Many of us have heard the term, “the world is your oyster.” That is exactly how moving to a self-directed IRA can make people feel – that the world of investing has opened up to them due to the multiple investment options they are now able to employ.

The investment world is full of stories of investors who have benefited from taking the nontraditional route of the self-directed IRA – and other stories of people who have been penalized for not following the complicated rules or have been scammed.

To understand whether a self-directed IRA is right for you, you must first understand exactly what it is – and isn’t - and how to avoid the pitfalls.

What is a Self-Directed IRA?

A self-directed IRA (SDIRA) is a retirement account in which the individual investor, not a custodian, makes all the investment decisions. It permits greater asset diversification outside of the stocks, bonds and mutual funds generally available to investors in traditional and Roth IRAs (see What are the differences between a self-directed IRA and a traditional IRA?) The money can be invested in real estate, private tax liens, notes and even gold. All securities and investments are held in an account administered by a custodian or trustee.

Self-directed IRAs may seem like a new way to save for retirement, but the option has been around since the advent of IRAs in 1974. Many people have not heard of SDIRAs because the account requires a custodian and many investment firms only allow traditional investments.

Phillip Christenson, CFA and financial advisor at Phillip James Financial in Plymouth, Minn., explains the self-directed IRA, “Picture your last IRA statement and the types of investments held in your account. There may be some individual stocks, maybe some bonds and most likely mutual funds and ETFs. Stocks and bonds are fine and should be a core part of your investment portfolio, but maybe you want to take more risk or diversify into non-traditional assets. That’s where a SDIRA comes in.”

Christenson explains that if you want to invest in rental property or flip a house (buy a home at a low cost that needs repair and sell it), you can do this with a self-directed IRA. “This type of IRA account provides the flexibility to invest in alternative assets like physical real estate, gold bullion, mortgages, franchises and other assets.

“The reason for opening up a self-directed IRA has to do with accessibility, control and the potential rate of return on your investments,” says Christenson. “When your money is held in an IRA you generally cannot get access to it until you reach age 59 ½. Therefore, while the money is in a traditional or Roth IRA, you can only invest in things such as stocks, bonds and mutual funds.”

With an SDIRA, people have access to their IRA money for non-traditional investments, Christensen says. The other major benefit is that investors might believe they can get better rates of return from these alternative investments than they can earn in the stock or bond market.

How to Set Up a SDIRA

Christenson says the first thing you need to do is evaluate what you’re trying to accomplish with your SDIRA. “Are you trying to purchase real estate, flip properties, invest in gold or fund a start- up company? This will help when finding a custodian, setting up the account and determining if a self-directed IRA is going to help accomplish these goals.” Here's what to do.

  1. Consult with a an objective professional, such as a CPA, financial advisor or attorney. Review what you want to accomplish, learn the rules associated with a SDIRA and consider the risks.  
  2. Find a custodian: This will be the company that will hold your assets and administer the account. You can find a company online, but investors must do due diligence by checking reviews, asking other investors and comparing fees. Your custodian will be able to help you follow IRS regulations, but not analyze and choose investments.
  3. Fill out the required paperwork provided by the custodian.
  4. Deposit money or roll over funds from an old IRA or 401(k) account into your new self-directed IRA.

The Pros of a SDIRA

  • It allows investors to use tax-advantaged money held in their IRA for nontraditional investments, such as gold and real estate.
  • Investors gain greater flexibility and control over their money.
  • It provides greater diversification and reduces the risk of too narrow a retirement portfolio.
  • It has the potential for greater return, given the increased investment opportunities.

The Cons of a SDIRA

  • Additional rules make it complex and more costly to administer.
  • Alternative assets can be hard to value and analyze.
  • There is a risk of not correctly following IRS regulations and losing the tax-advantaged status of the account, which may lead to taxes and penalties. One of those rules prohibits “self-dealing.” These are investments in which you or your family members of lineal descent have prior ownership. In addition, some investment types, such as life insurance, are still not permitted in an IRA. It is entirely up to the investor to follow all of the IRS regulations regarding a self-directed IRA.
  • There is a greater time commitment needed to set up and direct investments.
  • Depending on the amount you invest and the type of investments, you could greatly increase the overall financial exposure of your retirement portfolio.
  • SDIRAs have a greater risk of fraud due to their complexity and the prevalence in the SDIRA market of custodians from small operations, rather than mainstream firms.

The Bottom Line

Many investment professionals believe that the SDIRA doesn’t typically provide enough benefit or ROI for the amount of work investors need to do to maintain it. What's more, only a savvy and sophisticated investor can benefit from the greater freedom without falling into the many traps that await the untutored.

“The bottom line is tread lightly,” says Greg Ostrowski, CFP and managing partner at Scarborough Capital Management in Annapolis, Md. “If an investment sounds too good to be true, it likely is. Conduct comprehensive due diligence and seek counsel from a trusted professional.” For more, see House Your Retirement With Self-Directed Real Estate IRAs and Analysis: Should You Get A Gold IRA?