IRAs: They're Not Just for Stocks, Bonds, and Funds
Self-directed IRAs can hold real estate, private equity, precious metals, and other nonsecuritized investments, but transparency and fraud can be problems.
Question: A friend is offering me the chance to invest in his start-up business. Am I able to do so using the funds in my IRA? How would I do that?
Answer: Mention an IRA, and most investors probably think of a long-term savings vehicle that holds only securities such as stocks, bonds, and mutual funds. But the IRA wrapper also can be applied to many other investment types, including real estate, precious metals, and equity in privately held companies, such as what you are proposing.
The vast majority of IRA assets are invested in the regulated securities with which most investors are familiar, typically through banks, brokerages, or fund companies. But a small segment--estimated at about 2% of all IRA assets--are held in so-called self-directed IRAs, which may be established through a custodian or trustee and which can encompass a much broader range of investment types.
What You Can and Can't Invest In
Tom Anderson, president of the Retirement Industry Trust Association, a trade group representing the self-directed retirement-plan industry, says that about 40% of the $50 billion in assets that the group's members manage is held in real estate--everything from income-producing properties to time-shares to co-ops. In fact, self-directed IRAs can be invested in just about anything with a few exceptions. Among these are collectibles, so forget about putting that Picasso original or '57 Chevy in your IRA. Life insurance also may not be put inside a self-directed IRA, nor can stock in an "S" corporation, which is a special type of corporate structure in which taxable income is passed on to shareholders. (The Internal Revenue Service bans these from non-self-directed IRAs, as well.)
Holding assets such as real estate or private equity within the IRA wrapper means enjoying tax-free growth and compounding, just as it does with stocks, bonds, and funds. A self-directed IRA also may use the traditional, Roth, or SEP IRA format, meaning that you could get a tax break during the contribution or distribution phase. For example, if you used money from a self-directed Roth IRA to invest in a rental property, not only would income be added to the account tax-free, but any proceeds from sale of the property would be tax-free, as well (once the account holder turned 59 1/2).
Rules Against Self-Dealing
Because they can hold such a wide array of asset types, self-directed IRAs tend to appeal to investors looking to diversify their retirement holdings and reduce correlation with stocks. The self-directed IRA is often used to complement, rather than replace, a more traditional IRA invested in stocks, bonds, and mutual funds. "Most of these IRAs are created as a result of someone working for 15-20 years, changing jobs, and rolling over [a piece of] their 401(k) into a self-directed IRA," Anderson says.
The rules governing self-directed IRAs can be tricky, however, so make sure you understand them before opening an account. For example, there are strict rules against so-called self-dealing, which means that IRA money may not be used to invest in a property that the account holder or a direct family member will use. Thus, buying a vacation home with an IRA and using it for trips with the kids or grandkids is not allowed. That's because the Internal Revenue Service requires that the investment be for the benefit of the IRA account exclusively--in other words, that its sole purpose is to potentially help the account increase in value as opposed to any ancillary benefit to the account holder or his family.
The rules regarding the use of self-directed IRAs for privately owned business investments are even murkier. For example, if the self-directed IRA is invested in a business wholly owned by the account holder, that account holder is not allowed to draw a salary from the business. Also, even though self-directed IRA funds can be used to start a business, they cannot be used to purchase equity in an existing business that is already 50% or more owned by you and/or other direct family members including spouses. Given the complexity of these rules, Anderson recommends that self-directed IRA users considering these or related strategies consult with a registered self-directed IRA custodian and/or an attorney well-versed on the topic to ensure these strategies don't run afoul of tax laws. (You can read more about some of these IRA restrictions on the IRS website.)
Lack of Transparency and a Potential for Fraud
Among the potential problems with holding alternative assets in a self-directed IRA is that the assets may be illiquid, making them harder to sell. That also might make assessing their true value difficult. In a 2011 alert about potential fraud in self-directed IRAs, the SEC warned that self-directed IRA custodians may list the value of an alternative investment as the original purchase price or a price reported by the entity running the investment, neither of which may be accurate.
The alert also pointed to the fact that self-directed IRAs may hold unregistered securities, which can serve as an invitation to fraud, and Ponzi schemes in particular. In one such case, the agency helped shut down a firm that had raised $20 million in assets from retirees in California and Illinois who were persuaded to open self-directed IRAs and told their money would be invested in Turkish eurobonds with guaranteed returns when in fact it was used as part of an alleged Ponzi scheme.
Before opening a self-directed IRA, you should think long and hard about whether it's the right choice for you. If you plan to invest funds in unregulated securities it's always best to get a second opinion from a trusted source such as your financial advisor if you have one. Aside from that, you'll need to keep in mind considerations such as fees charged by the custodian (Anderson says RITA members typically charge between 0.20% and 0.40% of assets), how accessible the money will be if you need access to it in a hurry, and other factors. You can read more about these important considerations in this article by Morningstar's Christine Benz.
A self-directed IRA can be an effective way to add diversification to your retirement portfolio, especially for wealthier investors concerned about having too many of their assets correlated to the stock market. But it's a strategy that takes careful planning and, most of all, due diligence.
Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.