Lawyers Journal

Alternative investments available through Self-Directed IRAs

With accounting scandals, weak earnings and an uncertain economy, more and more IRA owners are seeking alternative investments. There is in excess of $4 trillion in IRA funds in the United States today. Most is invested in the more conventional investment types, such as CDs, mutual funds, stocks and bonds. However, these funds are also available to be invested in IRS-permitted non-traditional assets, including mortgages, private notes, private stock, start-up businesses, shares in LLCs, Limited Partnerships, raw land, commercial buildings, vacation rentals and multifamily homes, just to name a few. The good news for investors considering this strategy is that it can be done without cashing in their IRA account, and can be done penalty-free, tax-deferred, and sometimes even tax-free!

A long-standing Internal Revenue Service ruling (see IRS publication 590 for complete regulations) allows all Americans to invest their IRA funds, or 401(k) funds rolled into an Self-Directed IRA, in a wide variety of non-traditional investment types. Rolling current retirement funds from an existing IRA for 401(k) account into a Self-Directed IRA to do this type of investing is penalty-free. Additionally, the taxes due on the growth of the investments are deferred until distribution begins at retirement. If the Self-Directed Roth IRA is involved, the principal and earnings are tax-free when distributed at retirement.

The process itself is simple: an individual opens a Self-Directed IRA account with a specialized custodian, transfers his current IRA funds to the new Self-Directed account, and finally, directs the custodian to invest the funds into the asset he specifies. After an administrative review to determine if the asset can be administered, the custodian forwards the funds to purchase the asset, and the asset comes into the ownership of the individual's IRA account.

The timing is excellent now to take advantage of this little-known retirement-planning tool, and the possibilities opened up by it. Daily headlines in the Wall Street Journal discuss the damage done to retirement funds by the low return of stocks, bonds, and bank CD rates and the uncertainty of the current and future economy. As a result, more and more Americans are pulling out of traditional investments and moving toward non-traditional assets as a primary or ancillary investment for their IRAs due to their potential for a higher return.

For example, over the past 13 years, home values have increased approximately 4 percent annually. This is an increase of 57.5 percent between 1990-2002. Since the beginning of the year, $2.41 billion has flowed into real-estate mutual funds, according to AMG Data Services, compared with only $307 million in the same period a year ago. Also, shares in real-estate investment trusts have climbed 11 percent this year, while the S&P stock index is down more than 17 percent.

This isn't the first time that real estate has climbed while the stock market declined. Back in the '70s, which was the last time the S&P 500 stock index posted two losing years, real-estate values soared along with inflation. Many people saw their home values double or even triple.

This is only one of many lucrative non-traditional investments available. Given today's market conditions and predictions, the time couldn't be better to consider alternative investments in retirement planning.

If it's so easy and potentially lucrative, why aren't the majority of Americans and their financial advisors aware of the unique use of Self-Directed IRAs? The reason is due primarily to the lack of knowledge on the subject, as there are, literally, only a handful of financial service firms in the nation that are willing and capable to provide the required custodial and administrative services. Typically, institutions that are licensed to administer IRA accounts, such as banks, credit unions, trust companies or savings and loan institutions, are not willing to undertake the challenging research, extensive paperwork, and IRS-reporting that is required in order to administer non-traditional assets within IRA accounts.

Others, however, such as broker/dealers and mutual fund companies, have to be separately licensed by the Employee Plans Division of the IRS (Treasury Department) and restrict their IRA clients to a limited set of investments. They do so for several reasons. First, if they offer investment advice, sell investment product, or have discretion over the management of investment assets, they will be concerned about the liability associated with the purchase and/or administration of any non-traditional investment. Second, their specific structure or license may restrict them from certain types of investments. Third, they may not be organized to profit from any investment other than their own proprietary investments (e.g., mutual fund companies). Consequently, the majority of institutions offering IRA servicing do not promote the fact that clients can choose from a variety of investment options for their IRAs.

Since most financial providers don't allow their clients to diversify their IRA holdings, how can the average person take advantage of these IRS regulations? It's simple - they must establish a truly Self-Directed IRA with an institution that offers them, and which does not restrict the choice of investment. For example, many large discount brokerage firms claim to offer clients "Self-Directed" IRAs. But in fact, they are only Self-Directed in the sense that you can make the investment decisions and choices independently (e.g. without advice or discretion by the provider). All of these institutions still restrict the "type" of investment to publicly traded investments.

True Self-Directed IRA custodians allow you to select from virtually any type of investment. Such investments as private notes, factoring, start-up businesses, real estate, annuities and private stock are possible choices for clients of firms that are truly Self-Directed. While clients can still include traditional investments such as stocks and mutual funds within their Self-Directed IRA, they also have the freedom to diversify their portfolio by adding a non-traditional asset.

Self-Directed IRA custodians provide a unique service to IRA owners and serve as a vital source of funds to new and emerging companies by assisting individuals, including "angel" investors, to invest their retirement funds in such firms. In many cases, these investors have large sums of money accumulated in their retirement accounts, which they can now put to work in non-traditional investments through the services of Self-Directed IRA institutions. Self-Directed IRA funds have been used to start-up a wide range of businesses from banks to dot-coms.

Self-Directed IRAs, when administered by a special-asset custodian, offer the opportunity to maximize retirement investment returns in a number of creative, non-traditional ways. Those interested in having a Self-Directed IRA are advised to contact their financial planning professional to determine if a Self-Directed IRA is right for their retirement planning strategy.

Tom Anderson is president & CEO, PENSCO Trust Company, an exhibitor at Annual Conference 2003. For more information on PENSCO Trust Company or Self-Directed IRAs, call toll free at (866) 818-4472 on the East Coast or 800-969-4472 on the West Coast, or e-mail them at [e-mail penscotrust]. Listen to PENSCO's weekly call-in radio show through the company's Web site at www.pensco.com.

©2014 Massachusetts Bar Association