Is a self-directed retirement account right for you?  This post goes into the main reasons one should consider opening one, the factors and limitations to consider, and the reasons you might want to consider a Roth IRA instead.

Think of a retirement account like a crockpot; the IRS will tell you how it cooks – by deferring or eliminating income tax on the assets you put in it but the IRS doesn’t put many restrictions on the ingredients. You aren’t limited to mutual funds, CDs stocks and bonds by any means.

That’s where a tool called the “self-directed retirement account” comes in; you can create an account, such as a self-directed IRA or 401(k), and have that account purchase assets on your behalf. You simply find yourself a third-party administrator to run it for you, in accordance with IRS rules, and provide them with detailed direction on what you want your IRA to purchase and/or sell, and at what price.

Benefits of Self-Directed Retirement Accounts

Sure, there are a few things that aren’t Kosher. The IRS won’t let you put retirement account money in life insurance, collectibles, alcoholic beverages, jewelry, gems, or certain formats of precious metals. But outside of these few categories of assets, and some rules designed to prevent your retirement account from doing business with entities that have a conflict of interest, you have full run of the supermarket. Put almost anything you like in that crockpot!

And increasingly, people are doing just that. Consumers are using their IRAs, Roth IRAs, SEP IRAs, Solo 401(k)s and even health savings accounts to hold an ever-widening array of non-standard assets to fund their retirement security:

• Real estate
• Raw land
• FOREX
• Foreign property
• Tax liens
• Interest in a partnership
• S-corporation shares
• Privately-held businesses
• Farms
• Commodities
• Ranches
• Precious metals
• Art galleries
• Horse-breeding businesses

And other alternative types of investments.  Now, is it a great idea? As with most things in the investment world, it depends.

Who is A Self-Directed IRA Good For?

The self-directed retirement account may be a good fit for someone who has real professional expertise in a given industry or niche. I’m not saying just a casual familiarity with it – I’m talking bona fide expert-level knowledge at a level where other people are willing to pay you for your advice, assistance or counsel. The reason: Most self-directed retirement accounts are not very diverse. Portfolios with just one asset class in them – be it real estate, precious metals, or nearly anything else commonly held for long-term investment purposes – are generally riskier than portfolios stuffed with mutual funds diversified among hundreds or thousands of securities in a variety of asset classes.

But your upside, of course, is much greater in a concentrated portfolio, as well – especially if it‘s in a field you work in professionally, and in which you have a natural competitive advantage. For example, a real estate agent may do well holding rental real estate properties or flipping houses within a retirement account, because he gets first crack at the best deals on the market in his neighborhood. Likewise, the manager of a coin collectors’ shop may want to hold a few American Eagle coins in an IRA for her own account, because she feels that her professional insights allow her an advantage in knowing when to buy or sell them.

Aside from the risk inherent in concentrating retirement holdings in a limited number of asset classes (we assume you’re comfortable with that so far!), there are some potential disadvantages you should be aware of.

1.)  Liquidity issues. Remember that unlike your taxable accounts, you can’t dump an unlimited amount of new money into a retirement account in any given year. IRAs and other retirement accounts have annual contribution limits. So if you own a house in an IRA, and all of a sudden that house needs a $30,000 new roof, you can’t just write a check. That money has to come from an IRA. But you can only contribute $5,500 in new money to an IRA. Houston, you have a problem! Your IRA will have to borrow money to put the new roof on (more on that in a bit).

To minimize potential liquidity traps like that, you might consider using a Solo 401(k) account or a SEP IRA account, both of which offer much more generous caps on the amount of money you can contribute in a given year.

2.)  Required minimum distributions, or RMDs. Sure, these are factors with any tax-deferred, non-Roth retirement account. But they are especially hazardous if you hold a large and illiquid investment within your self-directed retirement account that doesn’t generate enough income to pay the RMD. If you’ve got a large plot of land, or a business that just isn’t generating much cash, it could be tough to sell a chunk of it to generate your RMD. So you might be forced to sell the whole thing, and launch yourself into a higher tax bracket – or sell a fractional interest at a discount just to make it happen before the RMD deadline. To avoid this, plan a year or two ahead.

3.)  Tax on unrelated debt-financed income. Think your IRA is tax-deferred? Think again. The only thing deferred is tax on income attributable to money you put in. If you borrowed money from outside your IRA or other tax-deferred retirement account to make investments, and your IRA made money, you become liable for a little known tax called “tax on unrelated debt-financed income,” sometimes called UDIT. Originally this tax was imposed to keep non-profit corporations from abusing the privilege by using their tax-exempt status to operate and shelter income from profitable businesses. But it also means that you have to pay taxes on profits attributable to borrowed money.  If 50 percent of your IRA investments were made with borrowed money, then you will have to pay income taxes on 50 percent of your profits.

4.)  Prohibited Transactions. Congress has laid down some restrictions on what you can and can’t do with IRAs and, generally, other retirement accounts as well, to prevent self-dealing. It’s important to understand these rules, because if you run afoul of them – even accidentally – you can blow up an entire IRA, forcing an immediate distribution and some nasty penalties. Here are the basic prohibited transactions :

• Your IRA (or other retirement account) can’t buy or sell property directly from you.

• You cannot lend money to your IRA, nor can you borrow from it.

• Your IRA can’t do business with a company you own or control. So if you have a rental real estate property in your IRA, you can’t have it hire your own landscaping company.

• The same goes for your wife, children, grandchildren, parents and grandparents, their spouses, and any entities they control.

• The same also goes for anyone advising you on your retirement account in a fiduciary capacity and any entities they control.

• You cannot rent property to any prohibited individuals above.

• You cannot use the property to benefit yourself or your family, personally.

• Siblings, for some reason, are fair game. Don’t ask me why. They just aren’t listed as prohibited counterparties for self-directed retirement account transactions.

• You can’t stay in your property, even overnight, even if you pay your IRA market-rate rent, and even if you are working on repairing the property. If you do, and the IRS finds out, you’ll blow up the whole IRA and be forced to take an immediate distribution of the whole account. (For 401(k) accounts, you only have to take a distribution of the part of the account that’s authorized.)

5. Less Transparency. Because self-directed IRAs typically don’t invest in publicly-traded securities – with all the inherent disclosures and protections – you can’t just crosscheck your IRA statement against the listings in the Wall Street Journal. Unfortunately, some unethical individuals have tried to exploit the lack of transparency to rip off shareholders. The Securities and Exchange Commission recently put out a consumer notice to warn of the dangers of self-directed IRA ponzi schemes and other possible frauds investigators have uncovered.

This is why it’s important for those considering the self-directed retirement account to have their own independent expertise, so that they know exactly what they are invested in.

The Bottom Line

The self-directed retirement account isn’t for everyone. Most people are probably better off with the traditional mix of stocks, bonds, CDs, annuities, mutual funds, ETFs and the like. It’s still the easiest way to diversify into a lot of asset classes quickly and cheaply. Indeed, the self-directed retirement account probably isn’t for most people. But if you’re an experienced and capable entrepreneur, with specific and marketable expertise, your retirement account can help you leverage that ability with tax deferral or tax-free growth. The potential is powerful indeed.

Another Smart Option: The Roth IRA

If you decide a self-directed IRA isn’t the right option for you at this point in time, another smart retirement account to consider is a Roth IRA .  A Roth IRA is a good bet for younger investors because it means you pay the taxes up front (by investing with your after-tax income) and then the investment grows tax-free for the rest of your life.

NerdWallets Top Picks for Roth IRA Accounts: