Most of us have a retirement account — either an IRA or a qualified employer plan like a 401(k) or 403(b). These plans provide easy access to traditional investment choices like stocks, bonds and cash.
But what about gold? What about real estate? What if you don’t want to bank your retirement on the stock market because you’re uncomfortable investing in what you don’t understand — or because you’re just plain wary of bull and bear cycles? Can’t you choose to invest your retirement money in other things?
A Way to Hold Alternative Assets in Your Retirement Account
The answer is yes. The IRS allows you to invest in a multitude of “alternative investments” including real estate, asset-based lending, precious metals, rare stamps and coins, art and antiques and more. In fact, IRS Publication 590-A explicitly states only a few things you can’t invest in with qualified retirement funds, such as life insurance and some collectibles.
In other words, the IRS code doesn’t prohibit investing qualified retirement funds in alternative investments — defined as any type of investment that falls outside the conventional instruments of stocks, bonds and cash — but brokers and financial institutions are not required to offer these alternatives as an option.
If you’re unable to invest in alternatives with your current plan, it’s simply because your plan administrator or financial institution restricts the choices they make available to you.
Most financial institutions choose to limit their offerings to traditional investments, largely because allowing alternative assets necessitates unique administrative and custodial requirements. It’s just easier for these institutions to transact and administer traditional choices like electronically traded stocks, bonds and mutual funds.
But here’s what they won’t tell you: It’s just as easy for you to roll over your funds to a trustee or custodian that allows you to own assets in any investment allowed by law.
The clearest path to investing in alternatives with qualified retirement funds is to open — or transfer your existing account into — a self-directed individual retirement account (SDIRA).
But let’s back up a minute. Why would you want to invest in alternatives?
The “Pros” of Alternative Investing
While it’s not mainstream — and not a good choice if you’re more comfortable being a passive investor — there are some compelling reasons to add alternative investments to your portfolio. Among them:
- Portfolio diversification. Publicly traded stocks, mutual funds and bonds have a place in every investment portfolio. Most investors also find it beneficial to diversify into alternatives like real estate and precious metals that are not publicly traded to achieve optimal asset allocation.
- Comfortability of investing in what you know. You might be very comfortable with real estate investments, for example, because you understand them better than stock investments.
- Ability to select specific investments. Owning the single-family residential home across town might be more attractive to you than owning a small percentage of many unseen properties in a real estate investment trust (REIT), for example.
- Higher gains potential. While many alternative investments carry higher risk (much of which can be mitigated when you know what you’re doing), the upside is the potential for higher returns than the stock market — much higher, in many cases.
- Less exposure to stock market volatility. Many alternative investments are not directly correlated to the stock market and can go the opposite way when the stock market fluctuates.
- Desire for tangible collateral. There’s a big difference between owning shares of a mutual fund that invests in gold and owning physical gold bullion. Alternative investments allow you to own tangible assets.
Real estate is the main alternative investment in my SDIRA for a variety of reasons. It provides an easy-to-understand structure for most people. If you own your primary residence, you’ve already had experience buying real estate. Real estate is tangible, provides portfolio diversification and protects your overall portfolio against stock market volatility. (You can read this article I’ve written for Investor Junkie for tips on how to get started with real estate investing.)
The “Cons” of Alternative Investing
As Paul wrote to the Corinthians, “Everything is permissible, but not everything is beneficial.” Just because you can doesn’t mean you should. A self-directed IRA is just that: self-directed. Handing your money over to a professional money manager and directing the investment decisions yourself are opposite ends of the control and responsibility continuums. You need to carefully consider downsides like these:
- Alternative investments can be time consuming. Will you devote the time/effort needed to choose your investments and do your due diligence? The success of alternative investments depends in large part on the thoroughness of the due diligence that is done for each opportunity.
- You must “own” direct responsibility for the result — success or failure — of your decision. I personally don’t see this as a downside. After all, nobody cares more about your money than you, so even if you hire a money manager, you need to take responsibility and ownership of the decisions made on your behalf. Your broker won’t live with the results he doesn’t deliver to your portfolio. You will.
- The tax compliance issues can be a headache. Do you understand — or are you willing to take the time to understand — the tax and compliance issues inherent in the asset classes and specific investments you choose?
Still interested? Good! Let’s dive into the rules and mechanics of self-directed IRAs, specifically with investing in real estate, which is what I have personal experience doing.
Two Broad Rules to Qualify
The government doesn’t make this easy. You have to follow the rules carefully to maintain the benefits of investing with the qualified retirement funds when using a self-directed IRA.
An SDIRA is a trust. As such, you must use an approved trustee to set up and manage your SDIRA. The trustee must be a bank, a federally insured credit union or an entity approved by the IRS to act as custodian.
To maintain status as a qualified retirement account, there are really two broad rules:
- You cannot transact with “disqualified persons” such as yourself, certain family members and key persons in a company-owned business.
- You cannot engage in “prohibited transactions” (as defined in IRC 4975(c)(1) and IRS Publication 590).
These broad rules were established to maintain that everything the IRA engages in is for the exclusive benefit of the retirement plan. In essence, it’s the plan — not you, personally — that benefits.
A Few No-Nos From the IRS
When you break down the rules into specifics, there are a few no-nos:
- You can’t transfer property you already own into your SDIRA. While you certainly view your primary residence as an investment, you can’t use qualified retirement funds to purchase properties that benefit you personally.
