned rental property.
Another rule prohibits entering into deals with specific relatives, including parents and children, and other people. See this IRS page for more on prohibited transactions.
It’s up to you to understand the investments you make in a self-directed IRA.
“The custodian and administrators are not allowed to provide financial advice. They will explicitly tell everybody that, but investors are not very good at listening,” Chisholm says. “
“It’s very important that the individual investor does all the homework themselves.”Kirk Chisholm, principal, Innovative Advisory Group
For his part, John H. Bishop, a certified public accountant and principal at Wellington Capital Advisors, an investment advisory firm in San Francisco that advises clients on investing in self-directed IRAs, says he approaches the due diligence process like an an operational audit. Among other things, he maps out future revenue and expenditures to determine if each investment makes financial sense.
Self-directed IRS fees can be many and steep, such as $250 or more for moving your IRA to a new custodian. They also vary depending on the custodian and type of investment. “From what I have observed, the fee structure varies by just about each offering,” Bishop says.
Lack of liquidity
Self-directed IRAs allow you to invest in a wide variety of investments, but those assets are often illiquid, meaning that if you run into an unexpected emergency, you might be hard-pressed to get money out of your IRA. You’ll need to find a buyer for the investment. This also can be an issue for owners of traditional self-directed IRAs when required minimum distributions come due at age 72.
Lack of transparency
How much do you know about the investment? What’s it really worth? The Securities and Exchange Commission warns investors that self-directed IRA promoters sometimes list the purchase price, or the purchase price plus expected returns, as the valuation. But that figure isn't the actual amount you'll get for the asset.
“Investors should be aware that none of these valuations necessarily reflect the price at which the investment could be sold, if at all,” according to the SEC investor alert.
Relatedly, do you have a plan for exiting the investment? “I’ve seen people buy a building with a group of people. One investor says, ‘We’re going to sell the whole building,’ while the other investors are saying, ‘No, we’re going to turn it into condominiums,’” Bishop says. “Before you know it, you’re into a mess just trying to get rid of it. That exit has got to be defined.”
Fraudsters have used self-directed IRAs as a way to add a stamp of legitimacy to their schemes. One common ruse is to say the IRA custodian has vetted or approves of the underlying investment, when, as the SEC notes, custodians generally don’t evaluate “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”
Proponents of self-directed IRAs say their ability to invest outside the mainstream improves their diversification, but a self-directed IRA can lack diversity just as easily as any other retirement account.
“Oftentimes, these are not investments that are as well-diversified as those one might traditionally populate an IRA with,” says Christine Benz, director of personal finance at Morningstar, the mutual-fund research company. “It’s usually not a basket of X. It’s X.”
Exchange-traded funds offer simpler solutions for investors seeking to diversify, Benz says. “You can buy a basket of some of these security types, like private equity, commodities, metals and so forth,” she says, “and you can do so in a better-diversified, safer way.”
A regular IRA may be enough
For most retirement savers, the range of assets available through a regular IRA — stocks, bonds, CDs, ETFs, mutual funds and REITs (that is, real estate investment trusts) — provide more than enough investment diversity. They are quick and easy to open and provide the same tax benefits as a self-directed IRA without exposure to all the extra IRS rules. Plus, you avoid the extra work of finding a specialized custodian who can set up an account for you.
If a regular IRA seems more your speed, here’s a side-by-side comparison of brokers we’ve selected as top providers of IRA accounts.
» Check out our list of top picks for best IRA accounts.