What is a self-directed IRA (SDIRA)?
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Updated 11:34 a.m. UTC Nov. 7, 2023
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Key points
- The self-directed IRA offers more investment options than other IRA types.
- Opening and managing an SDIRA requires knowledge of investing and tax law.
- SDIRAs can involve increased responsibility and risks.
Picture yourself in the driver’s seat of your retirement plan with the freedom to steer your investments in the direction you want them to go. Now imagine being able to veer off the beaten path of stocks, bonds and mutual funds to explore real estate, precious metals and private businesses.
Welcome to the self-directed individual retirement account, or SDIRA, a tool that gives you the keys to drive your investment portfolio anywhere you wish.
In this vast financial landscape, SDIRAs often remain a mystery, tucked away behind more familiar IRAs and 401(k)s. But we will pull back the curtain and explore this often-overlooked account that could give you more control over your retirement funds.
We’ll navigate the contours and corners of self-directed IRAs and uncover the potential they hold for savvy investors seeking to take the wheel of their retirement planning.
J.P. Morgan Self-Directed Investing
What is a self-directed IRA (SDIRA)? And how does it work?
A self-directed IRA is a type of traditional or Roth IRA, meaning it allows you to save for retirement on a tax-advantaged basis, says Lori Gross, financial and investment advisor at Outlook Financial Center. It has a contribution limit in 2024 of $7,000, or $8,000 for people age 50 and older.
Gross says the main difference between an SDIRA and a regular IRA is the investments you can hold. An SDIRA gives you more flexibility and control over your investments than other IRA types.
Regular IRAs typically limit your investment choices to:
- Stocks.
- Bonds.
- Mutual funds.
- Certificates of deposit.
SDIRAs offer you the freedom to invest in a wider array of assets, including:
- Real estate.
- Precious metals.
- Tax lien certificates.
- Private business entities.
How does an SDIRA work? It’s pretty straightforward. You open an SDIRA with a qualified custodian, which administers the account on your behalf. The custodian can be a bank, trust company or other entity approved by the IRS. Once you set up the account, you can contribute to it and direct the custodian to make investments for you.
Tip: Because SDIRAs are self-directed, custodians cannot give financial advice. The responsibility for making informed investment decisions rests solely with you and the account holder.
Is a self-directed IRA right for you?
Deciding whether an SDIRA is right for you is a bit like choosing a recipe for a dinner party. It depends on your tastes, your comfort level and the risks you’re willing to take.
First, consider your financial goals. An SDIRA could be a good option if you enjoy cooking up your own investment strategy and are eager to try more exotic ingredients (think alternative investments).
On the other hand, a regular IRA might be more to your liking if you prefer the convenience and predictability of a premade meal or tried-and-true recipe (think stocks, bonds and mutual funds).
Also, consider your risk tolerance. Alternative assets can be riskier than traditional investment options. If you’re comfortable with uncertainty and have the time and knowledge to thoroughly research your investment choices, then an SDIRA could be a great addition to your financial menu.
“For most people, the range of assets available through a traditional IRA are sufficient enough, and you can still have a diversified portfolio. They are quick and easy to open and provide the same tax benefits as a self-directed IRA without exposure to all the extra IRS rules and additional fees,” says Kendall Meade, financial planner at SoFi.
Self-directed IRA vs. regular IRA
It’s important to understand the key differences between a self-directed IRA and a regular IRA in terms of investment options, control and responsibility.
SDIRAs and regular IRAs have many of the same rules, such as contribution limits. The main difference is a self-directed IRA has more flexibility in what you are allowed to invest in.
A regular IRA is straightforward and a popular choice for many investors. It offers a set menu of investment options, mainly stocks, bonds and mutual funds. A regular IRA is a reliable, tried-and-true retirement vehicle that can be easily managed with the help of financial advisors and investment firms. It’s an excellent option for those who prefer a hands-off approach and want to stick to more familiar and traditional investment avenues.
On the other hand, a self-directed IRA offers diversification thanks to its ability to hold alternative assets and “broadens the horizon of potential,” Gross says. This flexibility allows you to customize your retirement portfolio to match your exact preferences and risk tolerance. But with greater control comes increased responsibility.
