How Does a Self-Directed Individual Requirement Account (SDIRA) Work?

Self-Directed IRAs (source: ramseysolutions.com)

With extensive experience as an electrical/software/coding engineer along with having a diverse financial background, Thomas Wettermann’s areas of interest include Machine Learning (ML), artificial intelligence (AI), and Financial Technology (FinTech). For the past few years, Thomas Wettermann has focused on the underlying technologies that support and promote all phases of cryptocurrency, Web 3.0, and metaverse ecosystems.

What Is an Individual Retirement Account (IRA)?

An Individual Retirement Account (IRA) is a tax-advantaged retirement savings account. It is an account that must be established at a financial institution, like a bank, a brokerage, or a mutual fund company. A custodian must hold an IRA on behalf of an individual where these retirement investments grow on a tax-free or on a tax-deferred basis. All custodians must be approved by the Internal Revenue Service (IRS).

There are two types of conventional IRAs. There is the traditional IRA where contributions to the account are made with pre-tax dollars. And there is the Roth IRA where contributions to the account are made with after-tax dollars. Both the traditional IRA and the Roth IRA have their own rules and restrictions regarding fund accessibility, tax consequences, and eligibility.

What is a Traditional IRA?

Contributions to a traditional IRA are tax-deductible but there are strict eligibility requirements. These requirements are mandated by the IRS and are based on an investor's income, filing status, and availability of other retirement plans. Transactions in the account, including interest, dividends, and capital gains, are not subject to tax while the funds remain in the account. However, when funds are withdrawn from the account, withdrawals are subject to federal income tax. Investors might find traditional IRAs beneficial if their tax rate in retirement might be lower than when contributions are made.

What is a Self-Directed Individual Requirement Account (SDIRA)?

A Self Directed Individual Requirement Account (SDIRA) is an IRA type that must be set up as a conventional IRA, that is, either a traditional IRA or a Roth IRA. Whether you select either a traditional or Roth IRA for your SDIRA, the same limitations and eligibility guidelines apply to SDIRAs as conventional IRAs.

An SDIRA allows the account holder to invest in alternative assets for retirement savings. For example, these alternative assets may be real estate, precious metals (gold and silver), private equity, commodities, or digital assets (such as cryptocurrencies).

Importantly, SDIRAs have the same contribution and income limits as conventional IRAs. All individual retirement accounts including SDIRAs are covered under Internal Revenue Code 408.

How Does an SDIRA work?

The IRS requires custodians or trustees to hold all SDIRA accounts. Therefore, it is always best to fully investigate your options and your requirements before opening an SDIRA.

A self-directed IRA includes complex rules and presents potential risks, especially for the SDIRA owner. Such rules include prohibiting certain types of transactions along with how the assets can be used while they are held in the SDIRA. A violation of the rules can result in costly tax consequences for the account owner.

It is best practice to consult with a tax advisor if you are unsure of the potential tax ramifications of any transaction that you may initiate as the self-directed owner of an IRA. A few of these prohibited transactions are summarized below.

First, the IRA investor (or account beneficiaries) cannot engage in a transaction with a disqualified person. Disqualified persons are individuals or entities that cannot perform any direct or indirect deals, investments, or transactions with the IRA. That would include the IRA owner, IRA Beneficiaries, or IRA owner's family members.

Second, the IRA owner cannot use the SDIRA for personal benefit. For example, revenue that is generated from real estate held in an IRA must be deposited back into the IRA account. Such funds cannot be deposited into a personal account. All income generated by IRA assets must be invested back into the SDIRA.

All opinions expressed on this site are owned by Thomas Wettermann and should never be considered as advice in any form. Thomas Wettermann is not an independent financial advisor.

Any opinions, news, research, analyses, prices, or other information contained on this website is provided as a general market commentary of Thomas Wettermann and does not constitute investment advice.

Thomas Wettermann will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from the use of or reliance on such information.

Trading digital financial assets such as cryptocurrencies can carry a high level of risk, and may not be suitable for all investors. Before deciding to invest, purchase, and/or trade cryptocurrency you should carefully consider your investment objectives, level of experience, adversity to risk, and volatilities. The possibility exists that you may sustain a loss of some or all of your initial investment; therefore, you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with cryptocurrency trading, and seek advice from a qualified and independent financial advisor.

All the views expressed on this site are those of Thomas Wettermann and do not represent the opinions of any entity with which Thomas Wettermann has been, is currently, or will be affiliated.