What Is a Self-Directed IRA and How Does It Work?

A self-directed IRA is a tax-deferred retirement account for those who want more control than a regular IRA affords. Whereas a normal IRA has a fairly standard set of investment opportunities, a self-directed IRA lets you use alternative investments too. These could include real estate, commodities, private placements and more. This approach requires a bit more investing know-how, though its potential returns could be greater than index-related investments.

If you have questions about self-directed IRAs or other retirement accounts, you may want to consult a financial advisor.

How a Self-Directed IRA Works

A traditional IRA lets you save for retirement with money you can deduct from your taxable income when you file your annual returns. This also means you don’t have to pay income taxes on the money you take out until you retire. Roth IRAs are the opposite, meaning you pay taxes on that money now, but withdrawals are tax-free.

Usually traditional IRA holders stash their contributions in something dependable like mutual funds, target-date funds or exchange-traded funds (ETFs). These are essentially pre-diversified investments that allow you to mitigate risk and earn generally reliable returns. Some IRAs may also feature other investment options, like stocks and bonds.

A self-directed IRA offers the same tax perks as a traditional IRA, and they also come in a Roth variation. However, self-directed IRAs give account holders much more control over their investments. So if you want to get into the commodities game, or invest in private equity and real estate, a self-directed IRA could be right for you. A normal IRA would restrict you from these types of investments.

Self-Directed IRA Tax Rules

If you go the self-directed IRA route, be sure to follow IRS rules, or you’ll risk losing the tax-deferred benefits of your IRA. In fact, that’s one of the reasons some people avoid this type of IRA. If you think you might have a hard time figuring out and complying with the many regulations surrounding self-directed IRAs, you might be better off sticking with a traditional IRA through a brokerage.

A brokerage for a regular IRA would send you a tax statement every year. With a self-directed IRA, your tax prep is, well, self-directed. You also have to keep track of what’s allowed under IRS rules. For example, you can’t invest in a rental property that you live in or collectibles. If you break these rules, you may be at risk of your balance becoming taxable all at once.

Self-directed IRAs are subject to the same rules as traditional IRAs when it comes to early withdrawals. The most important among these is the early withdrawal penalty from the IRS. In short, you cannot withdraw from a self-directed IRA before turning 59.5, since it’s a tax-deferred retirement account. If you withdraw before that age, the IRS will tack on a heft 10% penalty. In other words, keep your money in your account until you retire at all costs.

Contribution Limits for Self-Directed IRAs

Another important rule to follow when managing your self-directed IRA is to abide by the contribution limits set by the IRS. These typically change every year to account for inflation. For both 2025, the annual IRA contribution limit is set at $7,000.

If you’re 50 or older, though, the IRS will let you contribute a bit more. These are called “catch-up contributions,” and they’re limited to $1,000 for 2025. In other words, you can contribute up to $7,000 if you’re at least 50 years old.

Should you exceed the aforementioned contribution limits, the IRS will hit you with a penalty tax rate of 6%. This rate applies for every year that you leave the excess contribution in your IRA. In order to avoid this rate, you’ll need to withdraw the excess funds, as well as any returns they may have earned.

Risks Associated With Self-Directed IRAs

The U.S. Securities and Exchange Commission (SEC) recently issued an investor alert concerning fraud risk in self-directed IRAs. According to an SEC report, some self-directed IRA custodians misrepresent their custodial duties and deceive investors. They may mislead investors as to the nature of alternative investments like metals and real estate, and promise returns that are uncertain or even impossible. Regulators have sued some self-directed IRA custodians for running Ponzi schemes, duping investors into investing in unregulated securities, committing other forms of fraud and using investor funds for living expenses.

If you’re not deterred by these risks, it’s important to do due diligence when shopping for a self-directed IRA custodian. Check the licensing and registration of the investors against SEC or state regulatory resources. Be wary of investment promises that sound too good to be true, or sketchy offers and tips from strangers.

How to Open a Self-Directed IRA

The first step to open a Self-Directed IRA is selecting a qualified custodian. Not all financial institutions offer Self-Directed IRAs, so it’s important to research custodians that specialize in these accounts. Look for a custodian with a solid reputation, transparent fee structures, and experience handling the types of investments you’re interested in. The custodian will be responsible for holding your IRA assets and ensuring your account complies with IRS regulations.

Once you’ve chosen a custodian, you’ll need to complete an application to establish your Self-Directed IRA. This process typically involves providing personal identification, selecting the type of IRA (traditional or Roth), and designating beneficiaries. Your custodian will guide you through the paperwork and help you understand any specific requirements or documentation needed for your chosen investments.

After your account is set up, you can fund your Self-Directed IRA through a contribution, transfer, or rollover from another retirement account. Each funding method has its own rules and potential tax implications, so it’s wise to consult with a financial advisor or tax professional before moving large sums. Make sure you stay within annual contribution limits to avoid penalties.

Bottom Line

If you’re a real expert in real estate, metals or private equity, using a self-directed IRA can let you put your knowledge to work for you and grow your retirement savings. A self-directed IRA lets you explore off-the-beaten-path retirement investment areas while still enjoying the tax-deferred growth that makes traditional IRAs so attractive. However, because self-directed IRAs carry more risk, they’re probably best used in combination with another retirement savings vehicle, or not at all, if you’re skittish.

Retirement Savings Tips

Saving for retirement is one of the most important financial ventures you’ll ever encounter. If you have questions about retirement planning, consider speaking with a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goal, get started now.
If your company offers one, consider taking advantage of a 401(k) along with your IRA. Use SmartAsset’s 401(k) calculator to get an idea of what kinds of returns you could see from one.