Self-Directed Individual Retirement Account Basics

June 07, 2021

By Daniel Gibson

Do you ever wish that you could use the savings in your retirement accounts to invest in assets other than stocks, bonds, mutual funds and exchange traded funds? Actually, you can through what is known as a self-directed individual retirement account (“SDIRA”).

What Is an SDIRA?

An SDIRA is a type of IRA that can hold a variety of alternative investments normally prohibited from regular IRAs. Although the account is administered by a custodian or trustee, it is directly managed by the account holder—hence the name "self-directed." Thus, it gives you more control over your retirement savings.

Investments options in these accounts are almost unlimited, provided certain guidelines are met. Some of the diverse alternative investments available via an SDIRA are:

  • Annuities
  • Commercial paper
  • Cryptocurrency
  • Farmland
  • Futures
  • Livestock
  • Options
  • Precious metals (e.g., gold, silver, palladium)
  • Private notes and loans
  • Private stock offerings (aka PPMs)
  • Raw land
  • Real estate, residential and commercial
  • Tax certificates – tax liens
  • Trust deeds/mortgage and mortgage pools

Comparing SDIRAs to Roth and Traditional IRAs

Available as either a traditional IRA (to which you make tax-deductible contributions) or a Roth IRA (from which you take tax-free distributions), self-directed IRAs are best suited for savvy investors who already understand alternative investments and want to diversify in a tax-advantaged account.

A key difference between a traditional and a Roth IRA is when you pay the taxes. With traditional IRAs, you have an opportunity to obtain an upfront tax break, but then pay taxes on your contributions and earnings as you withdraw them during retirement. On the other hand, you don’t get a tax break when you contribute to a Roth IRA. But your contributions and earnings grow tax-free, and qualified distributions are also tax-free.

Most banks and financial institutions tend to limit you to bonds, mutual funds, ETFs or stocks, not because they are limited to these investments, but because they have no financial (careful) interest in allowing account holders to invest in the aforementioned alternative investments.

Establishing a SDIRA

  1. Open a Self-Directed IRA Account
    • Identify a qualified IRA custodian for this type of account.
  2. Fund the Account
    • Transfer funds from an existing retirement account.
    • Make new contributions to your newly formed SDIRA.
  3. Identify Investments
  4. Determine Ways to Fund the Purchase of Investments
    • Instruct the SDIRA custodian to purchase the investments. Unfortunately, this can get expensive and time consuming because the custodian will normally charge transaction fees and need to approve of the investments.
    • Form a single-member limited liability company (“SMLLC”) with the SDIRA as the owner. Designate the beneficiary (you) as the manager of the SMLLC and its checkbook. Have the IRA custodian fund the SMLLC. Then you as the manager are free to make investments through the SMLLC that is owned by the SDIRA.

Other Important Points to Note

  • The owner of the investments is the SDIRA, not you.
  • The SDIRA cannot transact any business with or provide a benefit to disqualified persons who are the IRA holder or his/her spouse; ancestors; lineal descendants, including their spouses; or any corporation, partnership or trust in which the IRA holder has a 50% or greater interest.
  • Prohibited investments include collectibles (e.g., art, rugs, antiques, stamps, coins, wine,); life insurance; S corporation stock.
  • Self-directed IRAs can also be set up as traditional IRAs or as Roth IRAs. However, with any of the above IRA options, also include in your planning considerations employer-provided retirement plans and beneficiary selections, life expectancy forecasts and related adequacy of cash flow needs over lifetime(s) expectancy, the utilization of trust-owned life insurance as a funding vehicle to create supplemental assets for heirs devoid of related tax, and a review of your estate plan and advance health care directives and beneficiaries.

SDIRAs can be a powerful tool in building retirement wealth. Due to the potential intricacies, it is best to work with a financial advisor with expertise in this area.

About Daniel Gibson

Daniel Gibson provides accounting, tax planning and consulting services to real estate and services industries and is a member of the AICPA and New Jersey Society of Certified Public Accountants.