A self-directed IRA is a type of individual retirement account that allows you to invest in assets that are off-limits for conventional IRAs. If you’d like to purchase precious metals, real estate assets or cryptocurrencies with your retirement savings, check out self-directed IRAs. Just beware that they are more complicated to manage and come with more additional fees than regular IRAs.
How Does a Self-Directed IRA Work?
In many ways, a self-directed IRA follows the same template as a standard IRA. The annual contribution limit is the same: $6,000 for 2021, or $7,000 for those 50 and over. You can choose to open a self-directed IRA as a traditional IRA or a Roth IRA, with the same pre-tax and post-tax contribution rules.
“What’s different is that the custodian of a self-directed IRA allows you to buy a variety of alternative investments,” says Scott Butler, financial planner at Klauenberg Retirement Solutions.
With regular IRAs, the custodian—usually a bank or a brokerage firm—limits your investment options to approved securities like stocks, bonds, exchange-traded funds (ETFs) and mutual funds.
Different custodians offer self-directed IRAs that can own gold bars, silver ingots or even cryptocurrency like Bitcoin. Certain investors want the tax advantages of an IRA for investments in non-traditional asset classes, for purposes of diversification or potentially more lucrative returns.
It’s important to note that you cannot buy non-traditional assets from a self-directed IRA custodian, which only holds the assets after you’ve purchased them from another broker. This adds an additional level of complexity to setting up a self-directed IRA, and may offer the potential for fraud if you were to purchase alternative assets from untrustworthy dealers.
What Assets Can You Own in a Self-Directed IRA?
You can own the following non-traditional assets in a self-directed IRA:
- Cryptocurrency, like Bitcoin or Ethereum.
- Precious metals, including gold, silver and palladium at or above certain standards of purity standards.
- Real estate properties, although there are a variety of special rules that govern investing in real estate via a self-directed IRA.
- Startups, via crowdfunding platforms like Wefunder, SeedInvest or StartEngine.
- Tax liens and deeds on foreclosed properties.
- Foreign currency, via so-called forex IRAs.
You cannot currently invest in life insurance or collectibles, like artwork, antiques or precious metals that don’t meet IRS purity standards. If you do, the amount you spend will be considered a withdrawal. If you do this before you’re at least 59 ½, you’ll be on the hook for any applicable taxes or early withdrawal penalties.
Self-Directed IRA Benefits
People generally seek out self-directed IRAs for two main reasons: to pursue higher returns or to diversify their retirement savings outside of more traditional assets.
Potential for Higher Returns
Investment flexibility is the main advantage of self-directed IRAs, says Syet Nishat, partner with the Wall Street Alliance Group.
“In a self-directed IRA you can invest in alternative investments, such as commercial property or LLC membership interest, which are not permissible in a traditional IRA held by a brokerage company,“ he says. You can also put your retirement money into high-risk, high-reward assets like Bitcoin and early-stage private companies.
These sorts of assets may have returns higher than you could get investing in just the stock market, but they also involve much higher risks.
Many retirees—and soon-to-be retirees—are concerned about market volatility and inflation decimating their lives’ savings. For them, the ability to invest in alternative investments means they may be able to guard against downturns or time eating away the value of their money.
Investing in gold, for example, has long been viewed as a way to protect your portfolio against market downturns and inflation. While this is the popular perception and does to an extent bear out over the very long term, in the short term, gold historically has been just as volatile as stocks. Safe haven assets like gold and now cryptocurrency may help diversify your portfolio, but they offer no guarantees against loss.
If your concern is market volatility and inflation, you may be better served by inflation-protected government securities, like Treasury Inflation-Protected Securities (TIPS), that you can hold in a normal IRA.
Self-Directed IRA Disadvantages and Risks
While self-directed IRAs can make sense for some savvy investors, they carry greater risks and downsides than standard IRAs.
Because you’re investing in alternative assets like real estate and physical gold, it can take much longer to sell your assets when you need the money. Even if you are able to sell quickly, you may have to accept much less than the market value or even what you paid for them originally.
You can generally invest in an IRA without paying account management or trading fees. Depending on where you hold your self-directed IRA, though, you may owe account-related fees as well as fees based on the assets you invest in. With gold, for example, you may owe maintenance fees, storage fees and insurance fees, just to name a few. Make sure you’re fully aware of any charges you may owe as a result of investing with a self-directed IRA.
