Investing for retirement is vital for long-term financial stability, but capital gains taxes can deprive you of compound interest and delay your retirement age.

One of the most straightforward ways to avoid taxes on investments without having to spend your money or exploit a loophole is to make investments within a self-directed IRA (SDIRA).

These accounts let you grow your retirement savings by investing in alternative assets outside of the stock market with tax-deferred (Traditional SDIRA) or tax-free (Roth SDIRA) growth. By avoiding or deferring taxes, self-directed IRAs allow you to reinvest more money into assets that compound quickly to help you meet your retirement goals.

Over half of US households have access to a 401(k) or IRA with hundreds of thousands of dollars in their account that could be put toward high-growth assets like real estate, crypto, and precious metals inside a self-directed IRA to build generational wealth. Imagine setting aside an extra thousand dollars or more each year from a rental property investment to reinvest back into your real estate portfolio–that is the power of a self-directed IRA.

While retirement plans have built-in tax advantages, certain investments or prohibited transactions can trigger penalties and taxes that eat away at your earnings. This guide will discuss how taxes work within a self-directed IRA and provide tips to lower your taxable burden so you can save faster for retirement.

IRA Tax Benefits By Account Type

Self-directed IRAs are available in two account structures: Traditional SDIRA or Roth SDIRA. Both offer valuable tax advantages but work in different ways. Understanding how each one functions can help you select the account that best fits your income, timeline, and long-term goals.

Traditional Self-Directed IRA

A Traditional SDIRA allows you to defer capital gains taxes until you withdraw funds from your account, allowing you to reinvest your earnings back into your account for long-term growth.

Key advantages of this type of account include:

• Tax-deferred earnings. Contributions may be deductible, lowering your taxable income.
• Compounding growth. Earnings grow tax-deferred until retirement, helping your savings multiply faster.
• Lower tax bracket in retirement. Withdrawals are taxed as ordinary income—but often at a lower rate once you retire.

Social Security funds aren’t taxable, and if you have a low source of income, your income tax bracket can have you paying very little on your withdrawals. While this method still involves taxes, you can avoid a big hit and enjoy your savings without losing too much.

Roth Self-Directed IRA

A Roth SDIRA allows you to pay taxes now and enjoy tax-free withdrawals later so that you keep all your earnings.

Key advantages of this type of IRA include:

• Tax-free income in retirement. Contributions are made with after-tax dollars, so qualified withdrawals, including earnings, are not taxed.
• Early withdrawal flexibility. Certain scenarios allow for penalty-free withdrawals before retirement age 59 ½. These scenarios include:
  • Withdrawals from contributions (early withdrawals from earnings are penalized).
  • Qualified exceptions, which can include educational and medical costs as well as a downpayment for your first home.
• No required minimum distributions (RMDs). Unlike Traditional IRAs, RMD rules don’t apply to Roth accounts, so you can let your money grow as long as you like, benefiting from tax-free growth and withdrawals in retirement.

How to Manage Your Self-Directed IRA After Retirement

When it comes to retirement, timing is everything. Once you reach age 59½, you can begin taking penalty-free withdrawals from your IRA. For Roth IRAs, those withdrawals are tax-free, while Traditional IRAs are taxed as ordinary income based on your current bracket.

A balanced approach can help maximize flexibility and reduce taxes. Many investors use their Roth IRA for spending flexibility, drawing tax-free income as needed, and reserve their Traditional SDIRA for long-term growth. This mix can help you manage your taxable income while continuing to build wealth in retirement.

Tip: Review your withdrawal plan with a financial advisor each year to ensure your strategy still fits your income needs and tax outlook.

7 Tips to Help SDIRA Account Holders Avoid Taxes

Even tax-advantaged accounts can generate unexpected liabilities if not managed correctly. These best practices can help you avoid unwanted and unnecessary taxes.

1. Avoid prohibited transactions.

Never use SDIRA funds to benefit yourself or “disqualified persons” (spouse, parents, children, etc.). Examples include:

• Buying property for personal use
• Lending money to family members
• Paying yourself management fees

If you engage in prohibited transactions, you run the risk of not only penalties but potentially the loss of your account’s tax-deferred or tax-free status.

