The Self-Directed IRA: Should You Buy Alternative Investments with Your Retirement Account?

“From dairy cows to commercial real estate bridge loans, self-directed IRAs offer entrepreneurial-minded people a chance to invest in something besides stocks, bonds, and mutual funds.”

—Kim D. H. Butler

Diversifying Your IRA with Non-Correlated Assets

When we advise our clients to diversify out of stocks and into non-correlated assets that don’t rise and fall with the stock market, there’s often one-big obstacle: they already have a sizable figure in 401(k)s, IRAs, and other retirement plans that offer limited investment options.

If this scenario describes YOUR situation, you should be aware that you can often use money you already have and multiply it using proven alternative investments that your retirement plan administrator may have never heard of… with a self-directed IRA. However, you should be well-aware of the ins and outs of making such a move.

Many people assume that the only investments allowed in a retirement account are the options their employer offers, such as mutual funds, stocks, bonds, and perhaps a money-market account. In truth, about 1 out of 20 people with IRAs held alternative assets in a self-directed account as of 2015, according to innovative wealth.com. The dollar amount held in such accounts was last estimated by the SEC in 2011 to be around $94 billion, or approximately 2% of IRA funds.

 Self-directed IRA Basics

A self-directed IRA is an individual retirement account that allows you to choose and “direct” where your money goes, rather than simply select from the given options (which are typically mostly mutual funds). Alternative investments allowable in a self-directed IRA can include:

• real estate, from farmland to rental homes
• fractional interest real estate investments
• private mortgage bridge loans (trust deeds and bridge loan funds)
• life settlement funds
• peer lending accounts such as com
• tax liens and promissory notes
• oil and gas limited partnerships (or if you prefer…)
• funding for green energy or other start-ups through private stock
• precious metals (in certain forms, such as gold bullion)
• livestock, such as dairy cows or race horses,
• and a nearly endless list of other possibilities.

Rather than stating specifically what an IRA may be invested in, the Internal Revenue Code (Section 408) specifies what an IRA can not be invested in. You can’t use your IRA to purchase:

• life insurance
• collectibles including antiques, fine art, jewelry, stamps, and rare coins, or alcoholic beverages (Sorry, fine wine and whiskey aficionados!)
• S Corporation stocks, or
• any investment that constitutes a prohibited transaction, such as an investment that involves “self dealing” (selling your IRA an investment you already own) or the purchase of any investment from a disqualified person (such as a close family member).

The IRS requires that a qualified trustee or custodian hold the IRA assets on behalf of the owner. The trustee/custodian processes the transactions, maintains records, files required IRS reports, issues client statements, educates clients about IRS rules and regulations pertaining to prohibited transactions, and conducts other administrative duties.

Self-Directed IRA Pros and Cons

It is important to understand the pros and cons of self-directed IRAs, because they aren’t necessarily simple, and you can get yourself into trouble if you don’t do your homework. However, done correctly, there are some significant reasons to diversify your retirement account!

Self-directed IRA advantages

1. You can use money you already have. The hardest part of investing is saving the money to invest! If you have (typically) a minimum of $25k money in an IRA now, or money in a 401(k) that can be rolled over, you’re in an excellent position to use a self-directed IRA.
2. Diversify the investments in your IRA. During the Great Recession, the joke circulated that “401(k)s became 201(k)s” when retirement accounts suffered tremendous losses when real estate and stocks both collapsed. But the joke wasn’t particularly funny to those who watched their accounts drop 40% or more. Now savvy investors know better than to have a large percentage of their assets in the stock market.
3. Put your dollars into non-correlated investments. A non-correlated investment is one that isn’t tied to the stock market or sensitive to market swings. Our favorite non-correlated investment is one that is literally immune from markets, economies, and other forces that can create volatility. Listen to our podcast about life settlements.
4. Increase your control. By selecting your own investments, you have more control over your money than being limited to the choices your employer’s 401(k) plan administrator selected. And with non-correlated alternative investments, you’ll have more control if the market heads South.
5. Enjoy tax advantages. As with a traditional IRA, a self-directed IRA can be funded with pre-tax dollars which grow tax-deferred until withdrawal. With a self-directed Roth IRA, you invest after-tax dollars and the account growth and withdrawals are tax-free.

