How to Get Started with Self-Directed IRAs

February 17, 2009

As the general market trudges through uncertain times, investors are rotating to assets beyond traditional stocks and bonds for their retirement accounts. Growing investor sophistication has led many "self-directed" IRA (SDIRA) holders to real estate, private stocks, hedge funds, and other investments within their retirement accounts.

As the general market trudges through uncertain times, investors are rotating to assets beyond traditional stocks and bonds for their retirement accounts. Growing investor sophistication has led many “self-directed” IRA (SDIRA) holders to real estate, private stocks, hedge funds, and other investments within their retirement accounts. Alternative investments made through a SDIRA can provide greater flexibility and control over the investment returns generated by retirement accounts.

SDIRAs were created in 1974 and are within IRS rules and regulations. And while they are quickly growing in popularity, they account for only a small percentage of the almost $4 trillion currently held in retirement accounts. Though they were a little-known secret, SDIRAs are quickly moving into the mainstream for their ability to offer greater diversification, investment selection, and the ability to invest in assets in which informed individuals are familiar.

Why Set Up a SDIRA?

A SDIRA allows taxes on assets held inside the IRA account be deferred or postponed until the money is withdrawn from the account, presumably after the age of 59½. Alternative investments allow account owners to take a proactive approach to improving investment returns, because they choose asset classes that are not correlated to existing asset classes in their portfolios.

Recent volatility in the stock market has forced many investors to take a harder look at their investment allocations, eager to ensure a proper mix of opportunity and risk. A SDIRA provides a broad mix of investment opportunities beyond traditional publicly-traded assets.

Real estate investors may capitalize on their knowledge of a certain area and/or market by investing in local property. Private Equity investors may capitalize on their knowledge of emerging companies and industries. The leading investment option in SDIRAs, for many, is real estate. The following are a few examples of how retirement accounts invest using a self-directed IRA:

• Residential rentals

• Commercial properties

• Condominiums

• Land

• Trust Deeds and Mortgages

Others include:

• Private Equity and Debt

• LLCs

• Limited Partnerships

• Tax liens

• Hedge funds

• Mutual funds

• Annuities

Finding Out More

Alternative investment options are not offered by every financial advisor. Some brokers or custodians may not fully understand the investment opportunities available or lack the capabilities to provide this option to their own clients. However, investing in alternative investments is a common practice and within IRS guidelines. The process can be greatly simplified when account owners work with a knowledgeable advisor familiar with the different practices.

Choosing the right SDIRA custodian or professional advisor to assist you is an important decision. You might be surprised to find there are a wide variety of individuals and firms who claim to be experts in the field. While this does not make the selection process any easier, with a little preparation you can create your own scorecard to help separate those “in the know” from those who are not.

To begin this journey you need to know that the term “self-directed” has taken on a life of its own. At one point in time, this term was used to denote firms or individuals who specialized in the sale or administration of non-publicly traded investments, such as real estate, tax liens, private equities, partnerships, limited liability companies, etc. Not true anymore! Today, many advisors and IRA service providers have inserted this phrase into their marketing literature, advertisements, and websites simply because it generates phone calls and drives traffic to their websites.

Once you contact the individual or firm, you might find that what they call self-directed is simply an attempt to repackage their traditional investments products, such as stocks, bonds, and mutual funds. In other cases you might find that they have created a limited selection of investment, such as hedge funds or non-publicly traded REITs, that they are happy to offer utilizing their traditional commission arrangements. Do not despair, with a little time and effort you can narrow your search to those who really offer the investment flexibility and advice you seek.

Getting Started

If you have a particular area of interest, such as private equities or real estate, you will want to find a firm that has experience in administering those particular assets. Once you have identified a number of possible custodians, you should create a list of questions and a scorecard to help further refine your selection process. Below is a list of possible questions you may ask to help determine which firm might be the best for you.

Q: What type of entity is the IRA Custodian? Example: A bank, independent state chartered trust company, securities broker dealer, or a privately owned business.

Q: Who regulates the firm, if anyone? Example: FDIC, OCC, SEC, state banking commission, etc.

Q: How does the IRA Custodian invest idle cash, and are these funds available immediately for investment or distribution purposes? Reason: Some IRA Custodians provide an in-house interest bearing account, while others may sweep the funds to a money market account at a mutual fund company. If the IRA Custodian uses an outside money market account, you will want to ensure you have same day availability of your funds. Also, you may want to ensure that the IRA Custodian you choose uses an interest bearing account that is FDIC insured. Effective April 1, 2006, the FDIC increased coverage for IRAs and other qualified retirement plans to $250,000, the first increase in deposit insurance since 1980.

