Self-directed IRAs (SDIRA) allow you to invest in almost anything that’s investible — you’re not limited to standard investments such as stocks or bonds. You can invest in a wide variety of alternative assets that typically fall outside what most financial institutions are able to handle.

Here are the key things to know about self-directed IRAs and where some investors might get tripped up.

What is a self-directed IRA?

A self-directed IRA is like a typical IRA in almost every way, with the major difference being what it can invest in. Investors can choose between two major types:

  • Traditional IRA: This type of IRA allows you to invest cash on a pre-tax basis, meaning that you may be able to avoid paying taxes on any contributions. You’ll be able to grow your investments tax-deferred. When you withdraw money at retirement (defined as age 59½ or older), you’ll pay tax on the withdrawals at ordinary income rates.
  • Roth IRA: This type of IRA allows you to invest cash on an after-tax basis, meaning that you’ll pay taxes on any contributions before they go into the account. You’ll be able to grow your investments tax-free, and when you withdraw your money in retirement you won’t be subject to any taxes on the withdrawals.

Regardless of which kind of IRA you choose, your annual contribution is capped. For 2024, the maximum annual contribution to your IRA is $7,000.

If you’re looking for someone else to manage your IRA, you can hire a human advisor or a top robo-advisor to make the decisions for you. They’ll determine a portfolio strategy and invest in typical financial assets like stocks, bonds, mutual funds and ETFs, among others. That assortment of assets can offer you a diversified portfolio that can offer strong long-term profits.

But if you’re looking for a self-directed IRA, you want to make the investment decisions yourself. And here’s where the self-directed IRA really allows you to go anywhere.

Self-directed IRA investment options

A self-directed IRA can invest in assets that are well beyond the traditional stocks, bonds, funds and more that are available at a top online brokerage, and that’s the key advantage for investors looking to use a self-directed IRA.

A self-directed IRA can invest in the usual range of financial investments, but also allows you to invest in the following alternative assets:

The list of acceptable investments could go further if you can find an IRA custodian who’s willing to work with you (more below).

Despite the broad list of possibilities, the IRS does not allow you to invest your self-directed IRA in everything. It specifically forbids investing in life insurance and collectibles, which it defines as art, antiques, rugs, gems, coins, stamps and alcoholic beverages.

How to set up a self-directed IRA

If you’re looking to set up a “go anywhere” self-directed IRA, you’ll need to contact a custodian who specializes in these kinds of structures. Even the top brokers for IRAs don’t usually offer the ability to invest in alternative investments.

Here’s how to set up a self-directed IRA:

  1. Research self-directed IRA custodians. You’ll need to look around for a custodian who supports “go anywhere” self-directed IRAs that allow investments in the types of investments that you want to buy. As part of the process, pay particular attention to any fees you may have to pay. Custodians may charge a setup fee and ongoing annual fees, in comparison to the top brokers for traditional investments that charge no fees.
  2. Set up an account and pay any fees. Once you’ve found a custodian that meets your needs, set up your account and pay any fees for establishing the account.
  3. Make your contribution. Once you’ve created an account, you’ll need to deposit money so that you’re able to make investments.

You’ll want to carefully consider whether the extra fees charged by a custodian make sense, especially if you’re starting out with a small amount of money. Those who are rolling over a larger account can spread out the fees over their greater base of assets.

Pros and cons of a self-directed IRA

A self-directed IRA can open up the investible world to you, but it’s not without significant risks and downsides. Here are the advantages and disadvantages of using a self–directed IRA.

Advantages of a self-directed IRA

  • Complete control. Your success (or failure) depends on the investment selections you make.
  • Potentially higher returns. If you know a way to profit that’s a bit off most investors’ radar, you can take advantage of it and may earn higher rewards than in traditional investments.
  • Diversification. Nontraditional assets may provide diversification from regular investments, offering your portfolio lower risk and higher return.
  • It can be more enjoyable. With more investing choices, you may be able to invest in something that you enjoy more or have more knowledge of.

Disadvantages of a self-directed IRA

  • Complete control. Yes, complete control is both an advantage and a disadvantage. Your success depends completely on your choices, so you need to know what you’re doing.
  • Fees. Firms offering you access to alternative investments may charge significant fees, making it less cost-effective — even prohibitive — for small accounts to use them.
  • Liquidity. If you’re investing in traditional assets, you can sell them on virtually any day the market is open. Alternative investments such as real estate may take months or years to sell, and even then you may not be able to do so.
  • Need to take distributions. The lack of liquidity can create legal problems if you need to take distributions from your account in retirement. You may be forced to sell an asset when it’s down just to meet a required minimum distribution, for example.
  • IRA rules on prohibited transactions. You must scrupulously follow the rules for your IRA, or you can run into a whole heap of IRS penalties. For example, if you invest in real estate, you may not use that property for your own interest; it’s an investment. So you cannot reside in the property or you break the rules. You’re also not allowed to provide services to the IRA, including on real estate that you own. Fix that broken toilet yourself? You’ve just broken the rules. A self-directed IRA is like a third party that must cover everything. The IRS offers a list of other things that qualify as prohibited transactions.

Bottom line

Self-directed IRAs can make a lot of sense for certain types of investors who want and are able to do the extra legwork that’s necessary to manage their own retirement account. But others will be deterred by the extra fees and general hassle of this process and are likely better off sticking to traditional financial investments, which offer a strong track record of solid returns and low costs.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.