With standard individual retirement accounts (IRAs), your investment options are usually restricted to securities such as stocks, bonds and mutual funds. That means if you’re looking to branch out with more novel choices, such as real estate and precious metals, a self-directed IRA is your ticket. You get more investment options and the same tax perks. The one catch: You have to find a custodian who handles these accounts and there aren't that many of them.

As with other IRAs, you have two options.

The wider range of investment options with a self-directed IRA gives you the opportunity to pursue assets that have a potential for higher yields over time. Among them: tax lien certificates, private placement securities, gold, and even restaurant franchises.

Key Takeaways

  • Self-directed IRAs have more extensive investment options that may offer the potential for higher earnings, but they often come with significantly greater risk.
  • The custodian of a self-directed IRA doesn't vet clients' investment choices, so it's up to investors to do their due diligence and understand the tax consequences of their selections.
  • When choosing a custodian, consider their experience, fees, and areas of expertise, and check out their rating with the Better Business Bureau.

Self-Directed IRAs Carry Greater Risk

The catch? You’re also taking a much bigger risk. Many of the investment options that people tuck into a self-directed IRA are volatile by nature. What’s more, the custodian—which may be a bank, a federally insured credit union, a savings and loan association, a brokerage, or an entity approved by the Internal Revenue Service (IRS) to act as a trustee—doesn’t vet the investments you undertake.

That’s where the “self-directed” part comes in. It’s your responsibility to conduct the due diligence on the securities and other assets you buy. You’re also accountable for understanding the tax consequences of these less common investments. If your IRA includes a rental property for which you carry a mortgage, for example, some of your investment income could be taxable. A custodian won’t dig into those implications for you.

It's critical to know the rules for a self-directed IRA —such as not entering into deals with specific relatives—so you don't wind up owing taxes and penalties on your investments.

Choosing a Custodian

That’s not to say that all custodians are created equal. Roughly two dozen companies are currently licensed by the IRS to provide these services, and some have better reputations—as well as more experience with certain investment categories—than others, so it pays to do your homework. As self-directed IRAs are something of a niche market, you won’t find well-known names, such as Fidelity, in the mix. Therefore, it’s important to ask the right questions when you shop around. 

Here are some of the factors to consider. 

Experience

Some custodian banks have been around for decades; others are new kids on the block. Age certainly isn’t the only criterion to be thinking about, but, all else being equal, a longer track record suggests stability and competent management. You can also see whether the custodian is included on the IRS list of Approved Nonbank Trustees and Custodians

Fees

Pricing arrangements vary from one firm to the next. Some charge based on specific services they offer, while others levy a flat annual fee. If a custodian offers a non-fixed fee structure, you’ll want to ask plenty of questions and get a solid estimate of how much the total annual cost will be. Expect to pay more than you would with a traditional IRA provider, given the added complexity of alternative investments.

Expertise

Some custodian banks specialize in specific types of investments, such as private placement securities that are available to accredited investors. The more exotic your investments, the more you’ll lean on the expertise of a narrowly focused firm.

Cybersecurity

Hacks of valuable consumer information have been all too common in recent years. Ask what procedures the custodian has in place to make sure your data is secure. Any responsible bank will use up-to-date encryption, for example, to guarantee that customer records are protected.

BBB Rating

The Better Business Bureau (BBB) is an invaluable tool when researching IRA custodians. Any consumer can visit its website and search for businesses by name. The BBB assigns each one a letter grade based, in part, on the number of complaints it has received and how well the company has resolved its disputes.

The Bottom Line

There are certainly advantages to a self-directed IRA, but there are also some pretty serious risks. One of them is putting your trust in a custodian that you later find isn’t up to par. Asking the right questions ahead of time will help ensure that your assets are in good hands.