How a Self-Directed 401(k) or IRA Works

The self-directed individual retirement account (SDIRA) is for investors who are determined to go beyond the usual investments that are available for retirement accounts—way beyond, in some cases.

Self-directed retirement accounts are available from most banks, brokerages, and other financial institutions. They offer a wide range of individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and index funds. Investors can choose a conservative bond fund or an aggressive stock fund, and there are plenty of choices in between. Some offer alternative investments like cryptocurrency or mineral rights.

The self-directed IRA is for those who demand access to a wider range of investments in their retirement savings. And, they want total control over the buy and sell decisions.

What Are Alternative Investments?

Self-directed IRAs are in most ways similar to other individual retirement accounts (IRAs), meaning they have tax advantages designed to encourage Americans to save for retirement. As a result, the Internal Revenue Service (IRS) gets some say in what an IRA can and cannot be invested in, which includes some of the riskiest alternatives to the usual stock and bond funds.

The IRS currently permits self-directed IRAs to invest in real estate, development land, promissory notes, tax lien certificates, precious metals, cryptocurrency, water rights, mineral rights, oil and gas, LLC membership interest, and livestock.

Who Wants a Self-Directed IRA?

The self-directed IRA (SDIRA) might appeal to an investor for any of several reasons:

• It could be a way to diversify a portfolio by splitting retirement savings between a conventional IRA account and a self-directed IRA.
• It could be an option for someone who got burned in the 2008 financial crisis and has no faith in the stock or bond markets.
• It may appeal to an investor with a strong interest and expertise in a particular type of investment, such as cryptocurrencies or precious metals.

In any case, a self-directed IRA has the same tax advantages as any other IRA. Investors who have a strong interest in precious metals can invest pre-tax money long-term in a traditional IRA and pay the taxes due only after retiring.

The self-directed aspect may appeal to the independent investor, but it's not completely self-directed. That is, the investor personally handles the decisions on buying and selling, but a qualified custodian or trustee must be named as administrator. Otherwise, it's not an IRA as the IRS defines it.

The administrator is usually a brokerage or an investment firm.

How a Self-Directed IRA or 401(k) Works

Self-directed IRAs are held by a custodian chosen by the investor, typically a brokerage or investment firm. This custodian holds the IRA assets and executes the purchase or sale of investments on the investor's behalf.

If you are offered the option of a self-directed 401(k) by an employer, the custodian would be the plan administrator. The same contribution limits apply as for regular IRA and 401(k) plans. In 2022, the maximum IRA contribution is $6,000, plus a $1,000 catch-up contribution for those aged 50 or above. In 2023, the IRA limit go to $6,500 plus the $1,000 catch-up contribution.

The maximum annual contribution for 401(k) plans is $20,500 for 2022 (increasing to $22,500 for 2023), plus a $6,500 catch-up contribution for each year for those aged 50 and older (increasing to $7,500 in 2023).

The withdrawal rules are also the same. A withdrawal made from any traditional IRA or 401(k) prior to age 59½ will trigger a 10% early-withdrawal penalty unless an exception applies.

Required minimum distributions (RMDs) begin in the year a person turns age 73 as of Jan. 1, 2023.

Roth Option

For those who choose the Roth option for a self-directed IRA or 401(k), the rules are mostly the same, except that there are no required minimum distributions at any age. The investor pays the taxes on the income in the year the money is invested, and the entire balance is tax-free when money is withdrawn in retirement.

Checkbook Control

A self-directed IRA has the option of a checkbook IRA, which essentially acts as a commercial bank account. A limited liability company (LLC) is established and owned by the IRA and the IRA owner can have a business checking account linked to the IRA funds. The IRA owner manages the LLC and controls the checkbook.

The checkbook control IRA gives the IRA owner the control of writing checks directly from the IRA for various purposes, including investments, such as purchasing real estate. A checkbook IRA helps streamline the payment process by eliminating delays since owners can write check themselves versus waiting for the custodian to make payments out of the account. The checkbook IRA can also lower transaction fees since the custodian isn't involved in the payment.

However, not all retirement account providers offer an SDIRA with checkbook control. Also, please consult a tax advisor to determine if a self-directed IRA with the checkbook option is appropriate for your financial situation.

Risks of a Self-Directed 401(k) or IRA

The U.S. Securities and Exchange Commission has warned that investors in self-directed IRAs may be subjected to "fraudulent schemes, high fees, and volatile performance."

Investors also have to be wary of accidentally violating the complicated IRS rules for self-directed IRA investments. Some of these rules specifically ban:

• Receiving money directly from an income-producing property in the IRA or 401(k)
• Using real estate held in the account as collateral for a personal loan
• Using property or other investments in the account in a way that benefits you personally
• Borrowing money from the account to repay personal loan obligations or lend to a disqualified person
• Allowing disqualified individuals to maintain a residence in a property owned inside the 401(k) or IRA
• Selling or leasing property within the account to a disqualified person

A disqualified person is a fiduciary of the plan, a person who provides services to the plan, and any other person or entity that may have a financial interest. That includes yourself, your spouse and heirs, the account beneficiary, the account custodian or plan administrator, and any company in which you own at least 50% of the voting stock, directly or indirectly.

If the IRS determines that a prohibited transaction has occurred, your account automatically loses its tax-advantaged status. All the money that you've invested into a self-directed 401(k) or traditional IRA will be treated as a taxable distribution, leaving you with a big tax bill.

The Bottom Line

The self-directed IRA isn't for everyone. It's for the person who has little or no faith in the professionals and plenty of confidence in his or her own ability to make the right choices about investing. It's also for those who are frustrated by the standard choices available in conventional IRAs, which may seem too conservative for some investors.

If you decide to go out on your own, be aware that the usual fraudsters and fee hogs are waiting for you. Reading the fine print is especially important when it's your retirement fund that's at stake.