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SDIRA Rules: What You Need to Know Before Opening a Self-Directed IRA

A self-directed IRA can help you invest your retirement assets in unique ways. But first, you have to know the rules.


[Updated: Feb 04, 2021] Sep 21, 2020 by Matt Frankel, CFP
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A self-directed individual retirement account, also known as a self-directed IRA or SDIRA, can allow you to invest your retirement savings in real estate or other assets beyond just stocks, bonds, and funds.

However, like most financial products, there are some important rules to know before you get started. We answer some common questions here.

What types of investments can you make?

First of all, for an overview of what a self-directed IRA is and how it works, check out this guide.

The most important SDIRA rules have to do with what you're allowed to invest in. While a self-directed IRA is designed to allow investors to put their retirement savings to work in a wider variety of investments than allowed in a brokerage account, that doesn't mean you can simply buy anything.

Investments you can make in a self-directed IRA

First, let's discuss what you can buy in a self-directed IRA:

  • Real estate is one of the most popular SDIRA investment types. You can use a self-directed IRA to purchase investment properties and other types of real estate investments.
  • You can use a self-directed IRA to invest in private equity investments, such as venture capital and pre-IPO companies.
  • Businesses, such as LLCs.
  • Cryptocurrencies.
  • Hedge funds.
  • Gold and other precious metals.
  • Oil and gas rights.
  • Private loans and other debt investments.

This isn't an exhaustive list and is only meant to cover the most popular types of SDIRA investments. There are many other possibilities when it comes to alternative investments you can buy in an SDIRA, as long as you don't buy a specifically excluded investment.

Investments you cannot make in a self-directed IRA

The biggest prohibited transaction is collectibles. You can't own things like coins, artwork, and antiques through a self-directed IRA. Jewelry is also a prohibited investment. Admittedly, there can be some gray area when it comes to the difference between investing in precious metals (which are allowed) and jewelry. If you're curious about a specific investment opportunity, your self-directed IRA custodian (the company you use to open the account) can probably help, or at least point you in the right direction.

You also can't own real estate you plan to use personally. We'll discuss this more later, but the key point is that any real estate you buy through a SDIRA must be entirely for investment purposes.

Not just traditional and Roth IRAs

A self-directed IRA can be opened in several forms. Most SDIRAs are traditional IRAs, but you can also open a Roth account if your priority is creating tax-free IRA distribution income in retirement.

If you're self-employed, there are even more possibilities as a self-directed IRA owner. You can use a SEP-IRA or a SIMPLE IRA format for your self-directed IRA. As you'll see in the next section, contribution limits to these two account types are significantly higher than traditional and Roth IRAs allow.

Finally, self-employed individuals can open a self-directed IRA that isn't even an IRA at all. A self-directed 401k is a variation of the Solo 401k accounts that are quite common among self-employed professionals and has a unique tax benefit that makes it especially appealing to real estate investors: As we'll see later, obtaining a mortgage through an IRA account can have some big tax implications. But this (known as Unrelated Business Taxable Income) doesn't apply in an account structured as a 401k.

How much can you contribute to a self-directed IRA?

The short answer is: It depends on the exact type of IRA.

Most SDIRA investors open traditional or Roth IRAs, which both have the same contribution limits. For 2020, traditional and self-directed Roth IRA investors can contribute as much as $6,000 to their accounts, with an additional $1,000 allowed for IRA owners 50 or older. Remember, your ability to deduct your traditional IRA contributions might be income-restricted, while higher-income investors may not be able to contribute to a Roth IRA at all.

The other, less common types of self-directed accounts have significantly higher contribution limits. For example:

  • SEP-IRA: Here, it's the smaller of either 25% of your compensation for 2020 or $57,000. Since all SEP-IRA contributions are considered to come from the employer, there is no catch-up contribution allowed for older investors.
  • SIMPLE IRA: The 2020 SIMPLE IRA contribution limit is $13,500 plus an employer match of as much as 3% of compensation, up to a certain limit. Investors 50 or older can contribute an additional $3,000, making their maximum $16,500.
  • Solo 401(k): The 2020 Solo 401k total contribution limit (including employer and employee contributions) is $57,000, with an additional $6,500 catch-up contribution allowed for investors 50 or older.

Your SDIRA custodian can help determine which account types you qualify for and might be the best fit for your situation.

But even the higher contribution limits on this list are rather low in the context of buying real estate. Most SDIRA accounts intended for real estate investments are started by making a large lump-sum rollover contribution from an existing IRA.

Real estate rules to know

Since Millionacres is focused on real estate investing, it's important to spend some time on the rules for investing in real estate through a self-directed IRA. And there are some that are very important to know before getting started.

First, as previously mentioned, you can't use any real estate investment you own through an SDIRA for personal purposes. At all. For example, you can't buy a vacation rental property that you plan to use for an annual family vacation. You can't buy land to hold for investment that you also plan on using as a hunting club for you and your friends. Things like this would meet some definitions of "investment" but are not allowed for SDIRA real estate investments.

Another important rule is that all of the investment property's finances must flow through the SDIRA, not through you personally. So if your investment property needs a plumbing repair, the check needs to be written from the SDIRA, not your personal checking account. For this reason, it's very wise to make sure there's some financial cushion in the IRA, or unforeseen expenses could cause major issues. This also means rental income needs to be paid to the IRA (and held in the IRA).

You can't use any of your personal property in real estate owned through an SDIRA. If you want to offer a furnished rental, you need to buy furniture through the IRA for it -- you can't just use things you already own.

You also can't use your SDIRA to buy a property currently owned by you or anyone you are related to.

You can obtain a mortgage to help acquire a property within an SDIRA. However, since all finances need to go through the account, the loan must be made in the SDIRA's name, not your own, severely limiting your options. Specialized companies offer nonrecourse mortgages specifically for this purpose. However, there's a tax rule known as Unrelated Business Income Tax, or UBIT, that says that the portion of your real estate profits that come from using borrowed money can be taxable (even though this is an IRA).

The bottom line

A self-directed IRA can be an excellent way to save money for retirement if you want to invest in real estate assets or other types of IRA investment beyond the stocks, mutual funds, bonds, and ETFs offered by brokerage IRAs. However, there are some rules to know before you get started. This guide puts you in a better position to make smart (and legal) decisions with your IRA funds.

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