How Do Self-directed IRAs Work?

While the days may feel long, the truth is that the years are short. This is especially true when it comes to saving away as much money as possible for retirement. 

If patience isn’t one of your strong suits, then looking for ways to build up for retirement as fast as possible may be tempting. 

One retirement plan I recommend to all of my followers and customers is a self-directed IRA (SDIRA). 

Unlike traditional retirement accounts, SDIRAs give you the freedom to explore alternative assets with high-growth potential. As a result, investors like me and Peter Thiel have used SDIRAs to significantly boost our wealth and portfolio. 

So how do self-directed IRAs work? Read more to learn the basics of opening a self-directed IRA.

What Is a Self-directed IRA?

A self-directed IRA is an individual retirement account that allows you to hold alternative assets. Unlike a traditional IRA that limits investments to stocks, bonds, annuities, unit investment trusts (UITs), mutual funds, and exchange-traded funds (ETFs), a self-directed IRA allows for investments in exotic, high-return assets. 

For example, a self-directed IRA allows investors to invest their IRAs in the following assets:

  • Commodities.
  • Real estate.
  • Raw/undeveloped land.
  • Water, oil, mineral, and gas rights.
  • Private stock.
  • Limited partnerships.
  • Cryptocurrency.
  • Precious metals that match specific standards.
  • Crowdfunded startup assets.
  • Foreclosure tax liens and deeds.
  • Foreign currency.

While custodians must oversee self-directed IRAs, each IRA is managed directly by the account holder. The burden is on the account holder to perform due diligence, conduct research, and maintain proper management of assets. 

Pros and Cons of an SDIRA

A self-directed IRA is an exceptional choice for someone seeking diversification of assets. 

For many people facing retirement, investing in alternative assets using an SDIRA is viewed as a shield against inflation and volatility. Here's a glance at the advantages of SDIRAs:

  • Flexibility: Self-directed IRAs provide a much broader scope of asset classes compared to traditional IRAs. Diversification beyond stocks, bonds, and mutual funds can help a portfolio to remain resilient against downturns. In addition, investors can dip their toes into exciting markets with everything from gold to cryptocurrency staking on the menu with SDIRAs.
  • Potential for Higher Returns: SDIRAs are especially attractive to investors looking for assets with higher-than-average investment returns. On the flip side, an SDIRA can also be a powerful tool for investment, such as raising capital for real estate using dormant retirement funds. 
  • Control: The account holder ultimately controls the destiny of an SDIRA. Many investors enjoy using their specialized knowledge regarding specific asset classes to make custom investment decisions. In fact, an SDIRA makes it possible to invest in hobbies and passions!
  • Tax Benefits: IRAs are amazing tax-free investments to build wealth to keep up with inflation without forfeiting most of it to the IRS. 

Some of the "pros" of self-directed IRAs can also be cons. For instance, the freedom and self-direction that make this an attractive option for some investors could turn an SDIRA into a hassle for others. Here's a look at the potential disadvantages of opening a self-directed IRA:

  • Full Control: The success of an SDIRA depends entirely on the judgment of the account holder. The pressure is really on when it comes to making smart investment choices.
  • Loss of Liquidity: While it's exciting to be able to invest in alternative assets, unloading them can take time and effort. Unlike traditional assets that can be sold off with the press of a button whenever the market is open, alternative investments can take years to sell, and some might never find buyers.
  • Fees: Fees can be slightly higher with SDIRAs. While the general cost to set up an SDIRA is reasonable, some custodial firms charge a lot for administration.
  • Complexity: A self-directed IRA comes with a long list of rules and prohibited transactions regarding your own assets. For example, real estate investments made through an IRA cannot be touched for personal use. The simple act of fixing a broken toilet in a property you own through an IRA could result in IRS penalties, interest charges, and forfeiture of your SDIRA tax benefits.

What's the Difference Between Traditional and Roth SDIRAs?

