Financial Poise
hand holds plant, a metaphor for investing in private equity for growth.

Invest Tax-Advantaged Retirement Funds in Private Equity for Growth

This Overlooked Investing Option Could Transform Your Retirement Fund

Despite a difficult 2018 for stocks and other assets, private equity continues to raise record levels of capital well into 2019 – with good reason. Over a 10-year horizon, returns from private equity funds (net of fees) outperformed the S&P 500 (without Facebook, Amazon, Apple, Netflix and Google) by 3.3%, according to the most recent report from the American Investment Council. To participate in private equity deals, investors typically use their taxable dollars, such as money held in a savings account. But investors rarely think to use the funds they hold in a tax-advantaged account, like an individual retirement account (IRA), to invest in private equity. Why? The simple answer is that most investors are not even aware it is possible to do so.

Why Invest Retirement Funds in Private Equity?

One of the complicated factors for IRA investments in private equity is the long-term horizon that typically accompanies these investments. The exit for a PE investment is generally a buyout, which means the company is acquired by another company, sold in a secondary sale to another PE firm or makes a public offering. The time between the initial investment and buyout currently averages approximately five years.

For some investors, that “holding period” can be seen as a negative, and a long time to lock up their capital. But for many retirement savers, these holding periods fit with their own long-term horizons. After all, many investors don’t intend to touch their IRA funds until they: (a) reach the age where the government requires distributions, or (b) they need the money to support their lifestyle in retirement.

Another benefit of using retirement funds is that it allows an investor to take any private equity returns and reinvest them in a tax-advantaged account. This allows the funds in the account to compound year after year, creating a powerful savings advantage over time. In a traditional IRA, that means returns can grow tax free until the account holder must start taking required minimum distributions (RMDs) at age 70½. In a Roth IRA, there are no RMDs and distributions are also tax free provided certain IRS requirements are met.

Limitations and IRS Rules for Self-Directed IRA Investments

Private equity investments can yield high returns, but this alternative asset can increase the risk profile of your portfolio. Such a decision should be made based on the risk profiles of other assets in the portfolio.

In addition, anyone who plans to invest their retirement funds in private equity through a self-directed IRA should be aware of IRS rules and regulations that dictate retirement plan transactions. For example, any disqualified person or fiduciary (any person with control or influence over the IRA and its transactions) is prohibited from investment transactions that benefit them personally (e.g., purchasing personal property or lending money). Investments must also not benefit the participant or fiduciary’s own company.

The Influence of Fintech on Private Equity

It wasn’t that long ago that the administration and due diligence for private equity deals was complicated and time consuming for investors. Fortunately, new technologies have emerged to overcome many of these barriers. Online equity crowdfunding platforms now allow accredited investors to research and purchase equity in a broad range of sectors, far beyond their local areas.

In 2017, a total of $17.2 billion was raised through crowdfunding platforms across the globe.

PENSCO, for example, has introduced financial technology that aims to greatly reduce the administrative burden on investors and capital raisers who use IRA funds to fill a deal. The technology, called Alt-Nav™, makes the deal funding process entirely simple and web-based.

Questions to Ask Before Investing in Private Equity

While technology is making it easier to access and invest in private equity using retirement dollars, there are still a few questions to ask before diving in:

•Is the Asset Administratively Feasible? Does the investment type or transaction comply with IRS rules for self-directed IRAs? Disqualifications can lead to tax penalties that cut through any gains made on the investment.

•When Can the Income Produced by an Investment in an IRA Trigger Certain Taxes? It’s important for you to understand the factors that trigger Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt-Financed Income (UDFI) when making investment decisions using IRA funds. If your retirement account generates active business income, or debt-financed real estate property owned by the IRA generates income, then you may be subject to certain taxes. Because every situation is unique, it is important that you consult with a CPA or attorney.

•How Long Does It Take to Turn Your Idea Into an Investment? There are several factors that will influence the time it takes to invest and realize returns from an IRA investment. Have you opened your IRA account and chosen an IRA custodian? Have you chosen the company you will invest in, and more importantly, have you done the necessary due diligence?

Of course, all investments come with their risks, and private equity through a self-directed IRA is no different. At the end of the day, it’s crucial to do your due diligence on any investment opportunity, or work with a financial professional whom you trust.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Goal Based Investing – Planning for Key Life Events and Marketplace Lending/FinTech. This is an updated version of an article that first appeared on September 24, 2015.]

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About Christopher Orr

Christopher Orr is a Director, Institutional Products, at PENSCO, where he has spent the past five years helping clients meet their retirement savings goals by using self-directed IRAs. Christopher started his career as a financial advisor, working with clients who invested primarily in exchange-traded products like stocks, bonds and mutual funds. Realizing he wanted to…

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