Power Up Your IRA

With These Money-Making Investments

Although most investors don’t realize it, you can turn your retirement account into something much more diverse than a collection of stocks and bonds. You can include unconventional investments ranging from condominium apartments to a franchise business to an alpaca farm. Or you can choose some slightly more familiar investments such as certain gold and silver coins or bullion…a vacation time-share…or lending someone money and charging him/her interest.

Sound fascinating and potentially lucrative? It is, on both counts. This type of “self-directed” IRA strategy can cushion your nest egg against setbacks for stocks and bonds in your conventional IRAs and improve your overall returns. But don’t expect to hear much about self-directed options from major investment firms such as Fidelity or Merrill Lynch. They tend to offer mainstream, publicly traded investments such as stocks, bonds and mutual funds, as well as real estate investment trusts (REITs) and certificates of deposit (CDs).

To incorporate unusual investments in your retirement savings, you’ll need to establish a self-directed IRA with an IRA custodian that specializes in privately traded assets. That isn’t hard to do. But it’s vital to understand that unconventional investments require more personal effort and expertise on your part than do run-of-the-mill investments. That’s why only about 3% to 5% of the entire $6.5 trillion IRA market in the US is invested in these specialized IRAs.

Bottom Line/Personal spoke with IRA expert T. Scott McCartan, CFA, about how to decide whether a self-directed IRA is right for you and ways that it might help you diversify your nest egg…

Do-It-Yourself

Over the next several years, traditional retirement investments face many challenges. Stocks are nearing the end of a long bull market, and rising interest rates will make bond prices volatile. Investors are rethinking how to smooth the future ups and downs of the markets and juice up returns.

One way is private investments. Opportunities in private investments are far less publicized and may offer greater potential returns than stocks or bonds. You also have more control because your ability to make a profit largely depends on your own skills and judgment.

Example: I had a client who, after spending years watching and studying his local real estate market, invested $150,000 of his IRA money in a condo near where he lived. He rented out the condo and has netted $1,000 a month after expenses, an 8% annual return. That money flows back into the IRA, and until he withdraws assets from the IRA, he doesn’t have to pay taxes on the income—or on potential profit when he sells the condo in the ­future.

Do-it-yourself investing like this is inherently risky because the ­investments lack the built-in diversification and liquidity that you could get from, say, investing in shares of a REIT that owns thousands of condominiums. Also, determining valuations of assets that are not easily converted to cash can be complicated. For these reasons, most investors might want to consider dedicating no more than 15% of their overall retirement money to ­specialized IRAs. Steps to get started…

Set Up an Account

Funding a self-directed traditional IRA or self-directed Roth IRA is similar to funding a standard IRA. You can even roll over cash into a self-directed IRA penalty-free from your existing IRAs or from an existing 401(k) or 403(b) when you retire or change jobs. All the standard annual IRA contribution limits apply. However, you do need to open an account with a custodian qualified by the IRS to handle self-directed investments, typically a trust company. To find a reputable one, ask a financial adviser or visit the website of the Retirement Industry Trust Association (Ritaus.org). Some custodians cater to multimillion-dollar retirement accounts and handle a variety of investments…others handle smaller sums and more specific ­investments.

The custodian of a self-directed IRA won’t provide investment advice or sell you financial products. The custodian simply holds your assets, makes sure that appropriate tax documents are filed, fulfills your requests to buy and sell assets, and credits your account for any recurring income such as dividends or rent. If you are not satisfied with your custodian, you can transfer your self-directed IRA to a different one without incurring a tax penalty. You can even liquidate your investments and roll the money back into a regular IRA. However, custodians often charge an account-termination fee, as well as a transfer fee if you are transferring the investments without liquidating them. Both types of fees vary widely.

Expect to pay the custodian a fee of 0.3% of the assets in your account each year (that’s $300 on every $100,000). Depending on the complexity of your self-directed IRA investments, you may also need to pay for the guidance of a tax or small-business attorney in addition to paying custodian fees.

Decide What to Invest In

Options in self-­directed IRAs include the following three ­categories…

Real estate is, by far, the largest and most popular investment. Owning apartments and multifamily homes is a business in which many investors feel they have or can develop a reasonable expertise and edge. Some IRA investors team up with friends or partners to pool their money to buy larger commercial properties such as office buildings and storage facilities.

Promissory notes and loans represent one of the fastest-growing alternatives for self-directed IRA investors. With this type of investment, you use your IRA assets to lend money. In return, your IRA receives interest from the borrower each month until the borrower pays back the principal.

Example: LendingClub.com, which matches up investors with borrowers who need personal loans ranging from $500 to tens of thousands of dollars, is popular with self-directed IRA investors, who may earn 5% to 10% interest or higher on loans. If a borrower fails to make payments, ­LendingClub will turn over the account to a collection agency, but there is a chance that you could lose your principal.

Private equity—owning a partnership interest in a private business or acting as a venture capitalist for a start-up company—requires extensive expertise and research, but it may provide the highest return over time.

Avoid the Pitfalls of Self-Directed IRAs

Self-directed IRAs have unique risks and specific guidelines that an investor must understand. These include…

Lack of government protections. Due diligence is up to you. If you invest in a private deal and it turns out to be a fraud, you can file a lawsuit against the con artist, but unlike publicly traded stocks, private investments have little oversight or scrutiny from government regulators.

Lack of liquidity. It’s easy to bail out of a bad mutual fund. But if you invest in, say, commercial real estate, you may not have access to your money for years until the building is sold.

Caution: Tied-up assets can be tricky for older investors who reach 70½ and have to start withdrawing required minimum distributions (RMDs) each year. Because your RMD is based on the aggregate of assets in all your IRAs and you do not have to withdraw a proportionate amount from each IRA, you will need to make sure that you have enough money to withdraw from more liquid IRAs to satisfy IRS requirements.

Prohibited investments. Some are off-limits even in self-directed IRAs, including life insurance contracts and certain collectibles such as artwork, rugs, antiques, gems, stamps, certain rare coins and wine.

Self-dealing. The IRS strictly prohibits owners of self-directed IRAs from using the accounts’ assets for self-benefit or profit other than distributions. Example: If you invest in a vacation home in your IRA, you can rent it out or resell it, but you cannot stay in the home yourself—not even for a single night—or allow immediate family members to stay there, even if they pay you to do so.

This prohibition against “self-­dealing” also applies to non–real ­estate investments. Example: You can’t use your IRA money to invest in a business start-up owned by your son.

If you cross these legal lines, the IRS could disqualify the IRA’s tax-deferred status and force you to pay income tax on the full value of the holdings, as well as a 10% penalty on that amount if you are under age 59½.