Self-Directed IRAs (SDIRAs)

TL;DR As a startup employee, business owner or experienced investor, you likely have extra insights into emerging areas of the economy and even the opportunity to invest in them. Unfortunately, most IRA custodians won’t allow you to invest in these opportunities with your tax-advantaged IRA account. However, by setting up what is known as a “self-directed” IRA, you can use your IRA money to make alternative investments.

A Self-Directed IRA (SDIRA) enables you to invest in alternative assets not normally allowed in a tax-advantaged account. As an experienced investor, you may want to leverage the SDIRA to invest in these assets because the gains can be tax-deferred or tax-free. Let’s start with some IRA basics. 

What is an IRA?

Individual Retirement Accounts (IRA) are tax-advantaged retirement investment accounts that are held by a Custodian or Trustee (such as brokerage firms, trust companies, and banks) for the benefit of the IRA owner. 

Who should have an IRA?

Generally, all working professionals should have IRAs to grow a portion of their investments tax-deferred for retirement.

What are different types of IRAs?

There are various ways to categorize IRAs, such as regular IRAs vs. SDIRAs (we’ll get to this in more detail in a moment). 

For all IRAs, a primary distinction is between Traditional and Roth. While both types may grow tax-deferred, they are opposite regarding their income tax treatment:

• Traditional IRA contributions are generally tax deductible, so they are considered to be funded with “pre-tax” dollars. When qualified withdrawals are made, the amount withdrawn is then counted as income and taxed at ordinary income rates. Early withdrawals may be subject to an additional 10% penalty (although there are some exceptions to this).
• Roth IRAs incur no tax liability for qualified withdrawals. There is no tax deduction for contributions, so they are considered funded with “after-tax” dollars. 

To be considered a “qualified” withdrawal, you generally must have reached age 59.5, and for Roth you have to have a Roth IRA for at least 5 years.

What are the annual contribution limits for an IRA?

The annual IRA/SDIRA contribution limit for 2025 is $7k (or $8k if you're age 50+). This may be completely phased out if your income is high enough. While taxed similarly, 401k contributions have their own separate annual limits. 

How else can I fund an IRA?

Rollover

Because of the annual contribution restrictions, IRAs are often created when an employee leaves a job where they had a 401k, and the balance is rolled over from the old 401k to an IRA. The rollover maintains the tax deferred nature of the account balance, whether Traditional, Roth, or a mix of both. Because yearly IRA contributions may be limited or phased out completely, it’s often a job change that creates the funding event for an IRA.

Back Door Roth

If tax deductible Traditional IRA contributions are not allowed, you may be able to use your annual contribution limit by doing a “back door” Roth contribution. This is where a non-deductible amount is contributed to the Traditional IRA, then converted (moved) to the Roth IRA. These can be tricky, so you should work with your Financial Advisor and your Tax Advisor to make sure this doesn't go sideways. 

Mega Back Door Roth

This is similar to the Back Door Roth, but bigger, by taking advantage of higher plan limits with a 401k compared to an IRA. Be aware that not all 401k plans allow for all the steps necessary to properly use this method. If allowed by the plan, the employee starts by making non-deducted (or After Tax) salary deferrals in addition to their regular deferrals, then converting from After Tax to Roth. After leaving the employer, this extra 401k money can be rolled over to Roth IRA/SDIRA as usual. 

What is a Self-Directed IRA?

A Self-Directed IRA (SDIRA) is an IRA that you can invest in alternative assets. Although a custodian or trustee administers the account, the investments are directly managed by the account holder, which is why it’s called “self-directed”.

Historically, custodians for regular IRAs (like Fidelity and Schwab) only allow you to invest your IRA money in traditional investments (like ETFs, mutual funds, publicly listed stocks, government bonds, etc.). An SDIRA opens up the opportunity to invest into a broader set of alternative investments. Investable alternative assets for SDIRAs can include things like private companies, real estate, leveraged buyouts, cryptocurrency, and many others.

What are the restrictions with an SDIRA?

The SDIRA comes with a few additional constraints:

1. You may not invest in life insurance, S-corporation stock, or collectibles (such as art, antiques, stamps, or rare coins).
2. The “No Self-Dealing” rule prohibits any transactions between your SDIRA and yourself, your fiduciary, or members of your immediate family.
3. You may not borrow money from an SDIRA, sell property to it, use it as security for a loan, or buy personal property from it.
4. Failure to follow IRS guidelines can result in a 10% penalty, immediate ordinary income tax obligations, and closure of the account.

