What is a Self-Directed IRA & How It Works?

Self-directed IRAs offer investors a way to manage assets outside of the paper assets common to most retirement accounts.

As of 2016, roughly half a million investors use self-directed IRAs to increase their asset diversity for retirement.

But, how do these accounts allow for alternative assets and how can they be used well?

Let’s look at what makes these rare IRA accounts work.

What is a Self-Directed IRA (SDIRA)?

A self-directed IRA is an individual retirement account (IRA) that holds investments not normally seen in normal IRAs.

These investments, for one reason or another, are not allowed in normal IRAs, forcing investors to opt into these self-directed accounts. 

How Self-Directed IRAs Work

Self-directed IRAs allow individuals to hold assets not allowed in standard IRAs in a tax-advantaged account.

Regular IRAs allow for assets like bonds, stocks, certificates of deposit, mutual funds, and exchange-traded funds (ETFs).

However, SDIRAs allow for more options, including precious metals, commodities, crypto, limited partnerships, and real estate. 

Despite their name, you don’t have to manage a self-directed IRA on your own.

Regulations require that SDIRAs are partly managed by a third party, including custodians or trustees, to ensure that investors follow the rules and regulations to maintain their tax-advantaged status.

How to Open an SDIRA

The first step you’ll have to take is to find a custodian or trustee to help manage the account. The IRS maintains a list of trusted entities as part of its oversight of SDIRAs, following the guidelines and rules set by legislation. 

Once you have a custodian in mind, the next few steps will look something like this: 

1. Work with your custodian to determine what assets will go into the SDIRA.
2. Carry out your due diligence with each asset to ensure it is something you want in your portfolio.
3. Locate a broker to buy the investment from.
4. Ask the custodian of the account to carry out the transaction and place the assets into your account.

Because of the custodian’s role in managing the account, they are not allowed to give financial advice to account holders.

This is why self-directed IRAs have their name, as it will be up to the investor alone to decide what they want to add to their account.

Advantages of SDIRA

There are several reasons why you might want to look into opening a self-directed IRA.

• Flexibility – With SDIRAs, you can hold a greater range of assets than you otherwise could with standard IRAs.
• Tax breaks – Taxes on investments held over the long term have more forgiving tax rates than what the standard federal income tax would cost across all income brackets.
• Invest with you expertise – With SDIRAs, investors can choose which categories of assets they want to invest in, including ones related to their expertise or passion.
• Diversity of assets – Using an SDIRA to have a little money off to the side in alternative assets gives you a way to use some of your money for potentially big returns, all while keeping most of your investments in safer bets.
• Access to higher growth potential – Commodities, cryptocurrencies, and similar volatile investments could experience rapid growth in the future, making them good choices for folks looking at a growth strategy for their retirement accounts.
• Creative investing strategies – SDIRAs work with some creative investing strategies, much like their standard counterparts.

Risks of Self-Directed IRAs

There are some downsides to opening up a self-directed IRA. Here are what those risks are and some more information about them.

• Due diligence – When you work with an SDIRA, you make all the decisions about what goes into the account. Your custodian manages the entry and exit of assets for your account and nothing else.
• Prohibited transactions – There are prohibited investments, a term that refers to investments that cannot go into an SDIRA. 
• Fees – There are several fees associated with opening and maintaining an SDIRA.
• Lack of liquidity – Most assets going into an SDIRA are physical assets like real estate, gold bullion, or commodities.  While these are great investments for growth and cash flow, they are not liquid like paper assets such as stocks and bonds. 
• Fraud – The IRS defines custodians or trustees of these accounts as trusted third parties that cannot offer any service outside of account management. 
• Lack of transparency – Another concern with promoters of SDIRA services is they sometimes present things in too positive a light.
• Concentrated portfolios – A self-directed IRA can be a great way to diversify your entire portfolio, but it is susceptible to lacking diversity like other IRAs.

Should I Invest in a Self-Directed IRA?

A self-directed individual retirement account is an investment account that can hold assets not allowed in standard IRAs.

These assets can be used as part of growth strategies involving physical assets, to implement creative investing strategies, or to express a passion for a particular asset or market. 

We recommend that you check out some trusted SDIRA custodians and see what they have to offer.

You can use these service providers to get a feel for what SDIRAs are like and if their offerings are something you want to add to your portfolio.

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