2. Watch for UBTI and UDFI.

Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI) are special IRS rules that can cause your SDIRA to owe taxes, even though the account is normally tax-deferred or tax-free.

• UBTI applies when your IRA earns income from an active business, such as flipping houses, operating a retail business, or managing rental properties directly.

• UDFI applies when your IRA invests using borrowed money, such as taking out a mortgage to buy real estate. The portion of income tied to that debt can be taxable.

To reduce the risk of UBTI and UDFI, you can try the following strategies:

• Avoid using non-recourse loans to purchase assets
• If you do use non-recourse loans, try to pay off the debt quickly
• Choose passive investment types, like real estate rentals, private lending, or metals, that don’t trigger business income.

3. Follow RMD Rules

If you have a Traditional SDIRA, you must begin withdrawals by age 73. Missing an RMD can result in a 25% IRS penalty on the amount not withdrawn. Setting an annual RMD reminder or automating withdrawals can reduce the risk of missing an RMD.

4. Keep Contribution Limits in Mind

For 2025, you can contribute up to $7,000 annually ($8,000 if you’re 50 or older). Exceeding this limit can result in a 6% excise tax each year until corrected.

Keep in mind that contributions can change year-over-year, so it’s important to review the IRS-issued IRA contribution limits annually.

5. Report Rollovers Correctly.

When transferring funds, use a direct trustee-to-trustee rollover whenever possible. This avoids the 60-day rule and the one-rollover-per-year limit that can create unexpected taxes.

6. Hold Investments Under the IRA’s Name.

Always title assets in the name of the IRA rather than your own. Improper titling can be viewed as a distribution, triggering taxes and penalties.

For example, if you had an SDIRA with Horizon Trust and used it to purchase property, the asset would be titled as “Horizon Trust Company FBO [Your Name] IRA.” This ensures the investment remains under the IRA’s ownership, preserves its tax-advantaged status, and protects it from being classified as self-dealing.

7. Track Your Five-Year Rule for Roth IRAs.

Withdrawals from a Roth IRA are only tax-free if the account has been open for at least five tax years and you’re age 59½ or older. The five-year clock starts on January 1 of the year you make your first contribution, not the exact date of the deposit.

Remember, this rule applies to earnings, not contributions. You can withdraw your original contributions anytime without taxes or penalties, but taking out earnings early could trigger both. Keep clear records of when contributions began to avoid premature or non-qualified withdrawals.

Self-directed IRAs are excellent financial vehicles that help you avoid taxes and compound earnings for faster growth. By keeping these strategies in mind, you can reduce your risk of unnecessary taxes, penalties, and fees, allowing you to keep saving for retirement uninterrupted.

FAQ

Can I avoid taxes completely with a self-directed IRA?

You can’t avoid taxes entirely, but you can reduce or defer taxes depending on the account type. Roth SDIRAs offer tax-free withdrawals in retirement, while Traditional SDIRAs let you delay taxes until you take distributions, potentially in a lower tax bracket.

Following IRS rules, avoiding prohibited transactions, and planning withdrawals carefully can help minimize what you owe.

What types of investments can I hold in a self-directed IRA?

Self-directed IRAs allow for a wide range of assets beyond stocks and bonds, including real estate, private lending, precious metals, and cryptocurrency.

However, all investments must comply with IRS regulations, and personal-use assets, like vacation homes or collectibles, are prohibited. Working with a qualified custodian helps ensure compliance and protects your account’s tax advantages.

How are taxes handled on income from self-directed IRA investments?

It depends on the account type and how the income is earned. In a Traditional SDIRA, investment earnings grow tax-deferred until you make withdrawals, which are taxed as ordinary income. In a Roth SDIRA, qualified withdrawals, including investment gains, are completely tax-free.

However, if your IRA earns Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI), such as from a leveraged real estate deal or active business, those earnings may be subject to a special IRS tax, even inside the account.