When Patriot Federal Bank, a community bank based in Canajoharie, New York, went looking for start-up capital last year, CFO Vince Fazio tapped into an unlikely source: individual retirement accounts. While the humble IRA will never be confused with a hedge fund, it turns out that in the right hands this most prosaic of long-term investment vehicles is actually far more flexible than most people realize. In its “self-directed” form, an IRA can embrace a range of investments far beyond the typical mix of mutual funds and money-market accounts; it can, in fact, be used to invest in real estate, tax liens, small business, and a host of other “nontraditional” investments (see “Investing, with Limits” at the end of this article).
None of that was lost on Fazio, and ultimately 10 percent of the $8.6 million his bank raised came from self-directed IRAs, including his own. Fazio diverted about $11,000 of his retirement assets into an account that invested in the bank. Part of the appeal was the ability to secure “a buy-and-hold investment for long-term gain” and to keep his money “local.”
Self-directed IRAs aren’t new, points out Paul Maxwell, chief operating officer of Carlesbad, California-based Trust Administrative Services. “Alternative investments have always been permitted [in IRAs] under the IRS code,” he says. What’s helping them grow at three times the rate of traditional IRAs, in terms of number of new accounts, is the greater control they offer — and at least the aura of more upside. And given that many investors are hungry for more upside, and sometimes have hundreds of thousands of dollars accumulated in their IRAs, they can afford to get creative in pursuit of better growth, despite the added risk.
In fact, there may be a temptation to get too clever. “When you have accumulated significant money in one or more IRAs, that presents all kinds of possibilities,” says Robert Holdway, vice president of Boston-based Fiduciary Trust Co. But Holly Isdale, managing director and head of Lehman Brothers Wealth Advisory Group, cautions that a self-directed IRA should be regarded as “play money,” and that investors should understand their individual risk profile, allocate accordingly. They should beware of “betting the ranch” with a self-directed IRA.
Whether those words of caution are necessary is debatable: there are no solid statistics regarding the performance of self-directed accounts compared with more-traditional IRAs, and they have tended to be embraced by more-sophisticated investors, who presumably understand that the potential for higher returns invariably entails higher risks.
Setting up a self-directed IRA is relatively simple. It must be administered through third-party custodial firms, and a cottage industry has emerged to oblige. Firms such as Trust Administrative Services; Entrust Administration Inc., based in Oakland, California; and Sterling Trust Co., in Waco, Texas, all specialize in self-directed IRAs.
In addition, some bank trust departments can set up these accounts, as long as they limit themselves to administrative functions and do not offer investment advice. There are fees involved, of course. Trust Administrative Services, for example, charges a base annual administration fee of $150 as well as transaction and asset-holding fees. Entrust charges $50 to open an account, plus annual record-keeping fees that can go as high as $1,850. (Fees to administer regular IRAs typically average less than $100 annually.)
Depending on the provider, some company 401(k) plans and corporate profit-sharing plans may also offer a self-directed option.
Once the account has been established, the investor has the option of moving funds into it from other IRAs, a 401(k), and similar plans, or essentially starting from scratch. Depending on the services offered by the underlying administrator or custodian, buying, say, individual stocks may be simple, while moving a real-estate asset into the account can be more complicated. (You write the check and essentially handle the administration yourself. See Publication 590 on the IRS Website for details.)
There are some specific pitfalls to consider as you manage a self-directed IRA. The first is to avoid anything the IRS deems off limits, such as life insurance and collectibles. And whatever investments are made must not hint of “self-dealing.”
In other words, the investor can’t benefit from the IRA beyond its tax-deferred growth. “You can’t buy that beach house you drove past and fell in love with,” says Lehman Brothers’s Isdale, so if you see your IRA as a viable way of both living in and investing in a second home, forget it.
The penalties for prohibited transactions can be severe: if you channel a percentage of a traditional IRA to a self-directed account and then are deemed to have violated self-dealing rules with the latter account, the entire original IRA may be ruled to have been distributed, opening you up to a raft of penalties and taxes. Self-dealing rules don’t just apply to you, but also to close family members, so if you decide to invest in a small business, make sure it isn’t your brother’s restaurant.
Assets that you make a part of your IRA must stay in your IRA even as you buy and sell. For example, if you invest in land, you must hire someone else to manage it, and if and when you sell it, those proceeds must go back into the IRA. Moreover, any fees and expenses relevant to the IRA have to come from the IRA, not from your personal checkbook.
Violate any of these boundaries and the Internal Revenue Service may treat the investment as an early withdrawal, taxing it as ordinary income and adding on a 10 percent penalty. To be safe, use an adviser to help navigate the rules, and if you suspect that a potential investment may be questionable, seek advance approval. and don’t get carried away: a self-directed account appeals to those who feel they are astute, but the rule of “diversify, diversify, diversify” still applies. Isdale recommends that no more than 25 percent of your retirement portfolio be channeled into a self-directed IRA.
Taxes and Taxing
A smart IRA strategy always takes into account tax strategies, and that’s true for self-directed IRAs as well. For any investment to make sense in an IRA, the benefits of tax deferral should outweigh the tax bill that applies if the investment is treated as a capital gain or ordinary income. And because of those tax rules, “there are just some investments that might not be appropriate,” says Fiduciary Trust’s Holdway.
For example, investing in a limited partnership may bring up the tricky problem of unrelated business taxable income. A partnership or LLC is known as a “pass-through” entity, explains Holdway, meaning that net earnings come from the business, not from the appreciation of stock. In such cases, the IRS treats the earnings as business income, not investment income, and levies taxes at the trust income-tax rate of 35 percent.
Even if you’ve addressed tax risk, there is always the question of investment risk. Patriot Federal Bank’s initial public offering was nine months ago, but the stock is still not traded on the pink sheets. Fazio plans to stand by his choice, however, and says he will continue to make the standard annual contribution to his IRA (currently $4,000), with his bank a key investment target. After all, IRA investments are for the long term. And, as Fazio says, “I’m just too busy running the bank.”
Lori Calabro is a deputy editor of CFO.
Investing, with Limits
Which investments are allowed in self-directed IRAs.
|Real estate||Life insurance|
|Gold bullion||Wine or other alcohol|
|Oil wells||S corporations|
|Source: ISMS International|