More Limited Protections
Self-directed IRA custodians generally are only responsible for administering and holding the assets. They are not liable for investigating the quality or legitimacy of the investment options in the IRAs they offer. This means, for example, that you might end up buying gold or another precious metal from a third party that does not meet the purity standards to be held in your IRA, which can cost you not only from the money you lose on a fraudulent purchase but also from the tax penalties you incur, which we cover more below.
This makes it very important to carefully research anything you want to purchase for a self-directed IRA, notes Scott Klauenberg, a financial planner at Klauenberg Retirement Solutions. “Asking questions and verifying information will be even more important than usual” with self-directed IRAs, he says.
Greater Risk for IRS Rule Violations
As you’re probably aware, it can really cost you if you run afoul of the IRS. The stakes are particularly high with self-directed IRAs because if you break one of the IRS’ strict rules about the investments you hold in retirement accounts and how you use them, your entire self-directed account could be liable and penalized.
Broadly speaking, you cannot hold unapproved assets in your IRA, borrow money from an IRA, sell property to an IRA, use an IRA as security for a loan or use an IRA to buy property for personal use. These rules are pretty easy to adhere to when you’re investing with a normal IRA. But things get murky when you’re dealing with alternative asset classes.
Consider, for instance, that you use a self-directed IRA to invest in rental properties. If you spend even a single night in a rental property purchased with IRA funds, your entire self-directed IRA would be considered no longer an IRA as of the first day of that year. For tax purposes, it is as if you withdrew all of the assets in the account at their fair market value on the first of the year. If these assets had made any gains in the time they’ve been in the self-directed IRA, you’d owe any applicable taxes—and potentially early withdrawal penalties.
How to Open a Self-Directed IRA
1. Find a Custodian
Self-directed IRA custodians can be banks, trust companies or another entity approved by the IRS. Be sure to check potential custodians’ reviews and look for any complaints filed with federal agencies.
2. Choose What Products to Buy
Once you figure out where you want to open a self-directed IRA, you can determine which alternative investments you want to purchase. Once you’ve settled on your alternative asset classes, you may need to locate a reputable dealer to buy from, especially if your custodian doesn’t have already established partnerships. Note: Some custodians specialize in specific types of assets, like gold or Bitcoin, while others are more general, so it may be helpful to determine your alternative assets of choice before choosing a custodian.
3. Complete the Transaction
Once you’ve found your custodian and dealer, you can instruct your custodian to purchase your investments from your dealer.
4. When the Time Comes, Plan Your Withdrawals
Self-directed IRAs are subject to the same withdrawal rules as other IRAs: You’ll owe taxes on any money that hasn’t been taxed before, except for earnings in a Roth account. If you take a withdrawal before you are 59½, you’ll also owe a 10% IRS penalty. Self-directed traditional IRAs are subject to required minimum distribution (RMD) rules, meaning you’ll have to start withdrawing money from your account once you turn 72.
Heres’s the big difference: Because they hold non-traditional assets, self-directed IRAs may be less liquid, making withdrawals more complicated. You’ll generally need to reverse the process you embarked on when you purchased your assets and find a broker to sell them for you. Allocate plenty of extra time to make RMDs in particular. Even if you ask the custodian to deliver precious metals to you, you’ll still owe taxes on the withdrawal that must be paid in dollars, based on the value of the distribution.
Should You Save for Retirement with a Self-Directed IRA?
For those hoping to finance their retirement with assets you can’t find at a traditional brokerage, self-directed IRAs can be an attractive option. But even if that describes you, you should still proceed with caution.
“This is definitely not something that I would recommend to the average or casual investor,” says Klauenberg. “With a self-directed IRA, there are more ways to make a mistake and some tax traps that you can easily fall into.”
If you’re serious about getting a self-directed IRA, consider speaking to a financial advisor or tax professional to help you navigate the decision. And remember, no experts recommend you invest all of your retirement funds in alternative investments. A good rule of thumb for most people is holding no more than about 10% of your money in these riskier bets.
And if investing n real estate, precious metals or even startups is important to you but you don’t want the hassle of managing a self-directed IRA, don’t forget that you can gain exposure to many forms of these alternative assets through specialized ETFs and mutual funds that you can hold in a normal IRA.