Calling the Shots: Self-Directed IRAs span every asset class
By Alicia Purdy, Contributing Editor, AIMkts
An individual retirement account (IRA) is just that – an account where an individual, without going through an employer (like a 401k requires), places money that will grow over time, with the purpose of providing a nest egg for retirement. An IRA can be invested in a variety of assets –like stocks and bonds, index funds or mutual funds, among other things. There are two types that of IRAs: traditional IRAs and Roth IRAs.
The money you put into a traditional IRA can be deducted from taxable income. So, by example, if you earn $100,000 in 2014 and invest $10,000 in an IRA that year, you would only pay taxes on $90,000. And, you won’t pay any taxes on the income earned in the IRA until you withdraw funds retirement. This is “tax deferred growth.” Retirees are required to withdraw their money starting at a certain age.
Roth IRAs, on the other hand, do not provide an initial tax break. However, on the back end, at retirement, no additional taxes need to be paid. This is “tax free growth“. Roth IRAs do not mandate an age by which money must be removed from the account.
Both types of IRA accounts are typically managed by professional money managers. Many financial institutions that manage IRAs limit the types of assets an IRA may be invested in.
A self-directed IRA allows you to invest in a broader array of assets. Generally speaking, those who use self-directed IRAs do so in order to invest in alternative assets. As explained by Deborah L. Jacobs in her excellent June, 2012 Forbes article, How to Invest Your IRA in Real Estate and Alternative Assets, “[t]he big financial institutions that act as custodians for most IRAs generally limit investments to publicly traded stock, bonds, mutual funds and bank CDs. “ So, a self-directed IRA requires you to first “move your IRA to one of about two dozen smaller custodians offering ‘self-directed IRAs.’”
James A. Jones, founder of the Self-Directed IRA Investment Institute points out, “a Self-Directed IRA is an IRA like any other under IRS Publication 590 in terms of annual contributions, required minimum distributions.” But, unlike traditional IRAs, self-directed IRAs are often invested in asset classes such as “private equity and debt, hedge funds, real estate, precious metals, real estate, trust deeds and now the exploding crowd funding securities market, ” according to Jones.
In 2012, the SEC estimated that about 2% of all IRAs are self-directed. As more and more accredited investors discover the work of alternative investments, AIMkts thinks more will consider whether to use their IRAs to invest in them.
Self-directed IRAs were conceptualized and written into law in 1974 through the Employee Retirement Income Securities Act (ERISA).
The legalities of self-directed IRAs are complex and navigating them can be confusing for non-experts, although the penalties for violations will not take that into account if an investor makes a mistake. Investors looking to strike out on their own will need more than a dollar and a hunch. “Self-directed IRAs are not for the faint-hearted,” attorney Patrick J. Felix III told Forbes in 2012. “You better damn sure know the rules.” While certainly not a comprehensive treatment, here are some things to keep in mind:
Self-dealing is verboten
One cannot borrow against a self-directed IRA, nor can one put its assets up as collateral. Any investments you make cannot be tied to you personally. IRS Code 4975 guides and defines “prohibited transactions” and “prohibited people.” A “prohibited transaction” involves buying, selling, leasing, exchanging or receiving any use, benefit, or compensation, directly or indirectly from an asset in an IRA. A prohibited person is the IRA holder and spouse, parents and spouse, children and spouse, fiduciary etc. “In other words,” says Jones, “one cannot buy a condo on the beach and use it for vacation, or rent it to a parent or child even if paid fair market value.”
Even if an investor decides to forgo hiring a tax and/or legal advisor, each of which will be costly, paying a custodian is not optional. A custodian, for what you’ll pay, won’t do much more than send a paper statement of the account through the mail each month and for that luxury, investors can generally expect to pay fees to open the account, fees to maintain an account, a fee per asset or security held, and transaction fees – each of which are going to be significantly steeper than fees in other alternative investment vehicles, according to MoneyWatch’s James Sterngold, who noted, “Not only does income from the assets remain in the account, but the expenses needed to maintain the assets—such as upkeep on rental properties, taxes and management fees—must come from the IRA too … investors aren’t allowed to commingle their personal funds with the trust’s funds. That’s why advisers urge that investors keep a cash cushion in their accounts.”
The possibilities for where self-directed IRAs can invest are quite broad and span virtually every alternative asset class. From startups to VC funds, to PE, the key advantage of a self-directed IRA is the flexibility and optionality it provides as compared to non self-directed IRAs.
Beware of Scams
While self-directed IRAs hold a number of possibilities and options for investors, especially those looking for something different to put their money toward, the SEC and the North American Securities Administrators Association (NASAA) have been working hard to raise awareness about the problems with fraudulent schemes involving self-directed IRAs.
“Self-directed IRAs aren’t bad, they aren’t illegal,” Matt Kitzi, Missouri’s Commissioner of Securities told USA Today Money, but scams involving self-directed IRAs are becoming more common. It’s happening so often, in fact, that the issue is making headlines in case after case (after case…) showing how investors were duped into losing putting money through bad investments. And if something bad happens and your money goes into a Ponzi scheme or you lose everything when the ranch you invested heavily in is discovered to be located on protected Native American burial grounds, don’t count on your IRA custodian to cover your losses. Contracts are very specifically worded to protect them so they won’t take the fall if you pick a bum investment.
“An investor better know the investment better than his/her advisor knows Wall Street,” says Jones. The answer is due diligence, doing business with people you know and trust, and getting good advice from knowledgeable legal and financial advisors, according to Jones. Be very skeptical of cold calls.
Things to watch out for, according to the SEC:
- Misrepresentations regarding custodial responsibilities – Fraud promoters often state or suggest that self-directed IRA custodians investigate and validate any investment in a self-directed IRA which is FALSE.
- Lack of Information for alternative investments – A legitimate self-directed IRA custodian will not investigate the accuracy of financial information, which means investors are at risk for fraudsters who love to fill in the blanks with their own advice.
- Exploitation of tax-deferred account characteristics –The threat of early withdrawal tax penalties may induce self-directed IRA investors to keep funds in a fraudulent scheme longer than those investors who invest through other means.
As USA Today personal finance columnist John Waggoner commented, “Lots of people are looking for alternatives to stocks, and that’s understandable. But some investments don’t deserve your money just because they’re there. If you’re not willing to spend time checking a self-directed IRA, don’t do it.”
*Image courtesy of Stuart Miles/FreeDigitalPhotos.net