Self-Directed IRAs Explained

Most IRA holders invest in traditional securities like stocks, bonds, and mutual funds through major brokerages like Fidelity, Vanguard, or Schwab. But a lesser-known option exists for investors who want to venture beyond Wall Street's offerings: the self-directed IRA. This specialized retirement account allows you to invest in a much broader universe of assets, including real estate, private businesses, precious metals, promissory notes, and other alternative investments that conventional IRA custodians don't support.

Self-directed IRAs offer exciting opportunities for investors with specialized knowledge or access to unique investment opportunities. However, they also come with increased complexity, higher costs, greater regulatory scrutiny, and significant risks if you don't understand the rules. This comprehensive guide explains how self-directed IRAs work, what you can and cannot invest in, the benefits and drawbacks, and how to determine whether this retirement account structure aligns with your investment goals and expertise.

What Is a Self-Directed IRA?

Despite the name, a self-directed IRA isn't actually a different type of IRA from a tax perspective. It's a traditional or Roth IRA held with a specialized custodian that allows alternative investments beyond the typical stocks, bonds, and mutual funds offered by mainstream brokerages.

The "Self-Directed" Distinction

The term "self-directed" can be somewhat confusing because technically, any IRA where you choose your own investments (rather than using a managed account) could be considered self-directed. However, in common financial industry usage, "self-directed IRA" specifically refers to IRAs that allow alternative investments not typically available through traditional custodians.

With a regular IRA at Fidelity or Vanguard, you direct your investments by choosing which stocks, ETFs, or mutual funds to purchase—but you're limited to publicly traded securities and investment products the custodian offers. With a true self-directed IRA at a specialized custodian, you can direct investments into real estate, private companies, precious metals, and other alternatives.

How Self-Directed IRAs Work

Self-directed IRAs follow the same contribution limits, tax treatment, and distribution rules as regular IRAs. The difference lies in what you're allowed to invest in and how transactions are processed.

When you open a self-directed IRA, you work with a custodian who specializes in holding alternative assets. Unlike mainstream brokerages that provide investment platforms and may offer research or advice, self-directed IRA custodians typically serve purely administrative functions. They hold the assets on behalf of your IRA, process transactions you direct them to make, handle reporting to the IRS, and maintain records—but they generally don't offer investment advice or evaluate whether specific investments are appropriate or legitimate.

You are entirely responsible for finding investments, conducting due diligence, determining fair market value, ensuring compliance with IRS rules, and managing the assets. The custodian simply facilitates transactions and maintains the legal structure that preserves your IRA's tax-advantaged status.

Types of Self-Directed IRA Structures

Self-directed IRAs can be structured in several ways:

Custodian-Held Accounts: The most common structure, where a specialized custodian holds title to assets on behalf of your IRA. You direct investments, but the custodian technically owns the assets in their capacity as IRA custodian, protecting the tax-advantaged status.

Checkbook Control IRAs: Also called IRA LLCs, this structure involves your IRA investing in a limited liability company (LLC) that you manage. This gives you "checkbook control"—the ability to make investments directly from the LLC bank account without processing each transaction through the custodian. While this provides convenience and faster transactions, it also increases the risk of prohibited transaction violations if you're not careful.

Trust Company Accounts: Some self-directed IRAs are held with trust companies rather than traditional custodians. The functional differences are minimal from an investor perspective, though trust companies may be subject to different regulatory oversight depending on their charter.

What You Can Invest In

The primary appeal of self-directed IRAs is access to alternative investments. Understanding what's permissible helps you evaluate whether a self-directed IRA offers value for your situation.

Real Estate

Real estate is the most popular alternative investment in self-directed IRAs. Your IRA can purchase various types of properties:

Residential Properties: Single-family homes, condos, townhouses, or multi-family properties held as rentals. Your IRA owns the property, collects rental income (which flows back to the IRA), and pays all expenses from IRA funds. When you eventually sell, proceeds return to the IRA.

Commercial Real Estate: Office buildings, retail spaces, warehouses, or other commercial properties. These typically require more capital and expertise but can provide substantial returns for knowledgeable investors.

