What is a self-directed IRA and how does it work?

A self-directed individual retirement account (SDIRA) is a type of retirement account that allows you to invest in a wider range of assets compared to a conventional IRA, where the account custodian usually limits you to approved asset types. This additional flexibility unlocks options to diversify your retirement investments with alternative assets such as real estate or precious metals.

With an SDIRA, you are in complete control of your investment strategy, but there's also added risk and complexity. "I, generally speaking, don't advertise self-directed IRAs because the potential to get yourself into trouble is quite high," says Rick Nott, certified financial planner (CFP) and senior wealth advisor at LourdMurray. A self-directed IRA has nuanced rules and if you don't closely follow them it can create issues come tax time.

Below, CNBC Select shares the details on how self-directed IRAs work and when it makes sense to consider this type of account for your retirement investments.

What is a self-directed IRA?

Self-directed IRA eligibility

Self-directed IRA pros and cons

Why a regular IRA is more than enough for most people

Bottom line

A self-directed IRA is a type of IRA that can be used to invest in alternative assets. An SDIRA can be set up as a traditional IRA or a Roth IRA. The standard IRA contribution limits and tax advantages apply to self-directed IRAs. With a traditional SDIRA, the contributions you make into the account are tax deductible and you pay taxes on the eligible withdrawals. A Roth SDIRA is taxed in an opposite manner, contributions are not tax deductible, but eligible withdrawals aren't taxed.

What's different with an SDIRA is what you can invest in, and that provides potential benefits and complications for investors. You can use the money from a self-directed IRA to invest in precious metals, cryptocurrencies, real estate and shares of a private company. However, these types of investments come with complex guidelines you'll have to navigate.

For example, you might want to purchase gold, silver or platinum coins with SDIRA funds and keep these coins within your SDIRA as an investment. But purchasing precious metals with an SDIRA account could be considered a taxable withdrawal if the metals are classified as a collectible by the IRS.

This level of nuance means that if you insist on using a self-directed IRA, you should definitely work with a financial advisor and tax professional to help you make sense of the consequences of your investment choices.

The eligibility requirements for contributing to a self-directed IRA are the same as they are with other types of IRAs.

The 2023 IRA annual contribution limit is $6,500 for individuals under 50 and $7,500 for those over 50 years old. These limits don't apply to rollover contributions.

How much you can contribute to a Roth individual retirement account (or whether you can contribute at all) depends on your filing status and modified adjusted gross income (MAGI) for the year.

You can contribute the full amount to a Roth IRA if your MAGI is:

• Less than $138,000 for individual filers
• Less than $218,000 for married filing jointly or qualified widower

You can contribute a reduced amount to Roth IRA accounts if your MAGI falls into these ranges:

• $138,000 or more and less than $153,000 for individual filers
• $218,000 or more and less than $228,000 for married filing jointly or qualified widower

You are unable to make Roth IRA contributions if your MAGI is:

• $153,000 or more for individual filers
• $228,000 or more for married filing jointly or qualified widower

You can get extremely creative with self-directed IRA investments. For example, with standard IRAs, you can indirectly invest in real estate by purchasing shares in a real estate investment trust (REIT). However, a self-directed IRA allows you to directly purchase and own investment property within the IRA. This can give a big boost to your retirement savings if that property increases in value and you sell it since the proceeds from the sale stay in the SDIRA and enjoy tax benefits.

The downside is, the rules for owning real estate in a tax-advantage account are more complicated than simply owning a property. You aren't allowed to receive any benefit from real estate held within an SDIRA, so you and your family can't live on the property. And any repairs or maintenance must be paid for with funds from the IRA. So, for example, if you need to replace the front door, the money for the repair needs to come from the IRA. "If you were to use ... your personal non-IRA money to then buy that front door, then you effectively are contributing to your IRA," Nott says.

Pros

• Greater control of investment decisions
• Higher potential returns
• More options for diversifying investments

Cons

• Can be extremely complicated
• Less liquidity
• Greater potential risk

A self-directed IRA has potential advantages for an extremely sophisticated investor. But for an average person, even one who has CNBC on the TV 24 hours a day, the potential benefits of investing in a self-direct IRA compared to a standard IRA aren't typically worth the risks and complications.

With a standard traditional or Roth IRA, you can invest in stocks, bonds, CDs, mutual funds, ETFs, index funds, REITs and more. These options can help the majority of investors reach their retirement goals with a fraction of the effort required to (successfully) manage a self-directed IRA.

For example, the popular robo-advisor Wealthfront is CNBC Select's best Roth IRA for hands-off beginner investors because of how easy it is to set up and maintain. Wealthfront helps you create a personalized portfolio and automatically rebalance your investment allocations.

A self-directed IRA is a tax-advantaged account that gives you more freedom compared to an IRA managed by a broker but also comes with a much greater chance of ruining your retirement savings. For most people, the investments available with a traditional IRA or Roth IRA will suit your needs without the pitfalls that come with managing a self-directed IRA.

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