What is a Self-Directed IRA?

A Self-Directed IRA is an account that allows for alternative investments not available with standard retirement platforms, like brokerage accounts offered by Fidelity, Charles Schwab, or TD Ameritrade.

The History of IRAs and Why Brokerages Limit Their Investment Options

Before we can answer the question of what is a Self-Directed IRA, an account that's a variant of a standard IRA, we should start at the beginning and discuss a standard IRA.

Congress passed an important act called The Employee Retirement Income Security Act of 1974 (ERISA). One of the features of this act was a tax incentive for working Americans to save for retirement. A worker could designate a part of their salary to go towards their retirement funds and then not have to pay taxes on those funds until a much later date. This tax deferral saved money on the immediate tax bill and provided possible future tax savings when the worker might be in a lower tax bracket. This option became known as an Individual Retirement Account, or IRA.

One of the specific provisions included in this legislation was that the IRA be held by a custodian. This was done primarily to provide oversight and tax accountability. The institutions that found themselves acting as custodians were, for the most part, banks and brokerage houses. They did a fine job holding the IRAs, but they didn't do such a good job providing investment options. A large majority of investors found that they were limited to stocks or a few mutual funds.

The reason for this limitation is that these were the products that earned significant profits for the banks and brokerage houses. With that fact in mind, it's easy to understand why, for a very long time, there was little to no self-direction in retirement investing.

Enter Self-Directed IRA Custodians

The lack of options for diversifying one's portfolio soon caused investors to become frustrated. This led to the creation of the first-ever self-directed custodians. Unlike the other custodian options available, the self-directed custodians used IRA platforms in which workers could place their retirement funds into different alternative investments.  Without being restricted to investing in the stock market, these investors started looking to franchises, real estate, and a wide variety of other investment opportunities to bolster their retirement accounts. This is the basic answer to, "What is a Self-Directed IRA?"

But account options that gave investors more freedom weren't perfect. From an asset perspective, things were great, but from a procedural perspective, a lot of work still remained to be done. The custodian model as an investment platform did nothing to encourage active investing. In fact, in many ways, it discouraged activity. Every investment and transaction required time-consuming paperwork and was accompanied by fees. Investors who wanted to take charge of their retirement funds found themselves frustrated by the endless, costly delays. It wasn't until relatively recently that an efficient and economical Self-Directed IRA option was established.

What Is a Checkbook Self-Directed IRA?

The perfected model of the Self-Directed IRA came to be popularly known as a Checkbook IRA. But what is a Checkbook Self-Directed IRA? It's a Self-Directed IRA that uses checkbook control. Although a custodian still officially holds the IRA, the investor has unlimited access to the IRA funds and may use them in real time without any transaction fees.

A Checkbook IRA works via a dedicated LLC. A new LLC is set up with the investor appointed as the non-compensated manager. This LLC, in turn, receives its funding from the investor's IRA. The investor may then open a checking account in the name of the LLC. At this point, the investor can use the IRA funds (as they are found in the LLC) simply by writing a check or sending a wire. There are no delays and no transaction fees.