If you recently watched your individual retirement account or 401(k) drop by double digits, you may wonder if there is a better way to sock away money in an uncertain economy.
What if you could replace some of your investments with tax-deferred holdings not tied to the troubles on Wall Street? Maybe you’d prefer to invest in cattle in Wyoming, a gas station in Philadelphia or an underwater cemetery in Miami.
Impossible — or even illegal — you say? Not so, according to the Internal Revenue Service tax code. Self-directed alternative IRAs, which are more widely known for their ability to fund real estate, can also be used for private equity investments, such as limited liability corporations, private stock offerings, leases and lease options, and joint ventures.
Many investors do not realize that investing IRA money in private equities is perfectly legitimate, and has been since 1974, when the IRA code was written.
“With this (stock) market being what it is, we will start to see more private equity funded by IRAs,” says Tom Anderson, CEO, president and founder of PENSCO Trust, a custodian firm for self-directed IRAs based in Portsmouth, N.H.
However, investing in self-directed IRAs is not a sure ticket to riches. These products often involve a high level of risk that can wipe out retirement savings for investors who are not careful.
Al Horrigan, 66, of Sarasota, Fla., is one of PENSCO Trust’s clients. He started investing in alternative private equities and real estate in 2000. He first dabbled in day trading with $21,000 from his Roth IRA and turned it into $70,000.
With his IRA custodian at his side, Horrigan used the money to purchase 40 acres of land in Nevada, which he flipped three years later for $350,000. He then bought more real estate and Apple stock, which mushroomed to a value of $680,000.
Horrigan’s IRA now contains a mix of selected stocks, real estate and private equity. His latest investment has been in Neptune Memorial Reef. The privately held company has created an ecological artificial reef off the Miami coast that doubles as an underwater cemetery.
The investment, Horrigan says, is for the long term and will eventually yield good dividends. His other investments have allowed him to live comfortably off his earnings without touching the principal.
“Alternative investments have allowed me to continue to do the things I want to do,” he says. “That’s what I call retirement.”
While Horrigan’s goal has been to retire comfortably, others use alternative IRAs to invest in companies that will give them not only savings for retirement, but a job.
Eric Gilkesson, 38, of Atlanta, used his self-directed IRA in 2006 to make a total investment of $95,000 in Signature Channels LLC (now Thanks Again LLC), a rewards program company.
He says the company is now worth about $10 million.
“We’ve been duped into thinking the 401(k) is the ‘end all, be all,'” Gilkesson says.
Gilkesson owns about 3 percent of Thanks Again. His initial investment has ballooned to about $300,000, he says. Moreover, his investment does not represent his entire retirement savings. He also has money in traditional IRAs.
While some investors may opt for self-directed IRAs, they are not for everyone. These investments come with risks that a prudent investor must weigh before taking the plunge.
Darrin Farrow, president of Pension Builders and Consultants of Westlake, Ohio,is not comfortable with these risks, and does not recommend self-directed IRAs for his clients.
“There are a lot a risks, particularly if investors are doing (it) on their own, or if they no experience with the investment, or don’t have enough assets,” Farrow says.
Self-directed IRAs are especially risky for people who don’t have much money to invest, or who are depending on the IRA for retirement income in the near future.
A deal gone south can mean financial ruin for such an investor, Farrow says.
Michael Rubin, founder of the financial education company Total Candor, agrees that self-directed IRAs are not for the average investor. For starters, most of these investments require a significant amount of cash. Relatively few Americans have such a hefty balance of IRA funds, he says.
“Your annual $5,000 contribution isn’t going to cut it,” says Rubin, who is also author of the book “Beyond Paycheck to Paycheck.”
Instead, Rubin urges most investors to stick with a more modest, tried-but-true approach.
“Boring as it may seem, the average investor is better suited focusing on good old low-cost index mutual funds,” he says.
Certain types of self-directed IRA investments can actually worsen your tax situation. For example, investing in an entrepreneurial venture through a self-directed IRA prevents a business owner from writing off any losses in the year they were incurred.
Self-directed IRAs may be more appropriate for high-net worth individuals — people with at least $1 million in net worth — who have enough assets in their IRAs to risk putting a percentage of their money into alternative investments, Farrow says.
However, investors of all income groups can run into other types of trouble if they are careless — or simply clueless — when establishing their self-directed IRAs.
