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What's a "Self-Directed" IRA? Not What it Sounds Like

From time to time, I participate on Quora, providing answers to personal finance questions. This one came across my desk last night: "Is self-directed IRA a good idea?" I'm not sure the person asking this question really understood the question, so I provided this answer:

First, let’s define the difference between self-directed and custodial account. The previous answer would leave you to believe that in a custodial (or custodian) IRA is directed by someone else and this is not necessarily true. It’s a matter of terminology.

Custodial IRA is an Individual Retirement Account that a custodian (typically a parent) holds for a minor with an earned income. Once the Custodial IRA is open, all assets are managed by the custodian until the child reaches age 18 or 21 (varies by state). All funds in the account belong to the child, allowing them to get started early on saving money and reap the benefits of compounded growth. You can open either a Custodial Roth IRA or Custodial Traditional IRA, and the respective account benefits and rules apply.
The confusion in terminology might be that that all IRAs require a “custodian”, or trustee, to hold the account, such as a bank, mutual fund company, or a stock brokerage.
Now, a self-directed IRA is different. This doesn’t mean you, as the owner, are the director, so to speak. A self-directed IRA is a type of traditional or Roth IRA, which means it allows you to save for retirement on a tax-advantaged basis and has the same IRA contribution limits. The difference between self-directed and other IRAs is solely the types of assets you own in the account. Just because you hire a financial advisor to manage your IRA, this would not necessarily be considered something other than a traditional IRA. It’s the type of account that matters.
Regular IRAs typically contain only stocks, bonds, mutual funds and other relatively common investments. Self-directed IRAs offer many more possibilities. For example, you could invest in a horse-breeding operation, a rental property, or a privately held company. If you can find a custodian to agree to the deal, you’re good to go.
Brokerage firms act as custodians for many types of IRAs, but most household-name brokers don’t offer self-directed IRAs.
Custodians of self-directed IRAs are often companies that specialize in them, including some banks and trust companies. They can differ from each other in the types of investments they’ll agree to handle, so you’ll have to shop around.
Given the complexity of self-directed IRAs you might want a financial advisor with experience managing investment deals for self-directed IRAs to help you with due diligence on the investments. A custodian generally won’t offer this.
Also, keep in mind that the IRS still forbids some types of investments in self-directed IRAs, including collectibles and life insurance.
Once you find a custodian, you’ll open an account and contribute money to it, just as you would with any other IRA.
I would suggest for the average investor, a regular Roth-IRA or Traditional IRA. These accounts will allow you to own stocks, bonds, gold, or most liquid assets. Even if you have a financial advisor, you still have total control over your investments, while a self-directed IRA may be more restrictive and less liquid.
Seems the terminology is a bit backwards and confusing, but that’s kind of the way many professions are: they like to keep the average person confused. Or you can blame congress and the IRS for making it more complicated than it needs to be. Don’t get me started on that :)
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