The difference between a Roth and Traditional SDIRA comes down to its tax structure. You have to consider whether you will be in a higher tax bracket now or at retirement to reap the full benefits of each IRA. 

Traditional SDIRA

With a traditional SDIRA, the account holder contributes pre-tax dollars. This investment then grows on a tax-deferred basis until being taxed as current income once withdrawals begin after age 59 1/2. 

This works for most people because they benefit from deferring taxes on a portion of their income during their "peak" earning years. For the average person, peak earning years are when their income is taxed at a higher bracket. 

The assumption is that people fall into lower tax brackets after retirement because they no longer work full-time. As a result, they will presumably pay a lower tax rate on their IRA withdrawals.


With a Roth IRA, the account holder contributes after-tax dollars that will then grow on a tax-free basis. All withdrawals made after age 59 1/2 will not be taxed as current income. This can be a good option for someone anticipating that they will be in a higher tax bracket during retirement.

Rules, Contribution Limits, and Prohibited Transactions

In 2023, account holders under the age 50 have a contribution limit of $6,500. Account holders over 50 can add an additional $1,000 in catch-up contributions to max out at $7,500. 

Once a person reaches age 59 1/2, they can begin making withdrawals tax-free. However, the IRS only requires withdrawals at age 72, known as required minimum distributions (RMDs). 

Withdrawing funds before age 59 1/2 will result in a 10% penalty. The account holder will also need to pay income tax on the withdrawal amount based on their ordinary income tax rate. 

Fortunately, Self-directed IRAs do qualify for the same hardship distributions as other IRAs.

While much is made of the alternative investment options available through the SDIRA, this account type isn't made for free-for-all investing. For example, SDIRAs cannot invest in art, S-corporations, or life insurance. 

SDIRAs also have strong restrictions against what the Securities and Exchange Commission calls self-dealing. This means that IRA owners are not permitted to essentially "do business with themselves." 

For example, selling your property to yourself, lending yourself funds from an IRA, taking IRA income, and paying IRA expenses with your own money are all prohibited. 

In this scenario, the SDIRA owner is referred to as a "disqualified person" by the IRS. 

In the case of a real estate investment, this distinction means that the IRA owner is prohibited from living at a property, staying at a property, doing any kind of work or maintenance, or directly funding any kind of work of maintenance. 

The disqualified person's title even extends to an account holder's spouse, children, grandchildren, and parents. The same goes for any entity where the account holder possesses more than 50% ownership, holds a director role, or can be classified as a "highly compensated" employee.

How to Open a Self-directed IRA

A self-directed IRA must be opened with help from an account custodian or trustee. While some brokerage firms offer custodial services for IRAs, it's more common to use banks and trust companies that specialize as custodians of self-directed IRAs. Once the account is open, you are free to select investments.

Is a Self-directed IRA Right for Me?

Anyone seeking a bit of diversification and adventure in investing should consider an SDIRA. Although riskier, they tend to yield higher rewards. 

I recommend SDIRA owners research the risk involved with their investments, as well as what is allowed and disallowed in an SDIRA.

Opening an SDIRA isn't a spur-of-the-moment decision. You have to be both passionate and knowledgeable regarding the asset class you're investing in because you're betting on your ability to know a good thing when you see it.

Ultimately, an SDIRA is a great way to enjoy tax-free retirement earnings gained from real estate, private companies, cryptocurrency, and other unconventional asset classes.

Self-Directed IRA FAQ

What Type of IRA Lets You Invest in Cryptocurrency?

Unlike regular IRAs, the self-directed IRA allows investors to invest in cryptocurrency using tax-deferred income.

Can You Manage Your Own SDIRA?

While account holders get to make all of their own investment choices using an SDIRA, a custodian is required to open an SDIRA account. Trust companies and banks typically help with setting up SDIRAs.

What Can't You Invest in with an SDIRA?

While SDIRAs allow you to invest in a range of alternative assets, not everything is permitted. Art and collectibles, life insurance, and S corporations are all considered prohibited assets. In addition, certain precious metals won't qualify.