Self-directed IRA disadvantages

It can be complicated. As mentioned, the self-directed IRA custodian holds and is the administrator for the asset. And while that can be fairly straight forward when investing in a bridge loan or a life settlement fund, imagine purchasing a rental property that you cannot manage or maintain yourself, live in or stay in, rent or sell to a relative, or even obtain a standard mortgage financing for in your own name. While it can work in some situations, in other situations, such restrictions can reduce flexibility, benefits, and returns.

Don’t miss out on tax benefits! Another disadvantage of owning assets such as real estate in your IRA is that you could be canceling some of your tax advantages. Real estate offers some nice write-offs to offset taxes, from certain mortgage costs to appreciation to annual losses in a year when you might make improvements or have vacancies. However, such write-offs will not benefit you when the property is in an IRA.

Increased yet limited control. While choosing your own investment increases control, it’s still an IRA with a host of rules and regulations, with taxes and fees to pay if you violate those rules. So in spite of being able to choose from a wide range of investments, your flexibility is still limited by the IRA “wrapper” that dictates, for instance, when you can take withdrawals without penalties, and when you must make withdrawals to avoid penalties.

Investors be careful! According to an Oct. 19, 2016 Forbes article, “IRAs Gone Wild,” “The Securities & Exchange Commission warns that scamsters encourage marks to invest through self-directed IRAs as a way to give their schemes a patina of legitimacy. But investors can’t rely on IRA custodians to vet their alternative investments.” Indeed, in June of 2016, a SEC case that attempted to hold an IRA custodian responsible for fraudulent promissory notes marketed to their customers was rejected by a judge.

So be wise in your investing. Realize an IRA custodian is NOT an advisor. If you want to purchase alternative investments with a self-directed IRA, you’ll benefit from working with a Registered Investment Advisor such as Partners for Prosperity that can offer fiduciary advice for your situation.

1. Increased fees. Perhaps it’s the economy of scale, or the increased administration often required for alternative investments, but you will pay more—perhaps a couple hundred dollars extra per year—to custodians for a self-directed IRA. However, it is well worth it to reduce your equity exposure and expand your investment options. And on the bright side, the fees are often tax-deductible.

Self-Directed IRA FAQs:

Can I buy an investment property that I can use for vacations/ rent to a family member for office space/ lease or sell to children or grandchildren/ retire in someday?

Not with a self-directed IRA! The importance of avoiding self-dealing or prohibited transactions cannot be over-emphasized.

One key is to avoid doing any business with a “disqualified person,” which can include (but is not limited to) your spouse, parent, child, grandparent, grandchild, and employees or employers in certain situations. If you violate those rules, your IRA will have to get rid of the asset at significant cost to you. You’ll pay a 15% penalty, possibly a 10% early withdrawal fee (depending on your age), plus any applicable taxes.

Roth or traditional?

Either can work, though we appreciate that a self-directed Roth IRA won’t subject your gains and withdrawals to unknown future tax rates.

What about REITs?

We don’t consider REITs to be true “alternative investments,” as they have a history of rising and falling with the markets. You’re also typically investing in someone’s ability to manage the real estate rather than the real estate itself. We recommend mortgage deeds of trust, bridge loan funds and cash-flowing investment real estate (directly or through fractional opportunities).

Do I need to be an accredited investor?

Nope! You’ll have some wonderful additional options if you are, but we can help you roll IRA monies into alternative investments with as little as $25k.

Should I start by choosing a custodian?

Nope! A common mistake is that people begin the process researching IRA custodians or trustees. However, you can’t choose a custodian until you know what investments you want! Reach out to us to get help sorting through your choices. We can connect you with providers offering bridge loan funds, commercial real estate notes, life settlement funds and fractional real estate investments.

Have you done a podcast on this topic?

Yes! Listen to “Self-Directed IRAs: The Lesser Known IRA” here.

Self-Directed IRAs: The Bottom Line

From dairy cows to commercial real estate bridge loans, self-directed IRAs offer entrepreneurial-minded people a chance to invest in something besides stocks, bonds, and mutual funds. And after a long bull market, the timing might never be better.

If you have IRA monies that are currently invested in mutual funds, we recommend diversifying with alternative investments that won’t roller-coaster ride along with the stock market, political news, or other events out of your control.

Find out more about alternative investments here and sign up for a free ebook, Financial Planning Has Failed, that explains why we’re so committed to helping you “build wealth without Wall Street.” Partners for Prosperity has specialized in helping clients with quality alternative investments since 1999.