Raw Land: Undeveloped land purchased for appreciation or future development. Keep in mind that raw land typically generates no income while incurring expenses like property taxes, potentially requiring cash contributions to your IRA.

Real Estate Notes: Your IRA can act as a lender, holding promissory notes secured by real estate. You earn interest income as borrowers make payments.

Tax Liens and Tax Deeds: Some investors use self-directed IRAs to purchase tax liens or tax deeds at government auctions, earning interest or potentially acquiring properties.

Important restrictions apply to IRA-owned real estate. You cannot live in or personally use properties owned by your IRA. You cannot sell property to or purchase property from yourself or certain family members. You cannot use your personal funds to improve IRA-owned property, and you cannot personally guarantee mortgages on IRA-owned real estate (though non-recourse loans secured only by the property itself are permissible).

Private Equity and Business Investments

Self-directed IRAs can invest in private companies and businesses:

Private Company Stock: Purchase shares in privately held corporations that aren't traded on public exchanges. This might include startups, small businesses, or investment opportunities sourced through personal networks.

Limited Liability Company (LLC) Interests: Invest in LLCs for various business ventures, real estate holding companies, or other purposes. Your IRA becomes a member of the LLC with ownership percentage determined by your investment amount.

Limited Partnerships: Purchase limited partnership interests in businesses or investment ventures, though you must remain a passive limited partner rather than taking an active general partner role.

Franchises: Some investors use self-directed IRAs to purchase franchise businesses, though this requires careful navigation of prohibited transaction rules and typically necessitates hiring third-party management.

Critical restrictions apply here too. You cannot invest your IRA in a business you control, work for, or receive compensation from. You cannot invest in S-Corporations (which have ownership restrictions incompatible with IRA structures). All income and gains must flow to the IRA, not to you personally.

Precious Metals

Self-directed IRAs can hold physical precious metals, subject to specific IRS requirements:

Approved Metals and Purity Standards: Gold must be 99.5% pure, silver 99.9% pure, platinum and palladium 99.95% pure. Acceptable forms include certain government-minted coins (like American Eagles) and bullion bars from approved refiners.

Storage Requirements: Precious metals must be held by an IRS-approved depository or trustee. You cannot store IRA-owned precious metals in your home, safe deposit box, or personal safe. Approved depositories provide segregated or allocated storage where your specific metals are identified and separated from other holdings.

Collectible Restrictions: Only specific coins and bullion qualify. Rare numismatic coins, most foreign coins, and collectible items don't qualify for IRAs regardless of their precious metal content.

Promissory Notes and Private Lending

Your IRA can act as a lender, purchasing promissory notes or making private loans:

Real Estate Notes: Lend money secured by mortgages or deeds of trust on real property. Your IRA earns interest as the borrower makes payments.

Business Loans: Provide financing to businesses in exchange for promissory notes with specified interest rates and repayment terms.

Peer-to-Peer Lending: Participate in structured lending platforms where your IRA funds loans to individuals or businesses, though you must ensure the platform structure is IRA-compatible.

Prohibited transaction rules prevent you from lending to yourself, your spouse, ancestors, descendants, or entities you control. All loans must have commercially reasonable terms, proper documentation, and appropriate security or collateral.

Cryptocurrency and Digital Assets

An emerging category, cryptocurrencies and digital assets can be held in some self-directed IRAs:

Bitcoin, Ethereum, and Other Cryptocurrencies: Some self-directed IRA custodians now facilitate cryptocurrency holdings, allowing you to invest IRA funds in digital currencies.

Security and Custody: Cryptocurrency held in IRAs must be custodied by the IRA administrator or a third-party custodian, not in personal wallets you control. This ensures proper IRA structure while creating custodial risk if the administrator is hacked or fails.

Regulatory Uncertainty: The regulatory landscape for cryptocurrency in retirement accounts remains evolving. Tax treatment, custody requirements, and permissibility could change as regulators develop clearer frameworks.

