Self-directed IRAs allow clients to decide where they want their IRA money to play. But watch out for sand traps.
Four years ago, Vincent McCord was approached by a developer about
investing in a Las Vegas shopping center construction project. While he
liked the idea, the bulk of his investment assets were in an IRA at a
firm that does not accept real estate investments beyond publicly
traded REITs or mutual funds that invest in them.
At his accountant's suggestion, McCord contacted a custodial firm that specializes in setting up and administering "self-directed" IRAs that allow nontraditional investments. Since then, the 60-year-old technology company chief financial officer has earmarked IRA money for three other real estate projects, as well as investments in a managed commodity pool and private debt. He calls the self-directed IRA "a great way to diversify and go beyond what a traditional IRA allows."
By law, IRAs cannot hold certain assets, including life insurance or collectibles such as art, antiques, gems, coins and most precious metals. Because there is no approved list of investments for IRAs, the rest of the investment universe is often viewed as fair game.
Many financial advisors probably have encountered clients who, like
McCord, would like to go beyond the tried and true menu of IRA
investments, such as stocks, bonds and mutual funds, into more exotic
and perhaps riskier fare. The majority discourage the practice, either
because their IRA custodians or broker-dealers won't allow it or
because they consider the deals too complex and dicey.
But those explanations don't always sit well with people who have firm ideas about where they want to steer their money, or who have heard about outsized returns from hot restaurant private placements on the golf course. Financial advisors who have helped individuals execute outside-the-box investment ideas through self-directed IRAs say that while they don't necessarily encourage them, they think it is good fiduciary practice to let clients know about all possible investment options, and good business practice to accommodate clients or prospective clients who will probably do what they want on their own anyway.
Financial advisors often investigate out of the mainstream assets at the suggestion of their clients, according to Hugh Bromma, president of Entrust Group, a custodial firm that specializes in self-directed IRAs. Others hear about them from financial intermediaries in their communities seeking to raise capital for investment. Entrust has handled real estate transactions; private placements in oil and gas development and exploration; equity deals involving restaurants, startups and small businesses; and secured loans. Deals in which investors purchase units of stock in small, startup community banks are "hot" right now, he says.
Business is brisk at Entrust, which handles some 30,000 self-directed IRA accounts, compared with 20,000 accounts three years ago. The average self-directed account holder there is well-heeled, with an average of $1.1 million in investable assets and family income of more than $150,000 a year. Still, many remain resistant to the idea of allocating retirement money toward nontraditional investments. Bromma says that while more financial advisors are opening self-directed IRAs for clients than did so a few years ago, "Some broker-dealers have given permission to use them, but a lot are not interested in going down that path."
One reason for resistance may be the nebulous area of compensation. Unlike most investment products, financial advisors don't receive a commission on assets in a self-directed IRA. Those who work on a flat-fee basis may include evaluation and due diligence for self-directed IRA assets in that fee. Others may negotiate a fee based on the percentage of assets under management, and some charge a flat fee for advising on a particular investment.
Tempe, Ariz.-based financial advisor Rene T. Espinoza says that, while
he will guide clients who want a self-directed IRA toward other
professionals who can help set one up, he does not advise them about
the investment itself or receive compensation for money attributable to
those accounts. "If a client has a $1 million account and $100,000 of
that goes into a self-directed IRA, it isn't a big deal to me," he
says. "Besides, if the transaction is successful there's a good chance
that money will come back here for investment."
Another issue is the need to steer clients around the prohibited transaction minefield and the danger of self-dealing that could lead to severe penalties and taxes. In real estate transactions, for example, an IRA cannot do business with a disqualified person, such as the individual IRA owner, a spouse, a parent, children or grandchildren. The whole thing, including improvement and management of the property, must run as an arm's-length transaction. Because an IRA cannot purchase real estate and then have a disqualified person use it while it is in the account, residences and vacation homes the owner or his family occupies are off the table. Even if a vacation home is rented out most of the time, the investment could be considered a prohibited transaction if the owner uses it even occasionally while it is in the IRA. A contractor who buys a house and fixes it up himself also could run afoul of the self-dealing rule, since he has direct, personal involvement in the transaction.
Private placements aren't immune to scrutiny, either. Bromma reports
that his firm receives subpoenas from the Securities and Exchange
Commission regarding private placements "about once every two to three
weeks." He says the IRS also has stepped in on a number of occasions to
investigate self-dealing issues in real estate deals, although none of
the transactions in question came through financial advisors. "We don't
get involved with opining about whether a particular transaction is
good or bad," he says. "It's the financial advisor's job to conduct due
Salem, Ore.-based financial advisor Kevin Winder says he often recommends that clients run proposed deals by attorneys, CPAs and other professionals who are familiar with these transactions. "If a deal looks questionable it's important to pull a team together and review it," he says. "The hard thing is finding professionals who are knowledgeable in this area. Advisors need to educate local professionals about possibilities they may not be aware of."
Failure to examine all the angles can lead to severe penalties and taxes. If the IRS determines that the IRA has engaged in a prohibited transaction, the account is terminated as of the first day of the year in which the infraction occurred. The account owner would have to pay income tax on the entire value of the IRA, not just the portion used for the nontraditional investment. If he is under age 591/2, a 10% early distribution penalty would also apply. For that reason, each nontraditional investment should be segregated into separate IRA accounts, suggests IRA expert Ed Slott, author of Your Complete Retirement Planning Road Map (Ballantine Books). Slott also advises investors to only buy assets from unrelated third parties, get professional advice on the transaction and avoid personal use or use by family members of the asset.
Costs are another issue. At Entrust, fees are based either on the number of assets in the account or by the asset value. Under the first option, account owners pay $250 per asset per year to a maximum of $1,500, plus a $50 setup fee. Under the second option, the charge is $125 to $1,850 a year, depending on the account size, plus a $50 setup fee.
Even with the problems that could arise, financial advisors say that exploring lesser-known corners of the investment universe with self-directed IRAs is an option worth considering.
"If someone is interested in going that route, I think it's my job to educate them about their options," says Winder. "It's a way to carve a niche because it's something a lot of financial advisors won't address."