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A Guide to Self-Directed IRAs (SDIRA)

By Austin Kilham · November 22, 2021 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

A Guide to Self-Directed IRAs (SDIRA)

Individual retirement accounts, or IRAs, typically allow for a lot of flexibility in what kinds of investments from stocks and bonds to mutual funds and exchange-traded funds (ETFs).

However, most IRAs don’t allow certain alternative investments like precious metals, real estate and cryptocurrency. If you want to hold assets like these in your retirement account, you’ll need a self directed IRA (SDIRA), a specific type of Roth or traditional IRA.

What Is a Self-Directed IRA (SDIRA)?

Self directed IRAs and self directed Roth IRAs allow account holders to buy and sell a wider variety of investments than regular traditional IRAs and Roth IRAs. Experienced investors, familiar with sophisticated or risky investments, often use these.

Recommended: Traditional vs. Roth IRA: Key Differences

While a custodian or a trustee administers the SDIRA, the account holder typically manages the allocation themselves, taking on responsibility for researching investments and due diligence. These accounts may also come with higher fees than regular IRAs, which can cut into the size of your retirement nest egg over time.

What Assets Can You Put in a Self-Directed IRA or a Self-Directed Roth IRA?

Individuals can hold a number of unique alternative investments in their SDIRA, including but not limited to:

•   Real estate and land

•   Cryptocurrency

•   Precious metals

•   Mineral, oil, and gas rights

•   Water rights

•   LLC membership interest

•   Tax liens

•   Foreign currency

•   Startups through crowdfunding platforms

How Do Self-Directed IRAs Work?

Aside from their ability to hold otherwise off-limits alternative investments, SDIRAs work much like their traditional counterparts. SDIRAs are tax-advantaged retirement accounts, and they can come in two flavors: traditional SDIRAs and Roth SDIRAs.

Traditional IRA Contributions and Withdrawal Rules

IRA contributions to traditional accounts goes in before taxes, which reduces investors’ taxable income, lowering their income tax bill in the year they make the contribution. For 2021 and 2022, individuals can contribute up to $6,000 in total across accounts. Those age 50 and up can make an extra $1,000 catch-up contribution for a total of $7,000. Investments inside the account grow tax-deferred.

It’s important to pay close attention to rules for IRA withdrawals. Once individuals begin to make withdrawals at age 59 ½, they are taxed at normal income tax rates. Account holders who make withdrawal before that age may owe taxes and a possible 10% early withdrawal penalty. Traditional SDIRAs account holders must begin making required minimum distributions (RMDs) after age 72.

Roth IRA Contributions and Withdrawal Rules

Roth SDIRAs have the same contribution limits as traditional SDIRAs. However, retirement savers contribute to Roths with after-tax dollars. Investments inside the account grow tax-free, and withdrawals after age 59 ½ aren’t subject to income tax.

Roths are also not subject to RMD rules. Individuals can withdraw Roth contributions at any time without penalty, though earnings may be subject to tax if withdrawn before age 59 ½.

There are also rules restricting who can contribute to a Roth IRA, based on their income. In 2022, Roth eligibility begins phasing out at $129,000 for single people, and $204,000 for people who are married and file their taxes jointly.

Individuals can maintain both traditional and Roth IRA accounts, however, contributions limits are cumulative across accounts, and cannot exceed $6,000, or $7,000 for those 50 and over.

Want to learn more about how IRAs work? Take a look at this article: The 7 Most Common Questions About IRAs.

Pros and Cons of Self-Directed IRAs

Self-directed IRAs offer unique perks for the right investor. However, those interested must weigh those benefits against potential drawbacks.

Benefits of Self-Directed IRAs

An SDIRA allows investors to branch out into different types of investments to which they might otherwise not have access. This allows investors to seek out potentially higher returns and diversify their portfolios beyond the offerings in traditional IRAs.

Alternative investments have the potential to offer higher returns than investors might achieve with stock market investments. However, investors beware: These opportunities for higher rewards come at the price of higher risk.

Also, investors’ ability to hold a broader spectrum of investments that can help them diversify their portfolio and manage risks, such as inflation risk or longevity risk, the chance an investor will run out of money before they die. For example, some SDIRAs allow investors to hold gold, a traditional hedge against inflation.

Drawbacks of Self-Directed IRAs

While there are some very real advantages to using SDIRAs, these must be weighed against their disadvantages.

For starters, investments like stocks and shares of ETFs are highly liquid. Investors who need their money quickly can sell them in a relatively short period of time, usually a matter of days.

However, some of the investments available in SDIRAs are not liquid. For example, real estate, physical commodities like precious metals, or some types of cryptocurrency may take quite a bit of time to sell if you need to access your money. Individuals who need to sell these assets quickly may find themselves in a situation in which they must accept less than they believe the asset is worth.

SDIRAs may also carry higher fees. Individuals who hold regular IRA accounts may not have to pay management or investment fees. However, SDIRA holders may have to pay fees associated with holding the account and with the purchase and maintenance of certain assets.

Finally, SDIRAs place a lot of responsibility in the hands of their account holders. Investors must research investments themselves and perform due diligence to make sure that whatever they’re buying is legitimate and matches their risk tolerance.

What’s more, investors must make sure the assets they hold meet IRS rules . Running afoul of these rules can be costly, in some cases causing investors to pay taxes and penalties.

Here’s a look at the pros and cons of SDIRAs at a glance:

Pros

Cons

Tax-advantaged growth. Contributions to traditional accounts are tax deductible. Investments grow tax-deferred in traditional accounts and tax-free in Roth accounts. Illiquid. Selling alternative investments may be slow and difficult.
Same contribution limits as regular IRAs. Individuals can contribute up to $6,000 each year, or $7,000 for those age 50 and up. Higher fees. Individuals may be on the hook for account fees and fees associated with alternative investments.
Higher returns. Alternative investments may offer higher returns than those available in the stock market. Increased responsibility. Investors must research investments carefully by themselves and ensure they stay within rules for approved IRA investments.
Diversification. SDIRAs offer investors the ability to invest in assets beyond the stock and bond markets. Higher risk. Alternative investments tend to be riskier than more traditional investments.

Opening a Self-Directed IRA

Investors who want to open an SDIRA will need to take the following steps:

1.    Find a custodian or trustee — this can be a bank, trust company, or another IRS-approved entity — and follow their requirements for opening an account. Some SDIRAs specialize in certain asset classes, so look for a custodian that allows you to invest in the asset classes in which you’re interested.

2.    Choose investments. Decide which alternatives you want to hold in your SDIRA. Perform necessary research and due diligence.

3.    Complete the transaction. Find a reputable dealer from which your custodian can purchase the assets, and ask them to complete the sale.

4.    Plan withdrawals carefully. Because alternative assets have less liquidity than other types of investments, you may need to plan sales well in advance of needing retirement income or meeting required minimum distributions.

The Takeaway

If you’re opening your first IRA account, you’re likely best served with a traditional or Roth IRA. Because of the complications involved in using an SDIRA, only sophisticated investors should consider it.

If you’re interested in opening a Roth or traditional IRA, SoFi can help. The SoFi Invest retirement account offers traditional, Roth, and SEP IRAs that you can open and manage online.

Photo credit: iStock/Andres Victorero


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