Other Alternative Investments

Additional possibilities include:

• Hedge fund investments (subject to fund acceptance of IRA investors)
• Private placement securities
• Intellectual property like patents or royalty rights (though valuation and prohibited transaction issues can be complex)
• Joint ventures and partnerships
• Options and futures contracts beyond what traditional brokerages offer
• Foreign real estate
• Mineral rights and oil and gas interests

What You Cannot Invest In

While self-directed IRAs allow many alternative investments, certain assets remain prohibited:

IRS-Prohibited Assets

The IRS explicitly prohibits IRAs from holding collectibles, which include:

• Artwork, antiques, and rugs
• Gems and jewelry (except certain coins as noted above)
• Stamps and most rare coins
• Alcoholic beverages
• Certain other tangible personal property

If your IRA purchases a prohibited asset, the amount invested is treated as a distribution, potentially triggering taxes and penalties.

Life Insurance

IRAs cannot purchase life insurance contracts, though annuities are permissible and commonly held in IRAs.

S-Corporation Stock

S-Corporations cannot have IRA owners due to S-Corp ownership restrictions, making these investments incompatible with IRA structures.

Understanding Prohibited Transactions

The most critical aspect of self-directed IRAs—and the source of the greatest risk—is understanding and avoiding prohibited transactions. Violating these rules can disqualify your entire IRA, triggering catastrophic tax consequences.

What Are Prohibited Transactions?

Prohibited transactions are interactions between your IRA and "disqualified persons" that the IRS doesn't allow. If you engage in a prohibited transaction, your entire IRA can be deemed distributed as of January 1st of the year the violation occurred, meaning the full balance becomes immediately taxable (and potentially subject to penalties if you're under 59½).

Who Are Disqualified Persons?

Disqualified persons include:

• You (the IRA owner)
• Your spouse
• Your lineal ancestors (parents, grandparents)
• Your lineal descendants (children, grandchildren) and their spouses
• Fiduciaries of your IRA (including your IRA custodian)
• Entities you own 50% or more of (corporations, partnerships, trusts, estates)
• Officers, directors, and 10%+ shareholders of entities providing services to your plan

Notably, siblings, aunts, uncles, cousins, and non-lineal relatives are not disqualified persons, meaning certain transactions with these family members may be permissible (though caution is still warranted).

Types of Prohibited Transactions

Prohibited transactions include any direct or indirect:

Sale, Exchange, or Leasing: You cannot sell property to your IRA, buy property from your IRA, or lease property between yourself and your IRA. For example, you cannot sell your rental house to your IRA, and your IRA cannot purchase your personal residence.

Lending of Money: You cannot lend money to your IRA or borrow money from it. This includes using IRA assets as collateral for personal loans.

Provision of Goods or Services: You cannot provide goods or services to your IRA, and your IRA cannot provide goods or services to you. This means you cannot personally manage IRA-owned rental properties (you must hire third-party management), perform repairs, or provide other services, even for free.

Transfer or Use of IRA Assets: You cannot use IRA assets for your personal benefit. You cannot stay in your IRA-owned rental property, even for one night. You cannot use the company car from an IRA-owned business. You cannot borrow artwork owned by your IRA for your home.

Receipt of Compensation: Fiduciaries cannot receive compensation from IRA investments beyond reasonable fees for their custodial services. You cannot pay yourself a salary for managing IRA investments or receive commissions from IRA transactions.

Common Prohibited Transaction Mistakes

Self-directed IRA investors frequently make these errors:

Personal Use of IRA Property: Staying in your IRA-owned vacation rental, using your IRA-owned vehicle, or enjoying other personal benefits from IRA assets violates prohibited transaction rules.

Mixing Personal and IRA Funds: Using personal funds to improve IRA-owned property or paying IRA expenses from personal accounts creates prohibited transactions. All expenses must be paid from IRA funds, and if the IRA lacks sufficient cash, you must contribute additional funds to the IRA first.

Transacting with Family: Buying property from your children, selling investments to your parents, or conducting business between your IRA and lineal family members' entities violates the rules.

Providing Sweat Equity: Personally performing repairs, maintenance, or improvements on IRA-owned properties, even to save money, is prohibited. You must hire third parties for all work.

