What are the differences between a self-directed IRA and a traditional IRA?

Individual retirement accounts (IRAs) are restricted savings accounts intended to provide a source of income for retirement. Contributions to IRAs are made by the individual account owner and, depending on the particular type of IRA, by the employer. The funds are held by a financial institution that invests them in traditional portfolio options such as stocks and mutual funds.

Differences Between Self-Directed and Regular IRAs

When funds are invested in a non-self-directed IRA, they are usually overseen by a brokerage house that invests the funds and manages the account. 

With a self-directed IRA, which can be either a traditional IRA or Roth IRA, the account owner directs all the investment decisions through a custodian and thus has a much greater degree of flexibility in choosing investment options. This option may also reduce the fees charged because the custodian isn't involved in the investment transactions – only the investor is.

A self-directed IRA may be a little more challenging to set up than a standard IRA, but many investors find the freedom is worth the extra work.

IRA Prohibited Transactions

The Internal Revenue Service (IRS) creates the rules for all retirement accounts, and all IRAs are prohibited from certain transactions regardless of the specific type of IRA. Account holders cannot take a personal loan against their funds or participate in other self-dealing activities, such as business transactions in which they or family members are personally involved. (For related reading, see "Avoiding "Prohibited" Transactions in Your IRA.")

Alternative Investments for Self-Directed IRAs

Within the IRS restrictions, self-directed IRA funds may be used to invest in a diversified portfolio beyond traditional stocks and bonds; the owner of a self-directed IRA can invest in partnerships, real estate, and the precious metals market. Self-directed IRAs cannot be used to purchase insurance instruments or collectibles, however, so an account holder can direct the custodian of the self-directed IRA to invest in the silver market but cannot order the purchase of collectible silver coins.

A popular investment choice for those with self-directed IRAs is real estate. Funds from the IRA can be used to purchase foreclosed property, for example, which will then be held in the name of the IRA custodian. The self-dealing restrictions apply, though, prohibiting the account holder from living at the property. (For related reading, see "House Your Retirement With Self-Directed Real Estate IRAs.")