Laurie Bachelder is principal and chief compliance officer with Nua Advisors, based in Portland, Maine. She stresses that investors should seek professional advice before making investment decisions.
She especially warns investors to stay away from “do it yourself” kits available online.
“If these deals are not constructed properly, you could lose the tax-deferred status of your IRA,” she says.
Garry Madaline, founder of the retirement planning company United Retirement Advisors Group based in Wayne, Pa., says the lack of transparency in some investments associated with self-directed IRAs can be a recipe for disaster for average investors.
“Most investors can’t afford the loss if it happens,” says Madaline, who is the author of the book “Making the Most of Your Retirement.” “Having to push your retirement back five to 10 years due to stock market losses is nothing compared to losing it all when a private deal goes bad.”
Despite these potential pitfalls, some people still decide that self-directed IRAs are the best option for at least a portion of their retirement dollars.
An IRA custodian is crucial to properly establishing a self-directed IRA. The custodial company is similar to brokerages and mutual fund companies that handle traditional IRAs. However, the IRA custodian offers investment choices that go beyond stocks, bonds and mutual funds.
The custodial firm purchases private equity or real estate investments and holds them on the IRA owner’s behalf, a requirement necessary to maintain the investment’s IRA status.
Just a handful of firms offer self-directed IRA custodian services, mainly because these investments require extensive research, paperwork and IRS reporting that many brokerage firms are not willing to undertake.
Expect to pay a lot more than a $10 yearly maintenance fee for this service. Costs can range anywhere from $100 to as much as $2,000 a year, depending on your investments.
Remember that custodians are only the keepers of your IRA — they do not offer investment advice or conduct due diligence on investments. For that, you need to find a financial adviser, certified public accountant or a lawyer.
When choosing such experts, be sure to turn to someone with experience managing self-directed alternative investments for retirement. Many experts recommend working with a fee-based financial planner rather than an adviser who works on commission.
Hiring the right help is crucial to staying in compliance with IRS tax rules regarding self-directed IRAs.
For example, it’s important to avoid what the IRS labels “prohibited transactions,” including investments such as life insurance, stock of S corporations and collectibles.
Also, people who open self-directed IRAs cannot use the funds to buy an investment from or sell an investment to a disqualified person as defined by the IRS in Internal Revenue Code Section 4975.
Disqualified people include the IRA owner and family members such as spouses, parents, grandparents and great-grandparents, children and their spouses, and grandchildren and great-grandchildren and their spouses.
Investors who violate self-directed IRA rules are guilty of “self-dealing” and can lose the tax-deferred status on the entire IRA balance. In such instances, they face having to pay income taxes and being charged an additional 10 percent penalty if they are younger than 59½ years of age.
With the right professional advice, careful investors can benefit from using self-directed IRAs to fund their retirement, Bachelder says. She contends that even investors without a lot of money can benefit from this investment option.
“Self-directed IRAs are not just for the very wealthy,” she says.
For example, investors can lower their overall stake — and the risk that comes with it — by joining forces with others, Bachelder says.
“An investor can participate within a part of an investment, if it is correctly structured,” she says.
Bachelder cites the example of two clients who each used $25,000 from their IRA to purchase a dressage horse that cost $50,000. After training, such a horse can be sold for as much as $70,000 to $100,000.
Catherine Wynne urges investors to stick with the familiar.
“Our most successful clients are the ones that are investing in something they understand,” says Wynne, president of Entrust New Directions, a franchisee of the Entrust Group in Boulder, Colo., a self-directed IRA custodian.
For example, she says one of her clients, a medical doctor, has pooled his IRA with other doctors to create a walk-in CAT scan clinic. Proceeds of the profits from the clinic are funneled back into the doctors’ IRAs.
Self-directed IRAs can even being used to help the community.
Ephren Taylor is CEO of Raleigh, N.C.-based Capital City Corp., which has a Web site called “IRA CashFlow.” The company specializes in helping link self-directed IRA investors to retail and service operations in low-income communities.
Taylor’s organization uses Equity Trust as a custodial firm and runs the business for the client.
“Our clients are getting returns even in a down market,” says Taylor, who brings self-directed IRA investors to established businesses such as gas stations and pizzerias in low-income urban areas.
“Pizza isn’t as sexy as dot-com, but (at the) end of the day, you have positive cash flow and early retirement,” he says.