- When you buy an investment property with your SDIRA, you personally cannot do any of the maintenance or rehab work yourself. While you make the decision about what needs doing and who does it, neither you nor any other prohibited individual can personally do any of the work.
- Documents of ownership cannot be in your name, ever. All documents, from the initial offer you make to the closing legal title and settlement forms, are owned and titled in the name of your IRA — and signed by the custodian of your IRA.
- You cannot purchase a property and rent it out to a relative — that would benefit you personally.
- All transactions and contracts — whether they be hiring a handyman to repair a toilet or securing an alarm system with a monthly contract — are conducted in the name of your IRA, never your personal name nor secured with your personal credit.
- You cannot receive rental income or pay expenses personally. All income and expenses are funneled directly into and out of your SDIRA.
- You cannot be the real estate broker and receive a commission when your IRA purchases property.
- You must pay and receive fair market value when conducting investment transactions.
This list isn’t exhaustive… and there are thousands of situations that would come up in which you need to exercise discernment. For example, your IRA can own acres of property designated for hunting, but you and your relatives cannot hunt on the property personally. That would benefit you, not your account. And if you allowed friends to hunt on the property, you would need to charge them fair market value for the service and this “rent” would be collected by your SDIRA.
Bottom-line: You need to make sure you understand the rules and follow them diligently.
The consequence of breaking the rules is disqualification of the entire retirement account as of Jan. 1 of the year the disqualifying transaction occurred. In other words, your entire account (not just the asset on which you broke the rules) is deemed “not qualified,” and the total is automatically distributed to you as taxable income. You may also incur hefty penalties (including a possible 20% “accuracy related” penalty fine) in addition to paying distribution taxes and the early withdrawal penalty if it applies.
Transferring Funds to Your SDIRA
As mentioned earlier, if you want to use the funds from your IRA to invest in alternatives, you need to transfer the funds from your traditional or Roth individual retirement account (IRA) to a self-directed IRA. There are many companies with expertise in this area — your local financial institution will very likely not be able to do this for you, nor will the big-name investment brokerages like Fidelity.
You have to find a custodian trustee that specializes in self-directed IRA administration. There are many custodian companies to choose from. It’s best you do your due diligence in selecting the custodian that’s right for you.
The brokerage firm from which you’re transferring your funds and the SDIRA custodian you choose will help you through the process of transferring your assets. You may be able to transfer them without liquidating your stocks, bonds and mutual funds, or you may desire to sell your current assets and transfer cash. The rules require account owners to make active investments on behalf of the plan. As such, you need cash to purchase assets in your SDIRA.
One thing you don’t need is strong credit. In fact, your credit doesn’t come into the equation at all. While you may choose to secure a loan against income-producing real estate held in your SDIRA, for example, it will be a non-recourse loan backed 100% by the equity of the property, not your personal credit.
Buying Investment Assets With Your SDIRA
Once you have your SDIRA set up, you can acquire investment assets. Remember, this is an investment account. The goal is to increase your investments, so the intent needs to be purchasing assets that will increase in value over time or that will generate income now, like rental properties, for example. Your SDIRA account holds the assets, and you direct the custodian to make purchase transactions on behalf of your account.
Assets are titled in name of your IRA trust (which is assigned to you by your custodian), not your name. It will look something like this: “Trust company, FBO Your Name IRA.” The steps are straightforward:
- Open account with authorized custodian.
- Prepare asset purchase agreement in name of SDIRA.
- Instruct custodian to complete the purchase and wire the funds.
- Custodian executes the purchase and signs, assisting you in ensuring the investment doesn’t violate rule or laws.
- All income and expenses go through the IRA only, never to you as the owner directly.
And you should always maintain a cash balance for unexpected expenses related to assets held in your SDIRA. This is important: It’s a prohibited transaction with a disqualified person to personally pay for any expenses related to assets held in your SDIRA. I am sure to always have cash in a money market account owned by my SDIRA to promptly pay insurance premiums or a maintenance issue that may come up with one of the rental properties owned by my SDIRA.
Interested in more information on acquiring a real estate asset with your SDIRA? This article walks you through the process I used to purchase my first rental property.
An SDIRA allows you to invest in a myriad of assets not available through most financial institutions and investment brokers, including tangible assets such as real estate and precious metals.
You can roll over any qualified retirement money — 401(k), 403(b), 457, Simplified Employee Pension Plan, SEP IRA, Roth IRA, etc. — into an SDIRA. And just like any qualified retirement account, you can make tax-deferred annual contributions to your SDIRA. The 2017 contribution limits are $5,500 if you’re under age 50 and $6,500 if you are over age 50.
It takes time and effort to set up the account as well as to manage activities such as the purchasing, maintaining and selling of assets. You must do your due diligence on the custodian you choose and all of the investment opportunities you consider. You are in charge of all decisions — your custodian acts on behalf of your account with directions from you. This isn’t for the passive investor.
Through the SDIRA, you’re building your retirement nest egg, and the funds are not available until you retire (without penalty and taxes in most cases). Until you withdraw funds at retirement, your investments are growing tax-deferred. You’ll pay income tax on the funds when you withdraw them — most likely you’ll be in a lower tax bracket at that time.
Engaging in prohibited transactions and/or with disqualified persons are serious infractions, and the penalties for negligence are severe. Don’t take chances with your future. Be sure to know, respect and follow the rules.
Let me know how you make out by leaving a comment below. Good luck!