Indirect Benefits: Creating situations where you indirectly benefit can also be problematic. For example, if your IRA invests in your child's business and your child uses profits to support themselves (reducing your need to provide support), this might be scrutinized as an indirect benefit, though the rules here can be gray.

Consequences of Prohibited Transactions

The penalty for prohibited transactions is severe. The IRS treats your entire IRA as distributed on January 1st of the year the violation occurred. This means:

• The full IRA balance becomes taxable income for that year
• If you're under 59½, you may owe an additional 10% early withdrawal penalty
• The loss of tax-advantaged status is permanent for those funds
• There's no easy way to "undo" or correct the violation

Given these dire consequences, extreme caution is essential when structuring self-directed IRA investments. When in doubt, consult with a tax attorney or CPA experienced in self-directed IRAs before proceeding with questionable transactions.

Benefits of Self-Directed IRAs

Despite the complexity and risks, self-directed IRAs offer genuine advantages for appropriate investors.

Investment Diversification

Self-directed IRAs allow true diversification beyond traditional financial markets. If you believe real estate, private businesses, or other alternatives will outperform stocks and bonds, or simply want exposure to non-correlated assets, self-directed IRAs provide access.

Leveraging Specialized Knowledge

If you have expertise in a particular area—real estate investment, oil and gas, private equity, cryptocurrency—you can apply that knowledge within your retirement account. A real estate professional might achieve better risk-adjusted returns investing in properties they understand than in stock markets where they lack expertise.

Access to Unique Opportunities

Some investment opportunities simply aren't available through public markets. Private company investments, direct real estate purchases, or private lending opportunities might offer attractive returns unavailable through traditional securities.

Inflation Protection

Certain alternative investments, particularly real estate and precious metals, may provide inflation protection and diversification during periods when traditional financial assets struggle.

Direct Control

Self-directed IRAs provide more direct control over your investments compared to mutual funds or delegating to financial advisors. If you prefer making your own investment decisions with hands-on involvement, this structure accommodates that preference.

Tax-Advantaged Growth

All the standard IRA tax benefits apply. In a traditional self-directed IRA, investment gains grow tax-deferred until withdrawal. In a Roth self-directed IRA, gains are completely tax-free if you follow the rules. Generating substantial returns from alternative investments while deferring or eliminating taxes can significantly enhance wealth accumulation.

Risks and Drawbacks

Self-directed IRAs are not appropriate for everyone and come with substantial risks and disadvantages.

Prohibited Transaction Risk

As discussed extensively above, violating prohibited transaction rules can disqualify your entire IRA, creating devastating tax consequences. The rules are complex, sometimes counterintuitive, and strictly enforced. Many investors inadvertently violate these rules without realizing it until an IRS audit discovers the problem.

Higher Costs

Self-directed IRA custodians typically charge substantially more than traditional IRA custodians. Expect to pay annual fees of $200-$500 or more, plus transaction fees for each investment purchase or sale, asset-based fees, and potentially other charges. These costs can significantly erode returns, especially for smaller account balances.

Lack of Custodian Oversight

Self-directed IRA custodians generally don't evaluate investment quality, verify legitimacy, or protect you from fraud. Unlike traditional brokerages that screen available investments, self-directed custodians simply process transactions you direct. Responsibility for due diligence falls entirely on you.

Illiquidity

Alternative investments are typically much less liquid than stocks and bonds. Real estate can take months to sell. Private company investments may have no market at all. This illiquidity creates problems if you need to access funds quickly or must take required minimum distributions in retirement.

Valuation Challenges

You must report your IRA's fair market value annually, but many alternative assets don't have clear market values. How do you value a private company investment, a promissory note from a local business, or a piece of raw land in a rural area? Improper valuations can trigger IRS scrutiny or problems with required minimum distributions.

Complexity and Administrative Burden

Self-directed IRAs require significant time and expertise. You must understand IRS rules, handle all investment management responsibilities, maintain detailed records, coordinate with your custodian for all transactions, and ensure proper documentation. This administrative burden is substantial compared to simply buying index funds at Vanguard.

