SELF DIRECTED IRA'S FAQ

By Jan B. Brzeski

Self-directed IRAs are estimated to hold about $100 billion in assets—about 2% of all U.S. retirement savings according to a recent article in the Wall Street Journal*. What are self-directed IRAs and why are they growing in popularity? This FAQ addresses many basic questions. The author does not provide self-directed IRA custodial services, but has concrete recent experience working with both companies that do provide custodial services and investors who use those services.


BASIC QUESTIONS

What is a self-directed IRA?

Self-directed IRAs were authorized by a Federal law called ERISA in 1974 and include both traditional and Roth IRAs. Both types of IRAs are designed to allow individuals to save for retirement. The income and capital gains from Traditional IRA investments are exempt from tax until they are withdrawn from the IRA account, at retirement age. For Roth IRAs, all earnings and principal are tax free.

With self-directed IRAs, investors can direct their retirement savings into a much wider variety of investments than was possible before, including real estate, notes and trust deeds secured by real estate, as well as equity and debt investments in private companies. Even unusual investments such as dairy cows can be held in a self-directed IRA.

Why do investors use self-directed IRAs?

Many investors are not satisfied with the investment options available from traditional IRAs. In the traditional model, the money almost always ends up in the public stock and bond markets, usually by way of a very large company acting as an intermediary. Self-directed IRA investors like to make their own investment decisions and frequently have some knowledge of local investment options in their area, or else they like to meet the people who will be executing a specific investment strategy personally. They usually like the personal aspect of investing self-directed IRA funds, and also tend to enjoy the education and research involved in putting their money to work.

Why is there so much growth in self-directed IRAs?

Among large financial services firms, there are many great ones that provide an honest service (for example, Vanguard) and also some that have a tendency to put their own interests ahead of the interests of their investors. For example, all the major broker-dealers on Wall Street have fought vigorously to avoid being forced by regulators to assume “fiduciary” responsibility for their clients. The trend toward self-directed IRA investing can be understood as a statement by many investors that: (1) they do not believe the existing mainstream/Wall Street financial services system is set up to benefit the individual investor, and/or (2) they don’t want their money poured into an impersonal system which always results in the money being allocated into public markets, which may or may not provide the best risk-adjusted returns.

Types of Investments

What kinds of investments can be held in self-directed IRAs?

The most common assets held in self-directed IRAs are: (a) single family homes held for investment, typically rented out to a tenant; (b) other real estate such as apartment buildings or shopping centers, or interests in real estate partnerships; (c) promissory notes secured by real estate or equipment; (d) ownership interests in businesses, or (e) unsecured notes (loans to businesses, not secured by any particular property). Other allowable investments include commodities such as precious metals; livestock; equipment used for business purposes (such as a yacht used exclusively for charters); and investments in funds that pursue a wide variety of investment strategies.

What investments are prohibited?

Prohibited investments include collectibles and life insurance policies. Also prohibited are investments that involve certain close family member, such as a child or parent, and investments that benefit the IRA owner himself or herself (such as a yacht used for pleasure). Remember that IRAs are exempt from the usual tax on investment income so the IRS set up strict guidelines to attempt to allow investors a wider variety of investment options, but to prohibit use of self-directed IRAs to simply avoid taxes on transactions and investments that are not strictly for retirement purposes. For a more detailed list of prohibited transactions, Pensco (the largest self-directed IRA custodian) has the created a useful question and answer page on its website

What are the most popular investments in self-directed IRAs?

The single most popular asset class for self-directed IRA investors is real estate and notes secured by real estate. Many self-directed IRA investors appreciate the ability to see and feel the assets into which they are investing.

ADVANTAGES AND DISADVANTAGES OF SELF DIRECTED IRAs

Who should consider self-directed IRAs?

