The self-directed individual retirement account (IRA) is for investors who are determined to go beyond the usual investments that are available for retirement accounts. Way beyond, in some cases.

IRAs are currently available from many financial institutions, and each offers a wide range of stocks, bonds, and mutual funds, including exchange-traded funds and index funds. Investors can choose a conservative bond fund or an aggressive stock fund, and there are plenty of choices in between.

The self-directed IRA is for those who demand access to alternative investments in their retirement savings. And, they want total control over the buy and sell decisions.

Key Takeaways

  • The self-directed IRA gives the investor control over buy and sell decisions.
  • It permits alternative investments in assets like precious metals and cryptocurrencies that are not normally found in IRAs.
  • The self-directed IRA requires a high level of confidence and a considerable investment of time and attention.

What Are 'Alternative Investments'?

Self-directed IRAs are in most ways the same as any other IRA. That is, they have tax advantages designed to encourage Americans to save for retirement. That means the IRS gets some say in what an IRA can and cannot be invested in. That includes some alternatives to the usual stock and bond funds.

As of 2019, the IRS permits self-directed IRAs to invest in real estate, development land, promissory notes, tax lien certificates, precious metals, cryptocurrency, water rights, mineral rights, oil and gas, LLC membership interest, and livestock.

The IRS also has a list of investments that are not permitted. That list includes collectibles, art, antiques, stamps, and rugs.

Who Wants a Self-Directed IRA?

The self-directed IRA might appeal to an investor for any of several reasons:

  • It could be a way to diversify a portfolio by splitting retirement savings between a conventional IRA account and a self-directed IRA.
  • It could be an option for someone who got burned in the 2008 financial crisis and has no faith in the stock or bond markets.
  • It may appeal to an investor with a strong interest and expertise in a particular type of investment, such as cryptocurrencies or precious metals.

In any case, a self-directed IRA has the same tax advantages as any other IRA. The investor who has a strong interest in precious metals can invest pre-tax money long-term in a traditional IRA, and pay the taxes due only after retiring.

The self-directed aspect may appeal to the independent investor, but it's not completely self-directed. That is, the investor personally handles the decisions on buying and selling but a qualified custodian or trustee must be named as administrator. Otherwise, it's not an IRA, as the IRS defines it.

The administrator is usually a brokerage or an investment firm.

How a Self-Directed IRA or 401(k) Works

Self-directed IRAs are held by a custodian chosen by the investor, typically a brokerage or investment firm. This custodian holds the IRA assets and executes the purchase or sale of investments on the investor's behalf.

If you are offered the option of a self-directed 401(k) by an employer, the custodian would be the plan administrator. 

The same contribution limits apply as for regular IRA and 401(k) plans. In 2019, the maximum IRA contribution is $6,000, plus a $1,000 catch-up for those age 50 or above. The maximum for 401(k) plans is $19,000, plus a $1,000 catch-up.

The withdrawal rules are also the same. A withdrawal made from any traditional IRA or 401(k) prior to age 59½ will trigger a 10% early-withdrawal penalty unless an exception applies. Required minimum distributions begin at age 70½.

For those who choose the Roth option for a self-directed IRA or 401(k), the rules again are the same. The investor pays the taxes on the income in the year the money is invested but the entire balance will be tax-free when money is withdrawn in retirement.

Your account automatically loses its tax-advantaged status if the IRS rules that you made a prohibited transaction.

Risks of a Self-Directed 401(k) or IRA

A self-directed retirement account can give you freedom of choice with your retirement savings, but it comes with obvious risks. This is an option for people who are very sure that they can beat the professionals, and are willing to bet their retirement savings on it.

The IRS has warned that investors in self-directed IRAs may be subjected to "fraudulent schemes, high fees, and volatile performance."

Investors also have to be wary of accidentally violating the complicated IRS rules for self-directed IRA investments. Some of these rules specifically ban:

  • Receiving money directly from an income-producing property in the IRA or 401(k)
  • Using real estate held in the account as collateral for a personal loan
  • Using property or other investments in the account in a way that benefits you personally
  • Borrowing money from the account to repay personal loan obligations or lend to a disqualified person
  • Allowing disqualified individuals to maintain a residence in a property owned inside the 401(k) or IRA
  • Selling or leasing property within the account to a disqualified person

A disqualified person is a fiduciary of the plan, a person who provides services to the plan, and any other entity that may have a financial interest. That includes yourself, your spouse and heirs, the account beneficiary, the account custodian or plan administrator, and any company in which you own at least 50% of the voting stock, directly or indirectly.

If the IRS determines that a prohibited transaction has occurred, your account automatically loses its tax-advantaged status. All the money that you’ve invested into a self-directed 401(k) or traditional IRA will be treated as a taxable distribution, leaving you with a big tax bill.