Caution Is Warranted with Self-Directed IRAs
Signs of market stabilization and recovery are prompting some investors to once again look to the future and reconsider the range of retirement investment vehicles available to them. Many individuals, burned by their recent experiences in the stock market, are seeking alternative investments in areas claimed to be “safer” or “non-correlated” to the market as a whole. There has been a resurgence of self-directed IRA “experts” across the Internet who are ready to help investors build their IRAs with alternative investment options. While legitimate experts certainly exist on the Internet and elsewhere, many analysts and regulators agree that investors, particularly those reaching retirement age, should carefully research the advantages and disadvantages of SD-IRAs before establishing such a plan.
An SD-IRA involves a high level of involvement on the part of the owner, who must make investment decisions and choose investments for the plan. These types of IRAs, which have existed since 1974, can often be allocated to a broader range of investment choices. IRS regulations require that either a custodian or a qualified trustee hold assets on behalf of the owner, helping to maintain assets and transaction reports. The trustee/custodian will also file required IRS documents, issue client statements, and help the owner understand the rules and regulations pertaining to his or her account.
Alternative Assets
While some SD-IRA custodians limit the type of assets that participants can select, “true SD-IRA” custodians will permit investors to select just about any investment area permitted by IRS code. While investors will still have the option to place assets in stocks, bonds and mutual funds, other investment areas such as commodities, private placements, foreign real estate, limited liability companies and other not so publicly traded investment options draw many SD-IRA participants who have been burned by traditional market investments.
In a 2005 Fortune magazine article touting the advantages of SD-IRAs, Raymond Yu, chief administrative officer of Entrust Administration (theentrustgroup.com) of Oakland, California, which handles $1.7 billion in self-directed IRAs, spoke of his investors having success with such varied investments as cemeteries and heads of cattle. The most popular sector that SD-IRA investors have flocked to in recent years is real estate.
Tax Considerations
During the real estate boom, some investors used the unique tax benefits of SD-IRAs to take advantage of real estate opportunities. For example, an investor familiar with real estate development might use IRA assets to purchase a commercial real estate lot. If the investor is able to flip this investment, capital gains on the sale will not be due until the investor begins taking distributions. However, unlike investing in stocks, mutual funds and bonds, losses incurred in the above real estate transaction cannot be written off.
Prohibited Transactions
While the range of acceptable SD-IRA investments is broad, prohibited transactions stop individuals from “self-dealing” with their tax-deferred funds. “Self-dealing” refers to the benefit that investors could receive today from investments made with IRA-deferred income. For example, if you buy a vacation home through your SD-IRA, you can rent it for profit. However, if your family decides to use that same house for your own vacation time, it would be a violation of the IRA’s self-dealing rule. Another violation would be to make repairs to the house yourself, rather than hiring out someone else to do so.
Using IRA funds to start a business can be similarly complicated. While you can legally use SD-IRA money to fund a start-up, you can’t be a majority owner of the business or pay yourself a salary unless the business is structured in such a way that the amount you get paid is not within your control.
While most investors utilize SD-IRAs for their intended purpose—a way to help invest retirement capital in alternative investments—others believe that they can use the structure of an SD-IRA as a loophole to buy a vacation home that they can use today and pay the taxes on later. Investors should avoid this temptation, as one misstep in your SD-IRA portfolio could result in the entire balance being taxed or subjected to penalties. Any self-dealing, even just fixing a leak in the roof of an SD-IRA financed house with a personal check instead of paying out of the SD-IRA, will prompt IRS investigation.
Due Diligence
Among the most important considerations when setting up an SD-IRA are the relevant regulatory agencies and the track records of custodians. Different custodians are overseen by different regulatory agencies, so before selecting someone to manage an IRA, investors should find out whether the custodian in consideration is regulated by a state securities administrator, a state attorney general’s office, the Securities and Exchange Commission or FINRA (Financial Industry Regulatory Authority), as is the case with broker-dealers and stockbrokers. Understanding who the regulators are means knowing who to go to if things go wrong.
While some of the companies promoting SD-IRA management have an established track record, it is important to choose a firm that is knowledgeable about the type of investments that you are interested in. In a recent interview, John Gannon of FINRA noted, “[You] want to know how long the firm has been in business, how long the firm has been a custodian of self-directed IRAs [and] how much experience they have with the specific type of asset to be held in the self-directed IRA.”
Assessing the Alternative
Reflecting in 2009, however, on the many SD-IRA participants who directed their funds toward real estate—from storage facilities to strip malls—it is evident that these alternative investments do not always pan out over the long haul. While managers who promote the advantages of SD-IRAs today may place a heavier emphasis on the latest hot investments—such as commodities or emerging market real estate—it is important for investors to remember the many bubbles in alternative asset markets that have occurred in the past.
Following a period of equity market disappointment there is often a resurgence of firms promoting alternative investment strategies to weary investors. While many investors will successfully use SD-IRAs to diversify their larger investment picture, it is important to remember that any concentrated investment could prove disastrous. In 2008 and 2009, investors were forced to face difficult losses in the real estate markets—a pain felt more acutely by those who had staked their retirement on the sector. It is tempting to shy away from an uncertain equity market to try to capture the next big alternative investment, but it is essential to evaluate the pros and cons of SD-IRA investing and view any concentrated positions as just part of a larger investment framework.
