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A Guide to Self-Directed IRAs

A self-directed IRA allows investors to hold unique and varied investment options inside a retirement account. Unlike traditional IRAs or Roth IRAs, which often consist of stocks and bonds, a self-directed IRA provides a broader selection of investment options. "The account owner is the person who is managing the account, and therefore they must take on the responsibility of due diligence and ongoing management of the underlying assets," says Cassandra Kirby, a partner and wealth advisor at Braun-Bostich & Associates in Pittsburgh. "You should be a pretty knowledgeable investor to open and manage a self-directed IRA, and you should also be aware of the risks associated with the underlying investments."

What Is a Self-Directed IRA?

In some ways, a self-directed IRA is like a traditional IRA or a Roth IRA. The account is designed to provide tax advantages, and participants must follow the same eligibility requirements and contribution limits. The maximum contribution limit for 2021 is $6,000, or $7,000 if you're age 50 or older. You'll be able to start withdrawing funds without penalty when you are 59 1/2 years old.

The difference lies in the type of investments you can hold in the account. While a traditional IRA or Roth IRA might be used to invest in CDs or mutual funds, a self-directed IRA can be invested in many other alternatives.

Funds in a self-directed IRA might be used for:

-- Real estate.

-- Undeveloped or raw land.

-- Promissory notes.

-- Tax lien certificates.

-- Gold, silver and other precious metals.

-- Cryptocurrency.

-- Water rights.

-- Mineral rights, oil and gas.

-- LLC membership interest.

-- Livestock.

[Read: IRA Contribution Limits for 2021.]

How to Open a Self-Directed IRA

A self-directed IRA is not a plan you manage completely on your own. "Self-directed IRAs require you to utilize the services of a third party, often referred to as a custodian or trustee," says Brian Stivers, president and founder of Stivers Financial Services in Knoxville, Tennessee.

To open a self-directed IRA, you can take the following steps:

1. Find a custodian or trustee for the account.

2. Select the investments you would like to make.

3. Carry out any due diligence needed for the investment.

4. Find a broker to purchase the investment.

5. Ask the custodian or trustee of the account to carry out the desired transaction.

Some institutions that offer other types of IRAs may not provide a custodian service for self-directed IRAs. Organizations that offer custodians for self-directed IRAs include The Entrust Group, Equity Trust, Madison Trust and Millennium Trust Company. There are usually fees involved for establishing and monitoring the IRA funds.

Every transaction requires a process, and a self-directed IRA is usually used for long-term investments. "Investors should be aware that these types of investments tend to be less liquid," says Chris Kampitsis, a certified financial planner for Barnum Financial Group in Elmsford, New York. "They are not typically entered and exited with the click of a mouse within the trading day."

Advantages of Self-Directed IRAs

Investing through a self-directed IRA provides several unique perks that can help bolster your retirement savings. The key advantages of a self-directed IRA are:

-- Greater flexibility in the investments you're able to hold in the account.

-- Built-in tax breaks on the earnings from your investments.

-- The opportunity to make investments that line up with your passions, knowledge or experience.

-- The chance to diversify funds by keeping some money in a self-directed IRA and other funds in traditional investment accounts or other retirement accounts.

-- The option of selecting investments that may have higher potential for appreciation.

[Read: How to Open a Roth IRA.]

Disadvantages of Self-Directed IRAs

Even if you thoroughly research an asset before investing in it through a self-directed IRA, the stakes can be high. Some of the main disadvantages of self-directed IRAs include:

-- You can't invest in collectibles, life insurance or real estate you live in.

-- The investments tend to have higher risk.

-- The account maintenance fees can be relatively high.

-- The record keeping and tax reporting requirements are complex.

-- The IRS prohibits various types of transactions.

-- You'll have to pay penalties or taxes if certain IRS guidelines aren't followed.

Traditional Versus Roth Self-Directed IRA

When you set up a self-directed IRA, the account can be traditional or Roth. Both types of accounts offer tax advantages, but there are several differences. With a traditional self-directed IRA, you may be able to take a tax deduction on the contributions to the account. When you take out distributions later, the withdrawals will typically be taxed as ordinary income. If you opt for a Roth self-directed IRA, the contributions you make won't qualify for tax deductions, but when you withdraw funds later, the distributions will be tax free.

[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]

How to Tell if a SDIRA Is Right for You

Since you'll direct many of the decisions of the account, including managing paperwork, transactions and communicating instructions, a certain level of dedication is needed. "A self-directed IRA can be appropriate for the more aggressive investor," Stivers says. It may also work well if you are specialized in an industry. If you have spent a career in real estate or have been involved in equity and company funding for decades, a self-directed IRA might be a solid fit.

Before making an initial investment in a self-directed IRA, you'll want to weigh the potential and risk involved. "Make sure you feel comfortable with any investment you make," Stivers says. "Take no more risk than you have to in order to achieve your needs, goals and dreams in retirement."