Unrelated Business Income Tax (UBIT)

If your IRA engages in active business operations or uses debt financing, it may owe Unrelated Business Income Tax on a portion of earnings, despite the IRA's tax-advantaged status. UBIT applies to:

• Income from active business operations (as opposed to passive investments)
• Income attributable to debt-financed property (like rental income from a property purchased with a mortgage)

UBIT is calculated and paid by the IRA itself, reducing your net returns and adding complexity to tax reporting.

Fraud and Scam Risk

The self-directed IRA space has unfortunately attracted fraudsters who target investors with alternative investment scams. Promoters may claim custodians "approve" investments when custodians actually perform no such evaluation. Ponzi schemes, overvalued assets, and fraudulent securities are unfortunately common. The SEC and state regulators regularly warn about self-directed IRA fraud.

Concentration Risk

Many self-directed IRA investors hold a single property or a small number of alternative investments, creating dangerous concentration. Unlike diversified stock portfolios spread across hundreds of companies, concentrating your entire retirement savings in one rental property or one private business investment exposes you to catastrophic losses if that investment fails.

Is a Self-Directed IRA Right for You?

Self-directed IRAs are sophisticated tools appropriate for certain investors but inappropriate for others. Consider these questions:

Do You Have Relevant Expertise?

Self-directed IRAs make most sense if you have genuine expertise in the alternative assets you plan to hold. A real estate professional with decades of experience might successfully manage IRA-owned properties, while a novice attempting the same could make costly mistakes.

Be honest about your knowledge. Overconfidence in unfamiliar investment areas is a recipe for losses. If you lack deep expertise in the alternative assets you're considering, a self-directed IRA probably isn't appropriate.

Do You Have Time and Interest?

Self-directed IRAs require ongoing attention. Finding investments, conducting due diligence, coordinating transactions with your custodian, managing assets, and maintaining compliance all take significant time. If you prefer a passive investment approach or lack time for active management, traditional IRAs better suit your situation.

Do You Understand and Accept the Risks?

Beyond typical investment risk, self-directed IRAs carry prohibited transaction risk, fraud risk, and illiquidity risk. Are you comfortable navigating these dangers? Do you have professional advisors (attorneys, CPAs) experienced in self-directed IRAs to consult when questions arise? If not, the risks may outweigh potential benefits.

Is Your Account Balance Sufficient?

Given the higher costs and need for diversification, self-directed IRAs typically make more sense for larger accounts. With a $10,000 IRA, annual fees of $300+ represent 3% of your balance before considering any investment returns. With a $100,000 account, those same fees are only 0.3%. Most experts suggest self-directed IRAs are most appropriate for accounts of $50,000 or more.

Do You Have Access to Quality Opportunities?

Self-directed IRAs only make sense if you have access to alternative investment opportunities that offer genuine value. Do you have real estate deals with attractive risk/return profiles? Connections to quality private companies seeking investment? Access to private lending opportunities with appropriate security? If not, you may be trying to force an investment strategy for which you lack the necessary deal flow.

Are You Disciplined About Following Rules?

Self-directed IRA success requires rigorous attention to prohibited transaction rules and other IRS requirements. If you're detail-oriented, disciplined about compliance, and willing to consult professionals when unsure, you can navigate the complexity. If you tend to be loose with rules or trust your instincts over technical requirements, self-directed IRAs are dangerously inappropriate.

How to Open a Self-Directed IRA

If you've determined a self-directed IRA suits your situation, here's how to establish one.

Research and Select a Custodian

Not all self-directed IRA custodians are equal. Research options carefully:

Reputation and Experience: Choose established custodians with track records and positive reviews. Check for regulatory violations or complaints with the Better Business Bureau and state securities regulators.

Asset Types Supported: Confirm the custodian supports your intended investment types. Some specialize in real estate, others in precious metals, and some handle diverse alternatives.

Fee Structures: Compare annual fees, transaction fees, and other charges. Calculate total expected costs based on your anticipated activity.

Service Quality: Evaluate responsiveness, processing speed, and customer support. You'll be working closely with this custodian for potentially decades.

