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Self-Directed IRA (SDIRA): Every detail you need to know

Self-Directed IRA (SDIRA): Every detail you need to know

This article is for informational purposes only and does not constitute legal or tax advice.

Always consult with a tax professional for your specific circumstances.

A self-directed Individual Retirement Account (SDIRA) provides a unique approach to retirement savings, offering a broader range of investment options and greater control over your portfolio.

However, with this flexibility comes a degree of complexity and potential risks. We will unravel the ins and outs of the SDIRA, shedding light on its advantages, risks, rules, and how to set one up.

We’ll also shed light on the peculiarities of tax reporting for your Self-Directed IRA and its variants.

What is a Self-Directed IRA (SDIRA)?

A Self-Directed IRA is a type of Individual Retirement Account that allows a wider range of investment choices compared to a conventional IRA.

SDIRAs permit investment in alternative assets like private equity, real estate, tax liens, precious metals, and even cryptocurrencies.

They retain the same tax benefits as a traditional IRA, with contributions potentially tax-deductible and earnings growing on a tax-deferred basis.

NOTE! For 2024, the contribution limits are $7,000, or $8,000 for those aged 50 or older.

SDIRA investment choices

Unlike regular IRAs, where a bank or brokerage firm typically limits your investment options, SDIRAs offer an expanded investment menu. The custodian of an SDIRA allows you to invest in various alternative assets.

Some of the non-traditional assets you can invest in an SDIRA include:

  1. Cryptocurrencies like Bitcoin or Ethereum
  2. Precious metals, such as gold, silver, and palladium meeting IRS purity standards
  3. Real estate, subject to specific rules
  4. Start-up equity through crowdfunding platforms like SeedInvest, StartEngine etc.
  5. Tax liens and deeds on foreclosed properties
  6. Foreign currencies through Forex IRAs

However, investing in life insurance or collectibles (e.g., artwork, antiques, precious metals not meeting IRS purity standards) is not allowed.

Doing so treats the amount spent as a withdrawal, subjecting you to taxes and potential early withdrawal penalties.

How does a Self-Directed IRA work?

In an SDIRA, specialized custodians hold the assets within the account and ensure compliance with IRS regulations.

Unlike regular IRAs, you'll typically buy non-traditional assets on specialized exchanges that cooperate with SDIRA custodians.

This process introduces an additional layer of complexity, fees, and a marginal risk of fraud, underscoring the importance of engaging reputable dealers.

"What’s different is that the custodian of a self-directed IRA allows you to buy a variety of alternative investments." - Scott Butler, financial planner

Types of Self-Directed IRAs

Different self-directed IRAs cater to various investment needs.

Examples include:

  • Traditional SDIRA: Pre-tax contributions with tax-deferred growth, paying taxes upon withdrawal.
  • Roth SDIRA: Contributions made with after-tax dollars, allowing for tax-free withdrawals in retirement.
  • SEP SDIRA: Simplified Employee Pension IRA, ideal for self-employed individuals or small business owners, with higher contribution limits.
  • SIMPLE SDIRA: Savings Incentive Match Plan for Employees IRA, for small businesses and self-employed individuals, with an employer match component.

Benefits of Self-Directed IRAs

SDIRAs offer several advantages including the potential for higher returns, increased diversification, and customization to align with your interests and expertise.

Let’s delve into these:

1. Potential for higher returns

"In a self-directed IRA, you can invest in alternative investments, which are not permissible in a traditional IRA held by a brokerage company. You can also put your retirement money into high-risk, high-reward assets." 

Essentially, the wider range of investment options in an SDIRA, including real estate, cryptocurrencies, and private equity, can potentially yield significantly higher returns compared to traditional investment avenues.

2. Increased diversification

Diversification is crucial for managing risk in your investment portfolio. SDIRAs allow you to diversify your investments beyond traditional stocks and bonds.

This diversity can insulate your retirement savings against market fluctuations, currency devaluation, and economic downturns.

Investing in assets like real estate and precious metals, which tend to be less correlated to stock market performance, can be an effective hedge against inflation and volatile markets.

3. Alignment with personal interests and expertise

With an SDIRA, you have the flexibility to tailor your investments according to your interests and areas of expertise.

For instance, if you have extensive knowledge in the real estate market, you can leverage that experience to make informed decisions in real estate investments through your SDIRA.

Similarly, if you are well-versed in precious metals or cryptocurrencies, you can focus your investments in those areas.

