How Self Directed IRAs Work

Pensions are becoming rare, making IRAs and company-sponsored investment plans essential for retirement planning. The challenge is that most accounts include significant restrictions on how you can invest contributions. For example, company-sponsored plans, like 401ks, tend to offer a dozen or so mutual funds, making it difficult to diversify adequately. Personal IRAs expand the list to hundreds of mutual funds and ETFs along with publicly traded stocks and bonds. But what happens when you want to participate in investments outside of the stock market?

The original legislation created IRAs (individual retirement accounts) in 1974 and never limited investments to the stock market. Even though the law allowed self-directed IRAs from the beginning, the concept of using retirement funds for alternative investments did not catch on until after 1996, when non-bank custodians began to emerge. Today, self-directed IRAs are a popular way to broaden portfolios beyond the stock market while retaining IRA tax benefits.

The Difference Between a Conventional and Self Directed IRA

Banks and financial institutions are the custodians of conventional IRAs. Financial institutions allow you to invest in CDs and publicly traded stock market products such as mutual funds, ETFs, stocks, and bonds.

Alternative investments, which can include assets such as hedge funds, cryptocurrency, or real estate, require a self-directed IRA held by a non-bank custodian.

Types of Self Directed IRAs
Like conventional IRAs, you can choose between a Traditional or Roth. Once opened, you may transfer some or all of the funds into a self-directed IRA without creating a taxable event.

Traditional IRAs typically involve pre-tax dollars and grow tax-deferred, whereas Roth IRAs use after-tax dollars and grow tax-free. The most common IRA is the traditional, partly because most 401ks and company-sponsored accounts involve pre-tax dollars and convert to a traditional IRA when rolled over.

Regardless of which IRA account you choose, you can qualify for tax-preferred treatment provided you follow IRS rules.

Rules Applying to Traditional IRAs include:

  • Income restrictions for traditional IRAs determine whether contributions are tax-deductible.
  • You may be able to contribute even if you have a work-sponsored retirement account.
  • Maximum annual contributions in 2022 is $6,000, with $1,000 catch-up contribution for those over 50. The IRS does not count rollovers toward the annual contribution.
  • Limitations on withdrawals before 59 ½.
  • If you don’t meet a qualifying exception, the IRA could charge a 10% penalty on funds withdrawn before 59 ½.
  • Mandatory distributions start at 72.
  • Tax-deferred gains. Taxes are due in the year of a withdrawal.
  • Can make contributions to the account until the tax filing date the following year.

Rules Applying to Roth IRAs include:

  • Income restrictions for Roth IRAs determine if you qualify to contribute. In 2022, single filers can earn up to $140,000, and married couples filing a joint return can earn up to $214,000.
  • May contribute even with a work-sponsored account.
  • Maximum annual contributions for 2022 is $6,000, with $1,000 catch-up contribution for those over 50. Rollovers do not count toward the maximum annual contribution.
  • Tax-free growth and withdrawals in retirement.
  • Limitations on withdrawals. You must reach 59 ½ and have the account open for a minimum of five years for tax-free withdrawals.
  • Can withdraw contributions prior to 59 ½ without incurring a penalty.
  • Can make contributions to the account until the tax filing date the following year.
  • No mandatory distributions.

Tax Benefits of Self-Directed IRAs

Self-directed IRAs allow you to put money in alternative investments like real estate without forfeiting the tax benefits. To learn more about how to participate in commercial real estate syndications with IRA dollars, in our introductory video.

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