A self-directed IRA can be a powerful retirement tool if you want more flexibility and control over how your retirement funds are invested. That flexibility allows you to access a broader range of assets, but it also means you play a more active role in understanding how the account is structured and how the rules apply.

Though there might be asset-related challenges along the way, most issues stem from misunderstandings of IRS rules, custodian roles, and ongoing reporting requirements. With the proper setup and clear understanding of these boundaries, you can manage and often avoid risks.

Below are the five most common self-directed IRA risks and how to avoid them.

1. Investing in Prohibited Assets

Self-directed IRAs allow far more flexibility than traditional retirement accounts, but not every asset is permitted. While the IRS does not publish a list of approved investments, it clearly defines what is not allowed.

A self-directed IRA cannot invest in:

• Life insurance
• Collectibles, including artwork, antiques, rugs, gems, stamps, and most coins
• Alcoholic beverages
• Certain precious metals that do not meet purity standards

Holding a prohibited asset can cause the IRS to treat the entire IRA as distributed, triggering taxes and potential penalties.

How to avoid it

Before purchasing any alternative asset, confirm that it is eligible for IRA ownership under Internal Revenue Service rules. If the asset is not clearly permitted, pause and verify eligibility before moving forward. When in doubt, review the asset structure rather than relying on marketing claims or informal advice.

2. Misunderstanding the Custodian’s Role

A qualified custodian is required to administer your self-directed IRA, but custodians do not evaluate investments or provide investment advice. Their role is administrative.

Custodians generally do not:

• Perform due diligence on investments
• Verify asset valuations
• Assess legitimacy, risk, or suitability

It’s easy to assume that if a custodian processes an investment, it’s reviewed and within IRS guidelines, but that assumption can lead to costly mistakes.

How to avoid it

Choose a custodian with experience in the alternative assets you’re interested in and clear reporting processes, but understand the limits of their role. Perform your own due diligence, verify documentation, and ensure asset values are updated and reported as required. Treat the custodian as a recordkeeper, not a gatekeeper.

3. Prohibited Transactions and Self-Dealing

Self-directed IRAs are subject to strict prohibited transaction rules designed to prevent personal benefit before retirement. Even unintentional violations can disqualify the account.

Examples of prohibited self-dealing include:

• Personally using property owned by the IRA
• Paying IRA expenses with personal funds
• Selling personal assets to the IRA
• Personally guaranteeing IRA-owned debt

Once a prohibited transaction occurs, the IRA may lose its tax-advantaged status retroactively.

How to avoid it

Keep a clear separation between personal finances and IRA assets. All expenses related to IRA investments must be paid directly from the IRA, and all income must be returned to the IRA. If a transaction benefits you personally today rather than in retirement, it likely crosses the line.

4. Transactions Involving Disqualified Persons

The IRS also restricts transactions between an IRA and certain related parties, known as disqualified persons. These rules apply regardless of intent.

Disqualified persons generally include:

• The account holder and spouse
• Parents, grandparents, children, grandchildren, and their spouses
• Entities owned or controlled by these individuals
• Advisors with discretionary authority over the account

For example, an IRA cannot purchase a rental property and lease it to a child or lend money to a parent.

How to avoid it

Before entering any transaction, review all parties involved and identify potential conflicts. When family members or closely held entities are involved, take extra care to confirm that no direct or indirect benefit flows to a disqualified person. If the relationship feels close enough to question, it is worth verifying before proceeding.

5. Concentration and Investment Risk

Alternative assets can improve diversification, but concentration risk still applies. Overallocating to a single deal, asset type, or strategy can expose retirement savings to unnecessary volatility.

Risk tends to increase when:

• An investor lacks experience in a specific asset class
• Due diligence is rushed
• Liquidity needs are overlooked
• UBTI or UDFI exposure is not considered

How to avoid it

Approach alternative investing with an allocation strategy rather than a deal-by-deal mindset. Diversification does not require dozens of holdings, but it does require balance, realistic time horizons, and awareness of tax implications tied to leverage or operating income.

How to Ensure Proper Due Diligence with a Self-Directed IRA

Self-directed IRAs carry more risk than standard retirement plans, as they allow investors to invest in a wide range of alternative assets with varying rules. Follow these tips to maintain account compliance and avoid unnecessary penalties that eat into your compound interest.

• Understand the rules before you invest. Make sure you are familiar with IRS restrictions around prohibited assets, prohibited transactions, and disqualified persons before committing funds.
• Verify investment eligibility and structure. Confirm that each asset is permitted for IRA ownership and structured correctly for a retirement account.
• Choose experienced professionals. Work with a custodian that regularly handles alternative assets and, when appropriate, consult tax or legal professionals for complex transactions.
• Keep personal and IRA finances separate. All expenses must be paid from the IRA, and all income must be returned to the IRA.
• Maintain accurate records and valuations. Ensure asset values are updated and reported as required, and keep documentation for all transactions.
• Review your account regularly. Periodic check-ins help you catch compliance issues early and reassess diversification, risk, and long-term fit.

Taking the time to follow these due diligence steps can help you avoid common compliance issues and make more informed investment decisions. With the right structure in place, you can use a self-directed IRA to support long-term retirement goals without unnecessary risk.

FAQs

​​What is the biggest risk with a self-directed IRA?

The biggest risk is violating IRS rules, especially around prohibited transactions or disqualified persons. Even unintentional mistakes can cause the entire IRA to lose its tax-advantaged status.

What assets are prohibited in a self-directed IRA?

Self-directed IRAs cannot invest in life insurance, collectibles (such as art, antiques, and most coins), alcoholic beverages, or precious metals that fail IRS purity requirements.

Can a custodian stop me from making a bad investment?

No. IRA custodians are administrative recordkeepers only. They do not evaluate investment quality, legality beyond basic documentation, or risk, which means due diligence is entirely the investor’s responsibility.

What is a prohibited transaction in a self-directed IRA?

A prohibited transaction occurs when the IRA holder or a related party personally benefits from the IRA before retirement, such as using IRA-owned property, paying expenses personally, or guaranteeing IRA debt.

Who counts as a disqualified person?

Disqualified persons generally include the account holder, their spouse, parents, grandparents, children, grandchildren, and entities they control. Transactions with these parties are restricted regardless of intent.

Can self-directed IRAs invest in real estate safely?

Yes, but only if the property is structured correctly, all expenses are paid by the IRA, all income flows back to the IRA, and no personal or family use occurs at any time.

Is diversification still important with alternative assets?

Absolutely. Concentrating too much of an IRA into one deal or asset type increases risk, especially when liquidity, leverage, or unfamiliar markets are involved.

How can I reduce risk in a self-directed IRA?

Reduce risk by understanding IRS rules before investing, choosing an experienced custodian, keeping personal and IRA finances separate, maintaining accurate records, and reviewing your account regularly.