Educational Resources: Better custodians provide educational materials about IRS rules, prohibited transactions, and best practices. This support helps you avoid costly mistakes.

Reputable self-directed IRA custodians include Equity Trust Company, The Entrust Group, IRA Financial, Strata Trust Company, and others. Research multiple options before deciding.

Complete the Application

The application process is similar to opening any IRA. You'll provide personal information, beneficiary designations, and investment instructions. Decide whether you want a traditional or Roth self-directed IRA based on your tax situation and goals.

Fund Your Account

Transfer funds from an existing IRA, roll over assets from an employer retirement plan, or make annual contributions. Direct transfers from other IRAs are typically the easiest method.

Identify and Execute Investments

Once funded, begin identifying investments. Conduct thorough due diligence on any opportunity. Verify that the investment complies with IRS rules and doesn't create prohibited transactions. Work with your custodian to execute purchases, ensuring all documentation properly names the IRA (not you personally) as the owner.

Maintain Proper Records

Keep detailed documentation of all investments, transactions, expenses, and income. These records are essential for annual valuations, tax reporting, and defending your compliance if ever audited.

Self-Directed IRA Best Practices

If you proceed with a self-directed IRA, following these best practices minimizes risks and maximizes your chances of success.

Consult Professionals

Work with a CPA and/or attorney experienced in self-directed IRAs. Before making significant investments, have them review the transaction structure for prohibited transaction issues and other problems. The cost of professional advice is trivial compared to accidentally disqualifying your IRA.

Maintain Clear Separation

Keep your IRA completely separate from your personal finances. Never mix funds, provide personal services to IRA investments, or create situations where lines blur between IRA and personal assets.

Diversify Within Your Self-Directed IRA

Don't concentrate your entire IRA in one property or investment. If you have $100,000 in your self-directed IRA, consider holding multiple investments or combining alternative investments with traditional securities to maintain diversification.

Maintain Adequate Liquidity

Keep some portion of your self-directed IRA in liquid investments (money market funds, short-term bonds) to handle expenses, unexpected costs, and eventually required minimum distributions without being forced to sell illiquid assets at inopportune times.

Conduct Rigorous Due Diligence

Investigate every investment thoroughly. Verify the legitimacy of promoters, review all documentation, check references, and understand exactly what you're buying. If anything feels off or too good to be true, walk away. Your custodian won't protect you from fraud, so due diligence is your responsibility.

Document Everything

Maintain comprehensive records of all transactions, expenses, income, and communications. Proper documentation protects you during IRS audits and helps track your IRA's performance.

Review Annually

At least once per year, review your self-directed IRA holdings, valuations, and compliance with all rules. Use this review to reaffirm that your alternative investment strategy continues to make sense and that you haven't inadvertently created any prohibited transactions.

Conclusion

Self-directed IRAs represent powerful tools for sophisticated investors with expertise in alternative assets and access to quality investment opportunities. They allow you to apply specialized knowledge within your retirement accounts, invest in assets unavailable through traditional IRAs, and potentially achieve superior risk-adjusted returns while enjoying tax-advantaged growth.

However, self-directed IRAs are decidedly not appropriate for everyone. The complexity, costs, risks, and administrative burdens exceed what most investors should accept. Prohibited transaction rules create catastrophic consequences for mistakes, higher fees erode returns, and the lack of custodian oversight exposes you to fraud and poor investment decisions.

Before opening a self-directed IRA, honestly assess whether you have the expertise, time, risk tolerance, and access to opportunities that justify this approach. For most investors, traditional IRAs holding low-cost index funds provide superior simplicity, lower costs, greater liquidity, and perfectly adequate long-term returns. The grass isn't always greener with alternative investments—often it's just more expensive to maintain and comes with hidden hazards.

If you do proceed with a self-directed IRA, educate yourself thoroughly about prohibited transaction rules, work with experienced professional advisors, conduct rigorous due diligence on all investments, and maintain meticulous compliance with all IRS requirements. Approached carefully and intelligently, self-directed IRAs can serve as valuable components of a sophisticated retirement strategy. Approached carelessly, they can jeopardize your retirement security and create tax nightmares that haunt you for years.