Despite the surge in popularity of target-date funds, which put retirement investing on autopilot, some bold individuals are going to the other extreme. These aggressive investors are using a special kind of account, called a "self-directed" Individual Retirement Account (IRA), to add alternative -- and sometimes off-beat -- investments to their retirement portfolios.
There's a long list of caveats, but basically, investors can use a self-directed account to do much more than a traditional IRA that invests in mutual funds or bonds. They can buy real estate, invest in businesses, hold gold or silver bullion or even lease a herd of cattle.
"With the real estate market down, we're seeing a lot of activity in investment real estate," says Jason Craig, president of The Entrust Group, which specializes in self-directed IRAs that must be held at a custodial firm. "And over the last couple of years, gold and silver bullion has become more popular as well." Investment in private businesses and venture capital investing, he says, are also on the rise. And all of this is despite the suddenly buoyant stock market.
Entrust reports that the number of accounts it handles has expanded from roughly 10,000 to nearly 13,000 over the last three years. PENSCO Trust, another prominent firm that offers self-directed IRAs, has seen its accounts grow from about 11,000 to 18,000 over the last four years. Estimates from various sources calculate that investors hold 2 percent, or $94 billion, of IRA retirement funds in such self-directed IRAs.
While these IRAs allow more investment options than a traditional brokerage account, there are substantial taxes and penalties if you don't follow Internal Revenue Service guidelines, and some of the investments in them can be risky.
Nonetheless, investors like Michael Glynn, a 56-year-old from the San Luis Obispo, California area, are bypassing traditional investments and opening self-directed IRA. "Even though I thought I was in control of my retirement money I really wasn't," says Glynn, who ended up using his self-directed IRA to make a founding investment in Esperanza Technologies, which develops and acquires businesses involved in renewable energy and water purification.
Douglas Nereu, a 56-year-old San Francisco area resident, leases 40 beef cattle through a self-directed IRA. Nereu, who works as an account representative at a credit union, got started in self-directed IRAs after the dotcom bust in 2000-20001 devastated his brokerage firm retirement account. He also has other, separate IRAs invested in real estate. Over the last six years, the sale of the cattle's offspring has left him with a 4 to 7 percent annual return, after expenses.
"I wouldn't go back to a traditional IRA again," he says.
Sara Graham, a 48-year old Las Vegas certified public accountant, used her self-directed IRA last year to buy a beachfront house in Ecuador for $150,000. The property generates income as a rental for vacationers or those needing a temporary residence.
"The self-directed IRA gives me the opportunity to diversify as broadly as possible," says Graham, who also invests in traditional assets such as stocks and bonds though a traditional IRA.
The funds for a self-directed IRA can come from a traditional IRA rollover, and the same annual contribution limits apply.
RISKS AND RULES
Self-directed IRAs can be very risky. Anyone considering using them should:
--Diversify. Many financial advisers believe that a diversified portfolio of stocks and bonds is better than having a large chunk of money in just one alternative investment in a self-directed IRA. "My recommendation to clients is that they have no more than 15 percent to 20 percent of their retirement assets in self-directed IRAs, with the rest in traditional IRAs invested in stocks, bonds and mutual funds," says Jackie Kleinman, a financial adviser with KB Financial Advisory in San Francisco. About 10 percent of her clients use self-directed IRAs, and the most common investment is real estate.
--Understand the investment thoroughly. Unlike with publicly traded securities, financial and other information may not be readily available for the alternative investments that typically go in these accounts. When it is available, it may not be audited and independently verified by an outside party. The lack of transparency and regulatory oversight often makes self-directed IRA owners targets for fraudulent investment schemes, according to an SEC Investor Alert on self-directed IRAs issued last year. (here)
--Know the rules, inside and out. First, there's the prohibited transaction rule, which means that IRAs cannot hold certain assets, including life insurance or collectibles such as art, antiques, or gems. And as with any type of IRA, you can't borrow money from them.
And there's also a rule against self-dealing that could lead to substantial penalties and taxes. To avoid self-dealing, the whole investment must be run as an arm's-length business transaction. That means the IRA cannot do business with what's called a "disqualified person," which would include the individual IRA owner, a spouse, a parent, or a child.
In a real estate transaction, for example, having the IRA purchase a home and renting it to a parent would constitute a prohibited transaction. Similarly, a contractor who buys a house and fixes it up himself could also run afoul of the self-dealing rule since he has a direct personal involvement with the transaction.
If the IRS determines that the IRA has engaged in a prohibited transaction the account owner would have to pay income tax (and if he is under age 59½, a 10 percent early distribution penalty) on the entire value of the IRA, not just the portion used for the prohibited investment.
Custodial firms that specialize in setting up these types of IRAs, such as PENSCO Trust (Pensco.com) and The Entrust Group (theentrustgroup.com), provide more details about the rules governing the accounts. While these firms may offer guidance on how to set up and administer them, they generally do not provide opinions about the quality or legitimacy of investments. If you are considering setting one up and are unsure whether the investment passes the smell test from a financial or legal standpoint, be sure to consult with an attorney or financial professional.
(Editing by Beth Pinkser Gladstone, Andrea Evans; Desking by Andrew Hay)