Functionally, how does a SDIRA work?

There are a few key players involved in an SDIRA transaction.

1. Depository account: this is where your assets are held.
2. Custodian: a bank, trust company, or other IRS-approved entity that holds title to the assets, investments, or other property and directs clients’ money (such as by issuing funds and creating accounts).
3. Administrator or Agent: a company that manages the paperwork (statements and tax reporting) associated with your retirement account, typically acting as the middleman between the account owner and the custodian. (The administrator must be affiliated with an IRA custodian.)
4. Account holder: Anybody age 18 and up (or younger with an adult involved) can open an IRA, and can contribute so long as they have “earned income”, such as wages, salaries, tips, or self-employment income.

Why should I consider a Self-Directed IRA?

Self-directed IRAs give you the ability to invest your retirement funds in assets beyond ETFs, mutual funds, stocks, and bonds.These higher risk assets can lead to greater returns which can grow tax-deferred if they’re in an IRA.

What investments make the most sense out of a Self-Directed IRA?

Real estate is the most common investment from a Self-Directed IRA. SDIRA holders can procure a residential or commercial property and achieve gains through rent and appreciation. Using leverage (mortgage) can be problematic, as it may subject the account to unexpected taxation (more on this later). While the depreciation deduction can be a valuable tool for real estate investors, it is not applicable in a tax-deferred account. You also have to be careful to avoid any personal use of the property, nor can you do any work on it yourself. Historically, real estate as an asset class returns the same (if not lower) as the S&P 500. 

Self-directed IRAs may be best utilized for investments in private tech companies. People involved in tech may have the unique advantage of understanding the various aspects of tech companies including product complexity, customer satisfaction, and market shifts. Further, private markets are currently creating significant value. As the emergence of more late-stage investors has caused some private market valuations to jump, it may be worthwhile to capture a portion of your investment gains in a tax advantaged account while the company is still private.

When someone invests capital from their IRA into a high-risk asset, they can increase the possibility of achieving higher returns. Instead of using their taxable capital (which is subject to taxes and may need to be more liquid), IRA funds give investors another pool of money to invest on a long-term schedule.

That said, with the current tax code offering 100% exemption for capital gains (up to $15 million) on qualified small business stock (QSBS), it may not make sense to angel invest through an SDIRA. Instead, SDIRA funds would be best deployed in those opportunities ineligible for QSBS treatment but still likely to produce exceptionally outsized gains if they are successful.

What are the best reasons NOT to have a SDIRA?

You might trigger current income tax for your IRA and be required to file additional tax forms. Some forms of “income” (from either business activities or debt financed activities) are taxed even when held within an otherwise tax free or tax deferred environment. Be sure to get professional guidance on dealing with Unrelated Business Taxable Income (UBTI), and Unrelated Debt-Financed Income (UDFI). 

There may be higher fees than you are used to. Annual fees, plus charges per transaction, wire transfer, and tax filing are common charges with SDIRA providers. Meanwhile, “No Fee IRAs” are common in the brokerage world. 

Since you can invest in unregulated (or lightly regulated) markets, you may be at higher risk of fraud. 

A potential lack of liquidity. The investments within the SDIRA may have long and unpredictable cycles, or no secondary market, so you may not have any influence over when your account will receive funds back. When investments close out (become liquid), the funds are transferred back to the SDIRA. However, that trait does not mean SDIRAs themselves are liquid, as withdrawal restrictions are the same as for any IRA. Plus you are still subject to Required Minimum Distributions (RMDs) at later ages, whether there is any liquid cash available to distribute or not. 

Investing in high-risk assets is risky (of course), bringing with it increased danger of loss. Instead of investing in risky assets through a SDIRA, some investors choose to invest their IRA assets in diversified ETFs, mutual funds, stocks, or bonds (where they aim for a 3-7% yearly return). If your SDIRA investments perform poorly and you wish to shift it back to a non-self-directed IRA, you can do so. Just keep in mind that there’s no way to recoup the losses from your risky investments, and you’ll also be out the time and effort of setting up and managing the SDIRA structure.

In Conclusion

Experienced investors may benefit from adding a Self-Directed IRA, and the additional investment choices available, into their wealthbuilding toolkit. Carefully weigh the increased opportunity with the increased risk, due diligence required, and avoid the tax pitfalls that can occur.