You must be comfortable doing your own research and making your own investment decisions if you want to open and manage an SDIRA.
In a nutshell, a regular IRA provides a simple and familiar path for retirement savings, while an SDIRA offers a wider landscape for those willing to take a more proactive and hands-on approach to their retirement planning.
Pros and cons of investing in a self-directed IRA
Like any financial decision, investing in a self-directed IRA has pros and cons. We’ll lay out the key advantages and potential pitfalls of this unique investment vehicle to help you make an informed decision.
SDIRA pros and cons
| PROS | CONS |
|---|---|
Greater flexibility: An SDIRA allows you to invest in a wider variety of assets, including alternative investments like real estate, private companies and precious metals
| Increased responsibility: With an SDIRA, you’re in charge of making investment decisions, which requires a solid understanding of different asset types and their associated risks
|
Potential for higher returns: Due to the wider variety of investment options, there’s potential for higher returns, especially if you have expertise with a specific asset type
| Lack of guidance: Unlike with a regular IRA, an SDIRA custodian can’t provide investment advice or conduct due diligence on your behalf
|
Tax advantages: SDIRAs are available as either traditional IRAs, to which you make tax-deductible contributions, or Roth IRAs, from which you take tax-free withdrawals
| Complex regulations: SDIRAs are subject to strict IRS rules and regulations; violations, even unintentional ones, can lead to severe tax penalties
|
Control over your investments: You have complete control over your investment choices, allowing you to align your retirement savings with your preferences and risk tolerance
| Higher fees: SDIRAs often charge higher fees than other investment accounts; they vary by custodian but can include transaction fees, account opening fees, annual account fees, administrative fees and asset-specific fees
|
How to open a self-directed IRA
Opening a self-directed IRA can be a straightforward process if you follow these steps:
- Choose an SDIRA type. First, decide whether you want a traditional SDIRA or Roth SDIRA. Each has its own tax advantages. With a traditional SDIRA, your contributions generally are tax-deductible and you pay taxes on withdrawals in retirement. Roth SDIRA contributions are made with after-tax dollars, meaning withdrawals in retirement are tax-free.
- Find a custodian. Next, find an IRS-approved custodian. It could be a bank, trust company or other entity. The custodian will hold and administer your SDIRA for you. Remember that not all financial institutions offer SDIRAs due to their complex nature, so do your homework.
- Open your account. Once you choose a custodian, fill out an application and open your account. You must usually provide personal information and agree to the custodian’s terms and conditions.
- Fund your SDIRA. After you open an account, you can fund it by contributing, rolling over funds from another IRA or transferring funds from an old 401(k).
- Choose your investments. Choosing your investments is the exciting part; this is where you can make the most of your SDIRA’s flexibility. But remember that the responsibility for making informed investment decisions lies with you.
- Manage your SDIRA. Keep a close eye on your investments and make changes as needed. Regularly review your portfolio to ensure it aligns with your goals and risk tolerance.
Frequently asked questions (FAQs)
A self-directed IRA gives you more control over your investments. But you can’t set up the account entirely on your own. You’ll need to work with an IRS-approved custodian, such as a bank, trust company or other entity, to establish and administer your SDIRA. It will handle all the necessary paperwork and ensure your account complies with IRS rules and regulations.
So while you have control of the steering wheel regarding investment decisions, the custodian helps keep the car on the road.
Whether an SDIRA is a good idea depends on your circumstances, investment knowledge and risk tolerance. If you’re comfortable taking a more active role in investment decisions and venturing into alternative assets, an SDIRA can be an excellent tool for diversification and potential growth.
But it’s essential to remember the increased responsibility and potential complexity. As with any investment decision, it’s always a good idea to consult a financial advisor or tax professional before moving forward.
In 2024, the contribution limit for an SDIRA, like other IRA types, is $7,000 if you’re under age 50. If you’re 50 or older, you can make an additional catch-up contribution of $1,000.
These limits apply across all your IRAs. That means if you have multiple IRAs, the total amount you contribute to them can’t exceed these limits. Remember to check for changes to the contribution limits each year.
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