Self-directed IRAs might make sense for investors who fit one or more of the following criteria: • Investors with relatively large IRAs or other retirement plans (because there are some economies of scale, both with respect to effort and money, in managing a self-directed IRA);

• Investors with strong knowledge of and experience with a particular asset class, such as real estate, who are confident in their abilities to generate good returns in that asset class;

• For active investors, the individual should have the time and desire to manage his or her retirement savings actively, because many popular strategies, such as owning rental property, require ongoing management (however, keep in mind that the IRS places limits on which activities can be handled by the account-holder personally and which must be handled by a third party service provider); and

• For passive investors, the individuals should have strong judgment and business instincts in evaluating the investment managers who will be managing the self-directed IRA funds. The individual must be comfortable and able to meet with, interview and perform due diligence on their fund manager or managers.

Who should avoid self-directed IRAs?

Investors who have very small IRAs, or who don’t have any interest or judgment selecting investments or investment managers may do better investing in a traditional IRA investment such as an index fund.

What are some of the advantages of self-directed IRAs?

Advantages of self directed IRAs include the following: • Re-invest before-tax dollars. The first advantage is a benefit of all IRAs—your money grows tax-free until you begin to withdraw it after reaching retirement age. In contrast, residents of many states such as California can see half of their investment income disappear to the IRS and the state franchise tax board each year. Therefore, investors are wise to set aside money into an IRA and to invest that money wisely.

• Choose your own investments. Investors can take control of their own destiny, as relates to their choice of investments. They do not need to put their future in the hands of an investment manager, or take stock market risk, unless they choose to do so.

• Larger variety of investment strategies and asset classes. Investors can choose from a very wide variety of investments, including investments in their own communities, rather than investing in broad market indices. Many investors particularly like the ability to touch and feel the specific real assets they have invested in, which is nearly impossible when investing in the public markets.

• Enjoy the investment education process. Some investors enjoy the process of researching their investment options. This is particularly true for many popular self-directed IRA asset classes, such as real estate, and less true for typical IRA investments such as funds that track various stock and bond indices. For those investors who enjoy real estate and other investments that can be touched and felt, self-directed IRAs offer a framework in which to “dive in” to the world of investing. Some custodians provide some assistance, such as educational opportunities, as well as checking on the good standing of any companies that investors might be considering as managers for their assets.

What are the biggest risks of self-directed IRAs?

The biggest risk can be summed up in the Latin phrase caveat emptor—“let the buyer beware.” There are many things that can go wrong with any investment and with self-directed IRA investments in particular. These include: • Risk of dealing with dishonest or careless people. If you are considering investing in a fund, the integrity of the fund manager is paramount. No matter what the documents say, a dishonest manager could find ways to defraud the investors.

• Deal-specific risks. For example, if you invest in a shopping center and the main tenant goes bankrupt, the income of the property could drop to less than the mortgage payment, resulting in the property being foreclosed upon and the investors losing as much as their entire investment.

• Market risk. There is always a risk that the entire market can drop, which may affect the value and/or the income of the underlying investment. For example, someone purchasing a rental house in the distant suburbs of Los Angeles in 2006 would have experienced a dramatic decline in value of the property during the ensuing years. Homes in many areas dropped by more than 50% in value.

For investors who do not want to take these risks, investing in a broad stock market index may be more appropriate. Of course, there is substantial market risk associated with investing in stocks as well. However the other two risks mentioned above do not apply to investing in a broad index with a major investment firm such as Vanguard.

HOW IT WORKS

What is a self-directed IRA custodian?

To open and maintain a self-directed IRA account, you need a custodian, just as one needs a brokerage firm to hold a traditional IRA. The custodian handles all transactions into and out of your account (such wiring funds to escrow if you are buying a property). They can also advise you about rules and regulations regarding self-directed IRAs to make sure you don’t accidentally trigger a tax liability.

How do custodians charge for their services?

Each custodian company has a slightly different set of charges but almost all of them charge a set-up fee to open an account; an annual maintenance fee; and certain transaction fees, generally when money is moved into or out of the account for any reason.

One way to compare fees on an “apples to apples” basis is to boil down the fee to an average percentage of assets in the account. For example, for a $100,000 account, if the average fees are $500 per year, this amounts to 0.5% of the assets in the account per year. The actual fees may be $750 in the first year, and $300 each year for several years. We have found that for accounts in the $50,000 to $100,000 range, 0.5% is a reasonable estimate of the average fees at many of the largest and best-known custodian companies. Fees can be lower for large IRA accounts and also for companies that provide lower service levels. Fees as a percentage of assets are generally higher on smaller accounts.

