Laura answers a listener's question about self-directed IRAs and how to invest with them wisely.
Laura answers a listener's question about self-directed IRAs and how to invest with them wisely.
Transcript: https://money-girl.simplecast.com/episodes/should-i-use-a-self-directed-ira/transcript
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Jackson, who says:
"I've been looking at opening an IRA and see that you can own different types of investments, besides stocks and bonds, in a self-directed IRA. Can you explain self-directed accounts and whether I should use one?"
Thanks for your question, Jackson! If you search online for an individual retirement account, you're likely to see the option to open a self-directed IRA or SDIRA. This post will answer Jackson's question by reviewing what a self-directed IRA is and who might benefit from having one.
Welcome back to episode 939 of Money Girl–I appreciate you spending time with me! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.
You can learn more, ask questions, and sign up for the Money Stack at LauraDAdams.com. You can subscribe for free or become a paid member with access to live educational events.
What is a self-directed IRA (SDIRA)?
A self-directed IRA is a type of individual retirement account that allows you to invest in a wide range of assets compared to a regular IRA. With a conventional IRA, you're typically limited to a menu of investments that are publicly traded, such as stocks, bonds, index funds, and exchange-traded funds (ETFs). In fact, they may prohibit you from owning anything considered an alternative asset.
With a self-directed IRA, a custodian closely oversees the account's rules and administration. They can be created for customers to own specific securities, such as precious metals like gold and silver. Other self-directed IRAs specialize in cryptocurrencies, real estate, and business opportunities.
However, the IRS prohibits certain investments in self-directed IRAs. They include life insurance, collectibles, and transactions with disqualified people, which I'll explain more about in a moment.
Therefore, you can't use SDIRA funds to buy antiques, art, or coins. You also can't do business with yourself or any close family member who could benefit from an investment, such as your spouse, child, or a fiduciary of the IRA.
For instance, you can't lend money to yourself from the account, take income from it, or
benefit from an asset in a self-directed retirement account in any way. Therefore, if you purchase real estate with SDIRA funds and use it as a vacation home for part of the year, that would be considered a self-dealing, prohibited transaction.
But you can own a rental property within a self-directed IRA and rent it to the public. However, all the income generated by the property would need to be deposited into the account.
A self-directed IRA also prohibits you from contributing your own labor to real estate owned in a self-directed IRA, like doing repairs or regular maintenance. Saving money by doing your own work isn't allowed because it's considered an indirect benefit and is deemed self-dealing.
Another rule prohibits owning a business inside a self-directed retirement account if a close relative, like your spouse, sibling, or child, owns more than 50% of it. You also can't invest in any entity where you're an officer, director, highly compensated employee, or a shareholder of more than 10%.
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What are the types of self-directed IRAs?
Just like with a regular IRA, you can choose a traditional or Roth self-directed IRA. With a traditional SDIRA, there are no income limits, and you contribute pre-tax dollars, giving you a tax deduction for the current year.
With a Roth SDIRA, you contribute nondeductible, after-tax dollars. But the advantage is that your earnings and income can be withdrawn after age 59.5 entirely tax-free, provided that you have owned the account for at least five years. If you believe you'll be in a higher tax bracket in retirement or just want more tax-free income, using a Roth is an excellent way to reduce your taxes.
Another significant advantage of a Roth retirement account is that it has no required minimum distributions (RMDs), unlike traditional accounts. When you reach age 73 (or 75 starting in 2033), you must take RMDs from any traditional self-directed or regular IRA and pay income taxes. The withdrawal amounts change annually based on your account balance and a life expectancy table published by the IRS.
However, there are no RMDs for a Roth self-directed or regular IRA. If you take distributions before age 59.5 from a traditional or Roth account that weren't previously taxed, you must pay income taxes plus a 10% penalty. Those same rules apply to self-directed accounts. That gives retirees the flexibility to take withdrawals based on their needs or to pass tax-free funds to their beneficiaries easily.
Roth accounts also allow penalty-free early withdrawals of your original contributions. For instance, if you contribute $7,000 and it grows to $10,000, you can withdraw $7,000 at any time before age 59.5. However, withdrawing your $3,000 of earnings would subject you to income taxes plus an additional 10% penalty before reaching 59.5.
