A Self-Directed Individual Retirement Account (IRA) is a specialized IRA that lets the IRA owner invest in a larger array of investments such as Real Estate, private stock, and LLCs in addition to more traditional IRA investments such as stock and bonds. Anyone is eligible to have a self-directed IRA.
As with a traditional IRA, the advantage of self-directed IRAs is that all contributions to the account are tax-deductible. For example, if someone puts in $2,000 into an IRA account and is in the 25% tax bracket, his tax liability decreases by $500. Transactions within the account, such as interest, dividends, and capital gains are not subject to tax while still in the account. However, the account owner has to keep the money in the IRA account till the age of 59 1/2 and faces a 10% penalty for withdrawing early. Withdrawals after the age of 59 1/2 are subject to federal taxes.
The founder of PENSCO Trust Company, a self-directed IRA custodian, estimates that less than 2% of the $3.7 trillion IRA market is held in self-directed IRAs. 
In essence, a self-directed IRA is a specialized Traditional IRA. Most IRA custodians limit account investments to traditional brokerage accounts (stocks, bonds, mutual funds), but a self-directed IRA can invest in real estate, mortgages, franchises, and private stock in addition to stocks, bonds, and funds.
A self-directed IRA is subject to the same taxes as a traditional IRA, however it can incur additional taxes depending on its investments. The primary caveat of a self-directed IRA is that it cannot hold any assets that are employed for the owner’s personal benefit or are used for the benefit of the owner’s lineal family or spouse. For example, an IRA-owned property cannot be rented to a family member. If any asset held in a self-directed IRA has been employed for personal use or for the gain of any other personal benefit, it can become immediately taxable.
Limited by the same IRS restrictions as a traditional IRA, self-directed IRAs are not allowed to invest in:
The primary disadvantage of a self-directed IRA is the increased risk associated with allowing IRA funds to be invested in almost any security. Traditional IRAs are usually invested in traditional securities that have some form of regulation (i.e. stocks, bonds), but the freedom of self-directed IRAs allows the fund to be invested in less regulated investments (i.e. private stock, foreign real estate) that potentially pose greater risk.
Anyone is eligible to set up a Self-Directed IRA, however self-directed IRA's are subject to more complicated regulations (depending on what the account is invested in) and not every IRA custodian has the expertise necessary to administer such an account.
A popular trend in self-directed IRA management is for the account owner to set up an LLC, invest the IRA in this LLC and then use the LLC to make investments. However, this is only one of many investing strategies and not mandatory to allow for the full range of possible investments.
The annual contribution limit for 2008 is $5,000 or total earned income whichever is less, for individuals under the age of 50. For individuals over the age of 50, the annual limit is $6,000. These amounts are the maximum contribution allowed to any IRA account. For example: If a person under 50 puts in $3,000 into a Roth IRA account, he or she can only put another $2,000 into a traditional or self-directed IRA. In the case of married couples, each spouse is eligible to contribute individually.
IRAs are managed by custodians. Custodians can be any type of financial institutions which offer IRA accounts, however not all custodians offer self-directed IRA accounts. The IRS explicitly permits custodians to impose their own restrictions and policies above the IRS rules. As a result, most custodians do not allow an IRA to hold real estate unless it is held indirectly by a Real Estate Investment Trust (REIT), however custodians that permit self-directed IRAs don't have these stipulations. Banks, insurance companies, mutual funds and brokerage firms are all valid IRA custodians.