For further discussion of fees in a self-directed IRA, see BankRate’s useful article about accounting for self-directed IRA fees.

Who are the largest custodians of self-directed IRAs?

It is difficult to find definitive information about market share in the self-directed IRA custodian industry. Of the approximately $100 billion invested in self-directed IRAs, about $10-$11 billion appears to be invested with Pensco Trust Company in San Francisco. Other large players are Equity Trust Company, Polycomp Administrative Services, and Entrust Group.

How can self-directed IRA investors educate themselves about investment alternatives?

Some of the largest custodian companies provide educational resources, such as webinars, on a variety of investment strategies and asset classes. For example, Pensco’s website includes an archive of all of their webinars from the past several years.

Other good educational options include taking classes on relevant topics. For example, in the Los Angeles area, UCLA Extension has a whole department devoted to real estate education. It includes many classes each quarter providing an analytical framework as well as practical suggestions relating to real estate investment.

Other ways for investors to educate themselves include: joining relevant associations and networking groups and attending their events; attending relevant conferences; reading publications devoted to investing in relevant asset classes; and joining online communities to gain insights from other investors’ experiences.

How can self-directed IRA investors avoid losing money?

To avoid losing money, investors need to follow a few simple rules: • Only invest in what you know. Don’t invest in a speculative land investment if you don’t have experience in land. On the other hand, if you can learn what you need to know to become educated, then get educated. For example, the Wall Street Journal article sited mentions an investor who has put his IRA money in dairy cows after conducting careful research on animal husbandry and the milk market.

• Focus on hitting singles. Let other people swing for doubles, triples and home runs. Specifically, look at investments where you are investing in a way that provides a large margin of safety, ensured by someone else’s money, that will absorb the first dollar of losses on the underlying investment. For example, if a developer is fixing up a house with plans to resell it for a significant profit, consider investing in the first mortgage secured by the property, rather than being a partner in the deal. Your returns will probably be lower, but if something unexpected happens, someone else will lose their money before you lose any of your principal.

• Conduct research on the investment manager. See the next question and answer below regarding how to avoid dishonest people.

How can self-directed investors avoid working with fraudulent advisors and/or investment managers?

The first step in evaluating a fund manager is to ask for that manager’s track record. Request details about past and current investments. Ask for documentation, especially any items that would be public record. For example, for a real estate lender, ask to see copies of the relevant promissory notes, deeds of trust, etc. Then, use independent sources to verify the representations made by the manager. In real estate, any title company can provide information about property ownership, lenders with recorded interest in the property and other liens.

Another simple step to protect yourself is a Google search of the key individuals that would be handling your money. Are they licensed real estate professionals, lawyers, or securities professionals? If so, you can check the relevant databases for any complaints. Each state maintains an online database that can be used to look up licenses. For example, if you are in California, check these links to look up licensed real estate professionals or members of the California Bar Association. For instance, you can click here to see the author’s real estate broker’s license information. Also, FINRA has a database for licensed securities professionals.

Finally, you can follow a simple rule that would have saved many Madoff victims millions of dollars. If the key investment manager won’t disclose how he or she makes money, don’t invest. If the answer is that the technique is a secret, you may well be dealing with someone dishonest. The best managers have a specific strategy and they stick to it. Many strategies work because they require specific market knowledge and lots of hard work, and are difficult to execute (for example, the author’s strategy of making short-term real estate loans on short notice, including loans on projects that need extensive renovation). Others take advantage of the irrationality of public markets (famously, Warren Buffett). Either way, the portfolio manager should be able to explain the strategy in simple terms that any investor can understand—otherwise it is probably very risky in one respect or another.

*Source: Wall Street Journal, “A Nervy Approach to Retirement Savings,” May 17, 2013, by James Sterngold. http://online.wsj.com/news/articles/SB10001424127887323372504578467133425317620