Before we begin exploring the do's and don'ts of self-directed IRA investing, including those associated with the use of leverage, it is important to understand what a self-directed IRA is and isn't. The term "self-directed" is not a technical or legal term, but rather a descriptive term relative to how the IRA is managed. "Self-directed" essentially means that the IRA owner or someone the IRA Owner appoints, makes all the investment choices and decisions for their IRA. One can have a self-directed IRA at a brokerage firm or a specialist self-directed IRA custodian like PENSCO Trust. The primary difference is that brokerage firms and traditional banks that offer self-directed IRA services, generally restrict investments to publicly traded assets such as stocks and mutual funds.
The second important thing to know about self-directed IRAs is that they may belong only to a single individual person and are unique by taxpayer ID. Except for some IRAs established for employees in an employment context, they IRAs are not subject to ERISA, so the restrictions placed on fiduciaries of pension plans that are subject to ERISA (such as prudence and diversification standards and foreign investment restrictions), generally do not apply to IRAs. IRAs are governed by IRC section (408), whereas pension plans, which are governed by IRC sections 401, 403, and 457.
Because IRA investments are not restricted to traditional (and supposedly less risky) assets like stocks and mutual funds (hard to say that post the Crash of 2008 as I write), there are innumerable ways to invest through self-directed IRAs and an unlimited array of investment choices. That's the good news. However, there are some investment types and some transactions that are prohibited that you must be aware of in order to avoid jeopardizing the status of your IRA, and exposing it and you to taxes and penalties. This chapter will review the basic tax rules on IRA investing, while providing you with a general understanding of the legal framework from which the rules flow.