A self-directed IRA gives you control over a greater choice of investment options, but it also means more responsibility and risks

• A self-directed IRA (SDIRA) is a kind of retirement account that allows you to invest in assets that are off-limits to regular IRAs.
• You directly manage your self-directed IRA, and so are responsible for researching your investments and their tax consequences. 
• Self-directed IRAs are generally for people with more investing experience, including experience dealing with alternative investments.

When it comes to IRA investments, stocks, bonds, mutual funds, and exchange-traded funds (ETFs) are traditionally the assets of choice. After all, these securities are easy to buy and sell. Mutual funds also offer other benefits: professional management and instant diversification for your portfolio.

Still, some IRA investors may be uncomfortable leaving their retirement savings in control of other people. They might want the opportunity to earn higher returns or the option to move their money to alternative assets that may. If that sounds like you, a self-directed IRA (SDIRA) might be worth a closer look.

Be warned, though: It also involves extra effort and definitely complicates your financial affairs.

What is a self-directed IRA?

An individual retirement arrangement (IRA) is a tax-advantaged retirement savings account: The money within it grows tax-free. You take a tax deduction when you put funds into it and pay taxes on the sums when you start withdrawing, which becomes an option when you turn 59 ½ years old and mandatory when you turn 72 years old.

Self-directed IRAs (SDIRAs) are structured like standard IRAs, with the same contribution limits, distribution rules, and tax advantages. What sets SDIRAs apart are two things:

• The wide variety of investment options they offer
• Who makes the investment decisions about them

Self-directed IRA alternative investment options

The IRS regulates what sort of investments regular IRAs can hold: stocks, bonds, mutual funds, ETFs, CDs, and other traditional assets. SDIRAs can own these too, but they can also hold alternative investments such as: 

• Real estate (the most popular SDIRA asset)
• Gold and other precious metals
• Tax liens
• Private mortgages
• Horses, livestock, and farmland
• Intellectual property
• Promissory notes
• Cryptocurrencies
• Partnerships
• Private equity

How self-directed IRAs are managed

All IRAs have to be held at some sort of financial institution, which acts as their custodian or trustee. Someone at or affiliated with that institution — a broker, wealth manager, or financial planner — might advise you on investments, or even make trades in it on your behalf.

An SDIRA also has a custodian or trustee to administer it, but the account owner directly manages it (hence the name, "self-directed"). The IRS prohibits SDIRA custodians from giving financial advice. As a result, many traditional brokerages, banks, and investment companies don't offer self-directed IRAs; you have to go to a different custodian who specializes in them. 

How to set up a self-directed IRA

• Find a custodian: To open an SDIRA, you'll need an IRA custodian that handles these accounts. You'll want to shop around to see all the investment options. It may be helpful to keep a preference for a particular asset in your mind while you're shopping. 
• Decide between traditional or Roth IRA: An SDIRA can either be set up as a traditional (tax-deductible) or Roth IRA (tax-free distributions). Making this decision will come down to your age when you start saving for retirement and your anticipated post-retirement income. If you anticipate your post-retirement income to be higher than your income now, it may be a good idea to choose a Roth IRA and pay the taxes within your current bracket. 
• Select your preferred investments: Choose your preferred investments. Ideally, since you've gone through the trouble of opening an SDIRA, you already know which investments you plan on putting your savings into. 
• Get a broker to make purchases: Once you have your investments selected, you need to get your custodian to make the purchase on your behalf. 

SDIRA funding options include direct contributions, transfers from other investment or bank accounts, and rollovers from other IRAs or 401(k) plans. Contribution limits for 2022 are $20,500 and $27,500 for those over the age of 50.

Benefits of self-directed IRAs

All IRAs offer a tax-advantaged way to save for retirement. But the self-directed version boasts a few extra perks that can turbocharge a nest egg:

Better diversification

Because they can invest across asset classes, SDIRAs can diversify your portfolio in much more effective ways. In fact, they can hold just about anything that's not specifically prohibited by IRS rules (mainly, life insurance, S-corps, and collectibles like art and antiques, stamps, or other tangibles). 

Higher potential returns

The average annual return for the S&P 500 is about 8% — about the same you would expect in a standard IRA. Many alternative investments, such as real estate, offer higher potential returns, without necessarily adding significant risk or volatility.

Flexibility with your investments

In general, you have to wait until you're at least age 59 ½ to take penalty-free withdrawals from either type of IRA (in the case of a Roth IRA, you can withdraw your contributions at any time without penalty) to invest in something else. However, you can access the capital in your SDIRA anytime and direct how it will be put to work — whether that's buying an office building or a racehorse. And because you're not withdrawing the money, doing so won't trigger penalties or taxes.

Legal protection

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provides bankruptcy protection for IRAs. That means the investments you hold in an SDIRA — including valuable assets like real estate — would remain untouched in the event of bankruptcy or legal action. 

Risks of self-directed IRAs

Of course, SDIRAs have their downsides, as well:

Fees

Even though SDIRAs are "self-directed," the IRS requires a certified custodian or trustee to oversee your investments — and they don't work for free. Expect to pay a fee to establish the account, plus annual fees and service fees for any tasks the custodian handles, such as bill paying. 

Limited liquidity

It's easy to buy and sell stocks, bonds, and mutual funds. That's not always the case with SDIRA assets, and your capital could be tied up in assets you no longer want. Poor liquidity also means you may not get the price you anticipated when it's time to sell.

Self-dealing

Self-directed IRAs offer greater freedom in your retirement investing within the confines of strict rules. Break these rules by making a prohibited transaction and you could find your savings set back with penalties and interest from the IRS.

A prohibited transaction happens when you, your beneficiary, or a disqualified person misuses your SDIRA. Self-dealing is one such prohibited transaction: Under IRS rules, you can't immediately or directly benefit from the assets in your account. Doing so could trigger a penalty or the immediate disqualification of the IRA, and its tax breaks. 

For example, you could invest in a rental property like a vacation home, but you better not spend any time there.

Disqualified persons

SDIRA account owners can't participate in transactions with certain other people (this directly relates to the self-dealing rule that prevents personal gain). According to the IRS, disqualified persons include:

• Any fiduciary to the account (including the account owner)
• A family member, including a spouse, parent, descendent, or the spouse of a descendent
• An employer of any employee covered by the plan
• A corporation, estate, partnership, or trust where a disqualified person owns 50% or more of the interests
• A director, an officer, or a 10%-or-greater partner or shareholder of any of the above entities

Lack of counsel

While they can (and do) make certain investments available, SDIRA custodians aren't allowed to give financial advice or make recommendations. In fact, the Securities and Exchange Commission (SEC) warns that custodians "generally do not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters." Without this guidance, you need to be wary of potential fraud.

You could certainly work with an outside advisor (but not the custodian) to help you pick investments and develop a strategy. But you have to make all the decisions and direct the custodian to execute them. 

Ultimately, you're on your own in evaluating the soundness of any investment, and in understanding the tax consequences of your investment picks.

The bottom line

Self-directed IRAs allow you to invest beyond the basics, diversifying your holdings for potentially higher returns. But while they offer more flexibility and options than standard IRAs, they involve more work, rules, and risks — and a steeper learning curve.

Consequently, SDIRAs are most appropriate for people who already have experience with alternative investments and want to hold those assets in a tax-advantaged account.