4. Tax-deferred or tax-free growth

Just like conventional IRAs, SDIRAs offer tax benefits. Contributions may be tax-deductible, and earnings grow on a tax-deferred basis in a traditional SDIRA.

In the case of a Roth SDIRA, contributions are made with after-tax dollars, and earnings can be withdrawn tax-free during retirement. This can be particularly advantageous if you invest in assets that appreciate significantly over time.

5. Estate planning

An SDIRA can be an effective tool for estate planning. With proper planning, you can use an SDIRA to leave a legacy for your heirs.

Since SDIRAs allow investments in tangible assets like real estate and precious metals, these can be inherited and possibly continue to appreciate in value for the benefit of your loved ones.

Risks & considerations

Despite the potential benefits, there are risks associated with SDIRAs:

  1. Reduced liquidity: Investments like real estate or precious metals can take longer to sell.
  2. Increased fees: SDIRAs often come with additional account-related fees based on the assets you invest in.
  3. Limited protection: Custodians are typically not responsible for investigating the quality or legitimacy of the investments.
  4. Risk of IRS rule violations: There are strict rules regarding what investments you can hold in an SDIRA, and non-compliance can attract severe penalties.

Setting up an SDIRA

Here is a step-by-step guide to setting up a Self-Directed IRA:

  1. Find a custodian: Seek an IRS-approved custodian specializing in holding alternative assets.
  2. Fund the account: Rollover funds from an existing retirement account or make a contribution.
  3. Select investments: Choose the alternative investments you wish to purchase.
  4. Instruct the custodian: Give the custodian instructions to purchase the investments on your behalf.
  5. Manage & monitor: Regularly review the performance of your investments and make adjustments as necessary.

Tax reporting for your Self-Directed IRA

An essential aspect of managing a Self-Directed IRA is understanding the tax reporting requirements. Depending on your SDIRA investments, you may be required to file specific tax forms with the IRS for your IRA’s investments.

Let’s look at some of these forms and the circumstances under which they are necessary:

1. Form 5498: IRA Contribution Information

This form is used to report contributions made to your IRA, including a Self-Directed IRA. Your custodian will usually file Form 5498 for you. It reports the annual contributions, rollovers, and the fair market value of the account.

2. Form 1099-R: Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

If you take a distribution from your SDIRA, the custodian must report this distribution to the IRS using Form 1099-R. This form is essential for tracking distributions that may be subject to taxes and penalties if taken before the age of 59½.

3. Form 1065: U.S. Return of Partnership Income

If your SDIRA is invested in a partnership or a multi-member LLC, the entity typically must file a Form 1065. This form reports the partnership's income, deductions, and other financial information.

Although your SDIRA itself does not pay taxes on its share of income, Form 1065 is necessary for the IRS to ensure that individual partners are reporting their income correctly.

4. Form 990-T: Exempt Organization Business Income Tax Return (UBIT)

In some instances, your SDIRA may generate Unrelated Business Income (UBI). When this happens, your SDIRA could be subject to Unrelated Business Income Tax (UBIT), and you must file Form 990-T.

This could occur if your SDIRA is invested in an active trade or business, or if it has used debt financing to purchase an investment.

Specifics of each form

  • Form 5498: Custodians typically file this in May, and it's not required to be filed with your personal tax return. It is, however, vital to ensure that your contributions are accurately reported.
  • Form 1099-R: If you took distributions, ensure that you receive this form from your custodian. The distributions must be reported on your tax return, and the form should be provided by the end of January.
  • Form 1065: This form is typically due on March 15th for partnerships. As an SDIRA holder, you should receive a Schedule K-1 from the partnership which reports your share of the income or loss.
  • Form 990-T: This form must be filed by April 15th if your SDIRA has generated more than $1,000 in UBI. Consulting a tax expert is recommended as this can be complex.

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Bottom Line

A Self-Directed IRA can be a powerful tool for retirement savings, providing enhanced control and diversification. However, while they can be an excellent tool for diversification and potentially higher returns, it's vital to consider the complexities and risks involved.

It is essential to understand the obligations and work closely with your custodian.

In many cases, consulting a tax pro is prudent. As Benjamin Franklin famously said, "An investment in knowledge pays the best interest."

Investing time in understanding the tax aspects of your SDIRA can reap benefits in efficiently managing your retirement investments.

Ines Zemelman, EA
Founder of TFX