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If you’ve ever felt trapped by the investment choices in your 401(k)… if you want to invest your retirement savings in something other than the standards (stocks and bonds)… a self-directed IRA might be right for you.

But before you go that route, you need to know about all of the potential problems that come up with these accounts – and how to avoid them. Before we dive in there, though, let’s talk how self-directed IRAs are different than regular IRAs.

IRAs: A Brief Review

Let’s start with a quick review of IRAs – individual retirement accounts.

IRAs let you stash money for retirement with special tax advantages. They come in two distinct types with very different tax situations:

Traditional IRAs, also called “regular” IRAs, give you

  • a current tax deduction for your contributions (unless your income is too high – more on that in a second)
  • tax-deferred growth inside the account (you don’t pay taxes while the account earns money through interest, dividends, and capital gains like you would in a non-retirement investment account)
  • taxable income when you eventually withdraw the money – and you do have to start taking money out when you turn age 72 in the form of required minimum distributions (RMDs)

If you earn too much to make a tax-deductible contribution, you can still put money in an IRA (by making a nondeductible contribution) and enjoy tax-deferred growth. Then when you pull the money out, only a portion of it would be taxable (instead of the whole withdrawal).

One big downside of traditional IRAs: Your money is locked up tight until you turn age 59½. If you need to pull the money out early, you may get hit with a 10% penalty plus current income taxes. (Click here to find out how the CARES Act affects IRA withdrawals.)

Roth IRAs work differently. You don’t get a tax deduction for your contributions, but you get some major benefits to make up for that:

  • tax-FREE growth
  • tax-FREE withdrawals
  • FREEdom to NOT take withdrawals if you don’t want to

Plus, because you’ve already paid tax on the money you put in, you can pull that money (just your contributions) out at any time without paying any more taxes or any penalties.

Self-directed IRAs can be either traditional or Roth.

The Self-Directed Difference

Most IRAs are held in traditional brokerage accounts that offer quick, easy access to stocks, bonds, mutual funds, and exchange-traded funds.

For some investors, those choices just don’t cut it. They want a broader range of options that includes “alternative” investments for their retirement accounts. That’s where self-directed IRAs enter the picture.

On the tax benefits side, self-directed IRAs work just like other IRAs, whether you choose traditional or Roth.

Expanded Investment Options

When you’re talking about the investment choices for self-directed IRAs, it’s easier to list the things you’re not allowed to invest in:

  • life insurance
  • collectibles (like works of art, coins, stamps, and antiques)

Everything else is fair game.

As long as you can find a custodian who accepts it, your self-directed IRA can invest in:

Basically, you can invest in anything you want except for those two prohibited options. That gives you a lot more flexibility when you’re designing your retirement portfolio, and more opportunity for diversification.

And while self-directed IRAs come with more choices, they also come with a lot more risk and a bunch of extra rules.

What to Watch Out for with Self-Directed IRAs

Self-directed IRAs are much more complicated to manage than regular IRAs.

Some issues to consider include:

  • Having to perform your own due diligence (investment homework) for every investment you choose
  • Lower liquidity, meaning it’s harder to convert many alternative assets into fast cash, and that get tricky issue when you’re trying to take your RMDs
  • Self-directed IRA accounts usually require much larger minimum investments than regular IRAs
  • There are fewer safeguards with self-directed IRAs, which can make them bad choices for newer investors
  • It’s harder to find a custodian for a self-directed IRA than for the standard variety, and they usually charge higher fees

You will want to use extreme caution when choosing your self-directed IRA custodian – there are a lot of fraudsters in this space.

Finding a Custodian for Your Self-Directed IRA

Most custodians you’ll find specialize in self-directed IRAs, and they may also sub-specialize in a particular type of asset (like real estate or limited partnerships). Most big-name providers (like Vanguard and Fidelity) don’t offer self-directed IRAs. Charles Schwab does, but their investment options are limited. You can also search through the IRS Approved Nonbank Trustees and Custodians list.

You’ll want to pay close attention to the fees associated with each custodian and each type of investment. These fees can run extremely high, and could wipe out a large portion – even all – of your earnings.

BEWARE: Con artists specifically target self-directed IRA owners with enticing investments that seem real but are really scams. To avoid being sucked in and potentially losing your entire retirement nest egg, work with a trusted financial advisor experienced in the type of investment you want to buy.

Self-Dealing Will Cost You… Big

The number one rule with self-directed IRAs: NO self-dealing.

If you cross this line with even a single toe, even by accident, all of the tax benefits will disappear and you may also be hit with substantial IRS penalties and interest.

No self-dealing means you absolutely cannot under any circumstances

  • borrow money from the account
  • sell assets to the account
  • buy assets from the account
  • interact with the assets in any way

That last one – interacting with the assets – gets a lot of people in trouble.

Here’s an example: Say you buy a residential rental property inside your self-directed IRA. One day, you drive by and realize that the flowerbed is covered in weeds, so you stop and pull them out. You just “furnished services” to your IRA asset, and that’s a prohibited transaction. If, instead, you pay a gardener out of your personal account to do the weeding, that still counts as a prohibited transaction.

Other examples of prohibited transactions when you have a self-directed IRA include:

  • Renting real estate to your parent or child
  • Using the IRA assets as collateral for a loan
  • Buying personal property (like a boat) and using it EVER
  • Buying goods or services from a company that you or any of your family members own

The IRS pays close attention to self-directed IRAs because they’re huge potential moneymakers for the agency. If they find that you’ve put even a hair across the self-dealing line, they may consider your IRA to be “fully distributed.” That means your entire IRA no longer exists—not just the related asset. You’ll have to pay current income taxes on the entire distribution (unless it’s a Roth IRA) plus a 10% penalty if you’re not age 59½ or older.

With all of the potential costs and traps, are self-directed IRAs worth it?

That depends on your specific situation and personal financial goals. But for a lot of people, the answer is YES. And if you work with an experienced, trustworthy advisor and make sure to follow all the rules, a self-directed IRA can be a very lucrative source of retirement income.

Not sure which is the best type of retirement account for you?  Learn more about all of your options  in my new book, Retirement 101.