Understanding Self-Directed IRAs: Should You Invest Retirement Funds in Alternative Assets?

When it comes to saving for retirement, there’s no one “perfect” strategy. There are several paths to take depending on your income level, risk tolerance, and post-retirement lifestyle goals. 

Some people are happy to set up automatic contributions to traditional retirement and taxable brokerage accounts and watch their portfolio balance grow over time. 

Others may be interested in investing a portion of their retirement savings in alternative options like precious metals and real estate.  

Investors looking for opportunities outside of traditional securities have never had more choices or fewer barriers to entry. 

If you want to invest in alternative assets, there are two ways to do it—invest in the assets directly or acquire them inside a self-directed individual retirement account (SDIRA). 

Investing inside an SDIRA offers the tax benefits you’d expect with other types of IRAs, but it also creates potential tax complications and creates liquidity challenges. 

Here’s how it works. 

What Is a Self-Directed IRA? 

Self-directed IRAs work similarly to traditional IRAs and Roth IRAs, but instead of holding stocks and bonds, they provide the opportunity to hold alternative investments, such as real estate and cryptocurrency, that aren’t typically available in other types of IRAs.  

Like standard IRAs, self-directed IRAs are typically held at custodians. However, unlike a standard IRA, where the custodian facilitates purchases of securities on behalf of the account owner, you are responsible for acquiring and titling the assets held in the SDIRA.  

Alternative Assets You Can Own in a Self-Directed IRA 

IRAs that are not self-directed generally limit investment options to traditional securities like stocks, bonds and mutual funds.  

However, self-directed IRAs offer investors opportunities to purchase other types of assets, such as real estate, precious metals, cryptocurrency, private equity, energy and natural resources and tax liens. 

Assets You Can’t Own in a Self-Directed IRA 

While self-directed IRAs offer investment options that other types don’t, there are limits to the investments you can hold in an SDIRA.  

Life insurance, S Corporation stock and collectibles, such as antiques and art, can’t be held in an SDIRA. 

Advantages of SDIRAs 

Investors considering adding alternative investments to their portfolio generally do so for a handful of reasons, including: 

• Performance: Investors may seek alternative investment opportunities, seeking to outperform the expected return of publicly traded investments.
  

• Tax-deferred investment income: Deferring taxes on investment income earned inside a self-directed IRA until taking a distribution from the account. For example, rental income generated by real estate investments held within the SDIRA wouldn’t be taxed until you make a withdrawal, whereas rental income is otherwise taxable in the year earned. 

• Asset diversification: SDIRAs offer investors a way to diversify their portfolio outside of traditional securities. 

Disadvantages of SDIRAs 

While investors who choose to participate in self-directed IRAs may reap benefits unavailable through more traditional investments, there are multiple downsides you should know about, including: 

• Risk: By nature, alternative investments are generally riskier than traditional, more closely regulated investment options traded on public market exchanges. While alternatives may have the potential for higher returns, the volatility and risk-adjusted returns may not warrant the higher risk.
  

• Liquidity challenges: SDIRAs are subject to required minimum distributions (RMDs) just like other types of IRA accounts. Because many alternative investment options are illiquid, account holders may have cash flow challenges meeting RMD requirements. Even where RMDs are years down the road, it’s important to consider the timeframe of monetizing an illiquid investment, especially when held within an SDIRA. 

• IRS rules and limitations on asset usage: SDIRAs are complicated, making it easy to violate IRS rules that put investors at risk of incurring substantial tax penalties. For example, real estate held within a SDIRA cannot be utilized or retitled for personal use.  

• Complex fee structure: Many retirement account types have simple, inexpensive fee structures, but that’s not true with SDIRAs. Fee structures tend to be complex and more expensive than other types of retirement accounts, reducing your net return. 

Types of SDIRAs: Traditional IRA vs. Roth IRA 

When investing in a self-directed IRA, you can opt for a traditional or Roth account. The tax rules for each are consistent with IRAs that are not self-directed. 

If you open a traditional SDIRA, you use pre-tax dollars to invest in assets, and taxes are deferred until you make a withdrawal from the account. 

If you open a Roth SDIRA, you use post-tax dollars to invest, earnings grow tax-free, and you don’t pay income tax on withdrawals—as long as you follow all the self-directed IRA rules. 

Tax Implications and Other Rules for Self-Directed IRAs 

Self-directed IRAs are subject to tax rules established by the IRS. Here are a few you should know. 

• Required minimum distributions: Traditional SDIRAs are subject to RMDs. Because many alternative investment options are illiquid, your account may not have enough cash to take scheduled RMDs.
  

• Roth IRA RMDs: Whether you own a standard or self-directed Roth IRA, you aren’t required to take RMDs from the account. However, if you leave your Roth IRA (whether self-directed or not) to your beneficiaries, they will be required to take RMDs after your death and may encounter liquidity challenges. 
  

• Total distribution: If you violate any SDIRA IRS rules, you may be required to take a taxable distribution of the total account. Multiple scenarios may trigger a total distribution, including being unable to take an RMD or personal use of a real estate investment held in the SDIRA. 
  

• IRA contribution limits: Self-directed IRAs are subject to annual contribution limits, but determining the value of illiquid assets contributed is not always straightforward. Valuations (or lack thereof) create gray area that’s open to interpretation by the IRS, creating more tax risk for the investor. 

Is a Self-Directed IRA Right for You? 

Because of the complicated rules and potential to trigger a complete distribution of your self-directed IRA or incur tax penalties, we recommend partnering with a trusted financial advisor to help determine if SDIRAs should fit into your overall investment strategy.  

A wealth manager skilled in complex financial planning can likely suggest more controllable ways to achieve the same goals without the same level of risk. 

Bottom line: if you’re considering complex investment strategies like a SDIRA, it’s likely your financial plan could benefit from a professional. Our money match quiz will recommend the right level of help with just 8 quick questions.