What Is a Self Directed IRA?

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A self-directed retirement account is known as a self-directed IRA. It's also commonly referred to as an SDIRA.

It's a type of Individual Retirement Account or "IRA" that can effectively hold a lot of investments that would normally be prohibited by traditional IRAs.

While it's also administered by a trustee or a custodian, it's self-directed by the person whose account it is. Hence the name "self-directed" IRA.

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This can come in multiple versions. One is a traditional IRA. This is where you would be tasked with making contributions that are tax deductible. The other is a Roth IRA. This is where you would be taking tax-free distributions instead.

An SDIRA is typically a better option if you are an experienced investor that already knows about the markets and alternative investments.

If you are someone with experience and you are knowledgeable in the field and you want to diversify your investments in an account that offers tax advantages, there's every reason to consider opening one.

  • It's another type of Individual Retirement Account. It's a variation on a Roth IRA or a traditional IRA.
  • It's an account where you can hold alternative investments in it. This includes real estate and others. You cannot hold these in a traditional IRA.
  • A SDIRA is typically only available if you are going through a specialty firm that offers it.
  • A custodian isn't allowed to give any sort of financial advice for these IRAs. Thus, all of the decisions must be made by the holder of the account.
  • There are plenty of risks associated with this type of account that you don't have with others.

What's a SDIRA?


As mentioned, an SDIRA is a self-directed retirement account. It allows you to invest in alternative investments. You can hold investments in areas you wouldn't be able to with a traditional one. You will have the same contribution limits.

Fully Understanding The Ins and Outs Of A Self-Directed IRA Account


The biggest difference between a traditional IRA versus an SDIRA is the kind of investments that are eligible to be held in the account. Typically, a traditional IRA would be limited to a specific type of investment.

You typically can only hold standard investments like common stock, bonds, CDs, and ETFs. Whereas, when you opt for an SDIRA, it opens up more possibilities. 

With an SDIRA, you can invest in various alternative assets including but not limited to precious metals, real estate, limited partnerships, and more.

Because of this, a self-directed IRA tends to require a lot more knowledge, experience, and due diligence from whoever is opening the account. It's a much more active alternative.

How You Can Open One


When it comes to the majority of IRA providers, you are limited to opening traditional IRAs. Usually, you would only be able to open a traditional or a Roth IRA. As such, you would also be limited to investing in stocks, bonds, and ETFs.

Whereas, if you decide to open a self-directed IRA, you will need to have a qualified custodian willing to do so and who specializes in it.  You won't find every custodian to be the same. Some will offer different investments.

Thus, if you want to invest in a specific type of asset, you will want to reach out to one that offers it. For instance, if you have your eyes set on gold bullion, you would need to ensure that you are choosing a custodian that offers it. 

Keep in mind, these accounts are self-directed. This means that you cannot legally get financial advice from your custodian. Thus, you will be tasked with doing the research and due diligence yourself.

No investment company or brokerage is going to offer advice to you. You will be tasked with doing your homework on whatever investments you are considering.

If you do need assistance picking one out and managing it, you'll want to enlist assistance from a professional advisor.

Roth versus a Traditional SDIRA


You can set one of these IRAs up in two different ways. You can either go with a Roth or a traditional IRA. However, it's important to understand that each has its tax treatments, contribution limits and guidelines, and more.

One of the key differences between the two is the fact that you pay taxes upfront with a Roth IRA. With a traditional IRA, you will be getting a tax break upfront. Then, you will be obligated to pay taxes on your gains once you withdraw them.

When you contribute to a Roth IRA, you will have both your contributions and earnings grow completely tax-free because you are taxed upfront.  There are several other things that you have to consider when choosing too.

Here are some of them:

  • There are Income Limits

When you are opening up a traditional IRA, you don't have to worry about income limits. There's none for a traditional IRA.

However, to open a Roth IRA, you need to be making less than a specific amount. This is true to open or when you are contributing to a Roth IRA.

  • There are Differences In Required Minimum Distributions

You will need to begin taking Required Minimum Distributions once you hit 72 years of age when you have a traditional IRA. Whereas, you do not need to do the same when you have a Roth IRA.

  • Early Withdrawals

When you have a Roth IRA, you can effectively withdraw it at any point in time. It doesn't matter why. Also, it won't trigger a tax or penalty either. Any withdrawal you make is tax and penalty-free once you hit 59.5 years of age.

This is true for any account that is 5 years or older. When it comes to traditional IRAs, you can start to take money out penalty-free starting at 59.5 years of age.

Keep in mind, you will be forced to pay taxes on all of your traditional IRA withdrawals.

You will have the same rules no matter what kind of SDIRA you have.  You will also find that SDIRA will need to abide by the general contribution limits per year.

For the years 2021 and 2022, that equates to $6,000 per year if you are under 50 years old. If you are over, that number rises to $7,000.

Putting Money In An SDIRA


A self-directed Roth IRA will expand the kind of investments that you can start to put your money into.

Along with the standard options you have available, you can begin to hold investments in various alternative investments that you most likely don't have in your current portfolio. 

For instance, if you are looking to invest in real estate, you can buy and hold it in your SDIRA. Likewise, you can hold tax liens and partnerships in it too. 

The IRS does forbid some investments in an SDIRA no matter what type you have. For instance, you won't be able to hold life insurance in it.

You also cannot hold stocks from S corporations, any investment that constitutes a prohibited transaction, or any collectibles.  Collectibles is a broadly encompassing term. It includes various things including artwork, antiques, baseball cards, and more. 

You will always want to speak with a professional financial advisor to ensure that you are adhering to these rules and regulations.

SDIRA Risks


You can experience a lot of benefits by opening up an SDIRA. However, it doesn't come without its share of risks. Here are some of them:

Prohibited Transactions 

One of the problems is, if you do end up breaking a rule, your entire account could be distributed out to you. This means that you would need to have to pay all of the taxes and penalties that are imposed.

You need to understand and abide by the rules to avoid this. It can be an expensive lesson.

Due Diligence 

The account is self-directed. Because of this, you aren't getting financial advice from people who know more than you.

As a result, you need to do your due diligence and make your own financial decisions. You could always hire a professional financial advisor for help.

Fees 

You will be responsible for paying all of the fees associated with the account. This includes the fee for opening it, establishing it, annual fees, and more. These fees can add up and eat into your earning potential.

Exit Strategy 

You need to have an exit strategy. It can be very difficult to exit some of the alternative investments that you have your money in. If you are talking about a traditional IRA, it's very easy to liquidate stocks.

It's a very liquid asset. However, the same cannot be said if you are talking about liquidating physical real estate.

Fraud 

While you cannot get financial advice from SDIRA custodians, you will need to be on the lookout for fraud.

Custodians will not do the due diligence nor evaluate the legitimacy of investments they offer or promote. Thus, it's on you to keep yourself protected and safe from it.

How Do You Set One Up?


As per the IRS, you will need to set one up with a qualified custodian. The custodian can be a bank or another kind of financial institution. They will hold the investments and keep them safe.

They will also ensure that the SDIRA complies with all of the rules of the IRS.  You can open one at a financial institution like a bank, the majority of the bigger box custodians don't allow you to invest in a lot of alternative investments.

Thus, if you have something, in particular, you want to invest in, you will need to identify one that offers nontraditional assets. It's important to note, you cannot get financial advice from them.

Therefore, you need to do your due diligence and research when you are choosing which alternative investments you want to make.