What Is a Self-Directed Roth IRA?

How a Self-Directed Roth IRA Works

A basic Roth IRA is a type of retirement savings account that allows you to set aside and invest money for retirement in the way you want while avoiding or minimizing taxes. You can set up a Roth IRA at financial institutions such as banks and investment brokerages.

Typically, Roth IRA accounts follow IRS regulations that dictate the specific type of investments that can be held in them. Generally, these are a mix of bonds, stocks, cash, and mutual funds. However, these funds may not meet your investing criteria or preferences.

In a self-directed Roth IRA, you can invest in a broader portfolio of assets than in a traditional or Roth IRA. However, these investments can be riskier, and self-directed Roths generally carry more risk because they can attract fraudulent schemes, high fees, and volatile performance.

Types of Investments

With a self-directed Roth IRA, you can invest in assets that don’t typically meet IRS guidelines, such as promissory notes, precious metals, or other commodities. You can also choose to invest in alternative assets such as tax-lien certificates and private-placement securities—which can introduce even more risk.

You’re still able to invest in traditional assets such as stocks and bonds, but the ability to invest in less-conventional assets allows for greater diversification in your portfolio. However, there are some limitations when using one of these accounts. For example, two investments can’t be held in a self-directed Roth IRA—collectibles and life insurance are not allowed in these accounts.

A self-directed Roth IRA is a significant undertaking because it differs from a standard Roth IRA. Before opening one, it’s important to learn the requirements and regulations associated with them and find a trustee to work with.

Example of a Self-Directed Roth IRA

Let's say you opened a self-directed Roth IRA with a custodian bank because you want to purchase and hold precious metals. You would first confirm with the financial institution that they can act as a custodian for your investment in precious metals.

Once your due diligence has been completed, and the account opened, you can contribute money to the account as you would with any other IRA. You could transfer funds from another IRA. The distribution rules, taxes, and contribution limits that apply to a standard Roth IRA would still apply to a self-directed Roth IRA.

What It Means for Individual Investors

Before investing in a self-directed Roth IRA, the key factor you should keep in mind is the risks associated with this type of account. Being able to invest in non-traditional assets can lead to problems.

Risks of Fraud

The Securities and Exchange Commission’s (SEC) Office of Investor Education and Advocacy published investor warnings about the risks associated with self-directed IRAs, especially as these accounts open you up to potential fraud.

For example, you can choose to add digital assets such as cryptocurrencies or tokens to your self-directed Roth IRA, which is a common source of fraud. Predators lure investors into digital assets through initial coin offerings (ICOs) that promise high returns that they can’t guarantee. Digital assets can be excellent investment opportunities, but it is easy to become a victim because the SEC can’t regulate them.

One of the reasons self-directed Roth IRAs—and other forms of self-directed IRAs—attract nefarious actors is that it’s easier to exploit these accounts. The custodians and trustees can offer limited protection because they can only validate the assets an investor is choosing or the background of the entity promoting those assets.

How To Protect Yourself

To reduce the risk of fraud, the SEC recommends you take the following steps if you’re interested in these accounts:

• Verify self-directed IRA account statements: Because alternative investments can be hard to evaluate, it’s important to independently verify information in your account statement, including prices and asset values.
• Decline unsolicited investment offers: If an unsolicited investment offer comes your way, ignore it. It is likely an attempt to lure you into transferring money from a standard IRA account into a self-directed IRA to become a victim.
• Consult an unbiased source and do your research: If anyone offers you an investment, confirm whether or not that investment is registered or licensed. It can be helpful to confirm these answers with unbiased sources such as your state securities regulator or the SEC.
• Don’t fall for “guaranteed” returns: All investments come with risk, so if anyone promises you a guaranteed return, be very wary of their claim.
• Hire a professional: When investing in an alternative asset, get a second opinion from an unbiased lawyer or investment professional with no interests in the asset.

Frequently Asked Questions (FAQs)