While all the benefits of a Roth IRA or SDIRA are fantastic, there is an income limit that must be met to qualify for contributions. For 2025, single taxpayers with a modified adjusted gross income (MAGI) below $150,000 can contribute $7,000 or $8,000 over age 50. The limit is $236,000 for married couples filing joint taxes. (Note that the Roth income rules don't apply to workplace retirement plans or accounts designed for the self-employed.)
If you have a self-directed IRA and violate the rules, you risk losing its tax status. For a traditional SDIRA, you'd owe taxes on the entire value plus a 10% early withdrawal penalty if you're under age 59.5. For a Roth SDIRA, violating the rules means you could owe taxes and a penalty on the earnings portion of the account.
So, before making any questionable investments with self-directed funds, check with a financial or tax advisor to ensure you don't inadvertently break the account rules and put its favorable tax status in jeopardy.
READ ALSO: Think you're too rich for a Roth? Think again
What are the pros and cons of using a self-directed IRA?
Here are some advantages of investing with a self-directed IRA:
You choose and manage your own investments.
The downsides of a self-directed IRA include having to follow strict rules that you could mistakenly violate. As previously mentioned, failing to follow account regulations could jeopardize its tax status, making you liable for income taxes plus a 10% penalty on the entire account balance if you're younger than 59.5.
Another drawback of a self-directed IRA is that it typically charges higher account fees compared to a regular IRA, which can reduce your earnings. That's because there must be lots of oversight and assistance from the account custodian to ensure you follow IRS rules.
However, the most significant drawback of a self-directed retirement account is that many investments you might own in it aren't liquid. For example, you can sell a mutual fund or ETF immediately if you need income in retirement or must take an RMD from a traditional, pre-tax account.
But if you own a rental home or business venture inside your self-directed retirement account, it could take years to sell, depending on the market. The penalty for failing to take a timely RMD is a hefty 25% of the amount you should have withdrawn. However, there is an exception that reduces the RMD penalty to 10% if you correct a shortfall within two years.
The bottom line is that when you have a self-directed retirement account with alternative investments that you can't easily sell, you must create a careful strategy to liquidate them and comply with RMDs that begin after age 73. However, as I mentioned, there are no RMDs with a Roth self-directed IRA.
Other self-directed retirement accounts
In addition to self-directed IRAs, there are self-directed accounts for the self-employed that are governed by the same IRS rules as regular accounts. They include a self-directed solo 401(k) plan for small business owners with no full-time employees except for a spouse. You can also choose a self-directed SEP-IRA, a retirement plan
designed for small businesses with or without employees.
For 2025, the combined employer and employee contribution limits are $70,000 for a self-directed solo 401(k) or SEP-IRA. There is an additional $7,500 catch-up contribution allowed for solo 401(k) participants over the age of 50, bringing their total contribution to $77,500. Alternatively, starting in 2025, if you're between the ages of 60 and 63, you can contribute an additional $11,250 if the plan allows.
Many people don't realize you can also have a self-directed health savings account (HSA) that works like a regular HSA, helping you cut health care expenses–if you have an HSA-qualified health plan. Your contributions and earnings are tax-free if used for qualified expenses, like medical, dental, vision, hearing, and alternative care costs.
RELATED: How many retirement accounts can you have?
How do you open a self-directed retirement account?
You can open a self-directed IRA or other retirement plan with many banks, credit unions, or other financial institutions. Once it's open, you can roll over funds from an existing retirement account or make new contributions up to the annual limit. Then, you can purchase any asset that's allowed.
For instance, if you transferred $50,000 from a regular Roth IRA to a Roth SDIRA, you
could use the money to buy $50,000 of cryptocurrency. If its value appreciated from $50,000 to $70,000, your $20,000 gain would be entirely tax-free in retirement.
Self-directed retirement accounts can be an excellent choice for savvy investors who understand alternative investments and want more diversification, responsibility, and control than a regular retirement account. However, SDIRAs may be too advanced for novice investors, who are more suited to using a regular IRA with mainstream investments, such as index funds.
Without knowing more about Jackson's financial situation and investing experience, I'd recommend that he use a regular IRA before considering a self-directed option. If he has a workplace option, such as a 401(k) retirement plan, that's the first account I recommend maxing out annually, ideally a Roth.
For 2025, you can contribute up to $23,500 in a workplace retirement plan or more when you're over 50. Then, if Jackson has more to invest and qualifies for a regular Roth IRA, that's the next best place to invest for retirement.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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