Self-Directed IRA vs. Traditional IRA: What Are the Differences?

Individual retirement accounts (IRAs) are tax-deferred savings accounts intended to provide a source of income for retirement. Contributions to IRAs are made by the individual account owner and, depending on the particular type of IRA, by the individual’s employer as in the case of a SEP-IRA. The funds are held by a financial institution that invests them in traditional assets, such as stocks, bonds, and mutual funds.

Differences Between Self-Directed IRAs and Traditional IRAs

When funds are invested in a non-self-directed IRA, they are usually managed by a brokerage house that invests the funds. Of course, the account-holder can make trading decisions and direct the brokerage. The broker must also get the account holder’s permission to make trades—unless the IRA is held with a money manager who has discretionary power over the account.

With a self-directed IRA (SDIRA), which can be either a traditional IRA or Roth IRA, the account owner directs all of the investment decisions through a custodian or broker. As a result, the owner has a much greater degree of flexibility in choosing investment options. This option may also reduce the fees charged because the custodian isn’t involved in the investment transactions—only the investor.

The main difference between an SDIRA and other IRAs is the types of investments you can hold in the account. In general, regular IRAs are limited to common securities like stocks, bonds, certificates of deposit, and mutual or exchange-traded funds (ETFs).

But SDIRAs allow the owner to invest in a much broader array of assets—what are commonly called alternative investments. As such, an SDIRA requires greater initiative and due diligence by the account owner.

Not every SDIRA custodian offers the same range of investments. So, if you’re interested in a specific asset, such as gold bullion, make sure it’s part of a potential custodian’s offerings.

Remember that SDIRAs are self-directed, which means custodians aren’t allowed to give financial advice. As such, traditional brokerages, banks, and investment companies usually don’t offer them to their clients. That means you need to do your own homework. If you need help picking or managing your investments, you should plan on working with a financial advisor.

Alternative Investments for Self-Directed IRAs

Within the IRS restrictions, self-directed IRA funds may be used to invest in a diversified portfolio beyond traditional stocks and bonds. The owner of a self-directed IRA can invest in private placements, limited partnerships, tax lien certificates, and precious metals.

Self-directed IRAs cannot be used to purchase insurance instruments or collectibles.

A popular investment choice for those with self-directed IRAs is real estate. Funds from the IRA can be used to purchase a foreclosed property, for example, which will then be held in the name of the IRA custodian. The self-dealing restrictions apply, though, prohibiting the account holder from living at the property.

IRA-Prohibited Transactions

The Internal Revenue Service (IRS) creates the rules for all retirement accounts, and all IRAs are prohibited from certain transactions regardless of the specific type of IRA. Account holders cannot take a personal loan against their funds or participate in other self-dealing activities, such as business transactions in which they or family members are personally involved.

IRA Contribution Limits

The IRS has established annual limits as to how much money can be contributed to an IRA. The annual contribution limit to both traditional and Roth IRAs—including self-directed IRAs—is $6,000 for 2022 and $6,500 for 2023. Individuals who are aged 50 and over can deposit an extra $1,000 each year as a catch-up contribution.