Q: How will the IRA Custodian register your investments? Example: individual registrations, or an omnibus arrangement where the custodian simply places all assets under the name of the firm. Reason: In the unlikely situation where an IRA Custodian goes out of business, individual registration will make it easier for the regulators or successor organization to quickly identify your assets. This would improve the turnaround time associated with transferring your account to another firm.

Q: Does the IRA Custodian carry Errors and Omissions insurance coverage, and if so, how much? Reason: In the event of losses, an E&O policy would help provide a safety net that might help offset losses sustained by processing errors by the IRA Custodian.

Q: What asset types does the IRA Custodian administer, and how long have they handled such assets? Reason: You will want to make sure that the prospective IRA Custodian will not only administer the type of asset in which you plan to invest, but has experience as well. Example: A broker dealer may allow you to hold a private equity within your account that is transferred to them as an IRA rollover or transfer. However, they may not allow you to make any additional investments into this category. Accordingly, you should find a firm that will allow you to actively invest in products that are of interest to you.

Q: What are the IRA Custodian’s fees for handling a self-directed account? Do they charge a percentage of assets under administration or an ala carte fee schedule (where you pay an annual administration fee plus transaction and asset holding fees based upon activity)? Also, don’t forget to ask about termination fees (the cost to close your account) as they often vary between IRA Custodians. Reason: Typically, you will find that your best pricing comes from those firms that utilize an ala carte fee approach. In such cases, with the exception of the annual fee, you are only paying the IRA Custodian for work they perform. However, in the final analysis, it will depend upon the facts and circumstances of your situation to determine who will provide the best pricing.

Q: What support, if any, will the IRA Custodian provide when you have questions relating to your investments? Reason: Don’t be surprised if you find that most firms simply refer you to your legal or financial advisor (this is normal). On the other hand, some custodians are willing to discuss your proposed investments with you and point out any possible problems upfront. These firms will also tell you to discuss the proposed transaction with your outside advisor(s); however, they will let you know if what you want to do is possible.

Investment Professionals

Unlike many IRA Custodians who are familiar with both traditional and non-traditional investments, investment advisors tend to specialize. Accordingly, investment advisors who work for broker dealers, mutual funds, or insurance companies tend to have limited experience in non-traditional assets, such as real estate, tax liens, or trust deeds. You might be surprised to learn that a number of Registered Investment Advisor firms across the country have started investing in non-traditional assets and may be a solution if you are looking for someone to invest your funds for you. If, on the other hand, you want to be actively involved with the selection of your investment, you may have to find several different individuals to assist you.

For example, if you are interested in investing in real estate, you will need to look for someone in that field who is licensed. In addition, you should ask them if they have experience working with IRA investors. This is an important issue and will help keep you out of trouble. For example, if a realtor has a rental income property that is available and of interest to you, they may recommend that you put 30% down and have the IRA borrow the remainder of the funds. Although the investment may yield a positive return (even with the debt service) it could create taxable income to your IRA, known as unrelated business taxable income (UBTI). This could materially affect your decision to use leverage for a property purchase and should be researched ahead of time.

How do you begin the process of finding an investment advisor who is familiar with the investments you wish to make? First, you may want to ask your friends, acquaintances, or business associates who may share your investment interest. Once you have found a number of prospects, create your scorecard and begin. Here are some sample questions to get you started.

Q: What type of investments do you handle?

Q: Are you licensed? If so, by whom and how long have you held your license?

Q: How do I check to see if any complaints have been filed either against you or your firm?

Q: How are you compensated for your investment recommendations?

Q: Are you familiar with using IRA funds for investing in such assets?

Q: Do you already work with an IRA Custodian and, if so, who?

Q: Are you familiar with the prohibited transaction rules affecting IRAs?

While the IRS permits almost any investment within an IRA, there are rules that must be followed to ensure there is no “self-dealing.” Simply stated, investments within your IRA must be at arm’s length and not involve you, your spouse, or an ancestral or lineal descendant of your family. Violation of these rules will disqualify your IRA. Accordingly, you will want to find a professional advisor who understands the “do’s and don’ts” of IRA investing or, at least, find an IRA Custodian who is willing to answer such questions.

Conclusion

Interest in self-directed IRAs, and the ability to diversify retirement investments, has grown in recent years. Whether you are trying to trying to find an IRA Custodian or a professional advisor, you want to look for someone who is experienced, professional, credible, and financially stable. With a little effort, you can compile the information necessary to help you with your selection process.

TommyJoe A. Valenzuela ("TJ") is VP of sales and marketing for TAS (Trust Administration Services) online at www.trustlynk.com and a division of First Regional Bank. He can be found at www.trustlynk.com