How Does a Self-Directed IRA Work?

by Sabrina Ashley ; Updated July 27, 2017


One of the best ways to save money for retirements and to save money on taxes is with an IRA or individual retirement account. The Internal Revenue Service (IRS) created these retirement plans and there are different types. The self-directed IRA allows the account owner to control all the money in the account and to make all investments decisions.

It is important to understand all the IRS rules and regulations about self-directing IRAs because these rules can be confusing.

How Self-Directed IRAs Work

The IRS established IRAs so this agency determines how the self-directed IRA plans can be set up and used. IRS requires that a trustee or custodian like a bank or trust company hold all the IRA assets on behalf of the account owner. This is done by opening an account with a trust company or a brokerage firm that offers self-directed IRAs. Each year an individual can contribute a maximum amount of money into the account. The IRS decides what the maximum contribution is. The money in the IRA account is not taxed, nor is the interest or profits made on this money taxed. The taxes on the assets into the IRA accounts are deferred until after retirement. When the individual reaches age fifty-nine and a half, he can start to withdraw the money. At that time the money withdrawn is taxed as regular income. This includes any capitol grain tax. After retirement annual income is usually lower so the individual is in a lower bracket and pays a lower tax rate. Another advantage of a self-directed IRA is that the IRS permits a wide variety of investment options. The investment choices include the traditional stocks, bond and mutual funds, but also more risky investments such as commodities, real estate, franchises, tax liens, Forex (foreign exchange) trading and mortgages. With these numerous investment choices the account owner has a more flexible and diversified portfolio and the possibility for a greater return on investment or ROI.

The Disadvantages of a Self-Directed IRA

One of the disadvantages of any IRA is that if the account owner withdraws any money before age fifty-nine and a half, there is a hefty penalty fee of 10%. The individual also pays taxes on the withdrawn money. While many investments are possible with a self-directed IRA, a few are not. Any collectibles such as antiques, paintings, stamps and coins are not permitted. There are also fees involved in setting up and maintaining a self-directed IRA. These fees vary considerably. If the IRA portfolio includes precious metals like gold or silver or real estate holdings, there are additional fees as well. Self-directed IRAs have their uses in financial planning. The best way to learn if this kind of retirement plan suits your needs is to research the subject and get advice from professionals.