You know you can invest in stocks, bonds, mutual funds and ETFs, while deferring tax, through a retirement account. But did you know that Self Directed IRA custodians provide a huge variety of alternative investment opportunities in your retirement accounts? Though typically riskier than your bread-and-butter target retirement funds, owning rental properties, private equity, or even a business, within your IRA has the potential to supercharge your returns.
The biggest benefit of holding alternative assets in your retirement account- your IRA, HSA, 401K and more- is that they retain the same tax benefits. However, alternative investments are typically riskier, not only because you must evaluate them yourself, but also because the IRS has not clearly outlined the tax law in all scenarios.
What has been clearly established is that your IRA cannot engage in any transaction that would directly benefit you (as an individual), or any prohibited person. Despite the fact that everything your IRA invests in eventually benefits you in retirement, the IRS does not want investors to bypass the rules surrounding distributions and contributions. You shouldn’t, for instance, lend money to yourself at a subprime rate or pay any expenses out of pocket for the benefit of your IRA assets.
There are other important considerations which I will cover in a future series of self directed IRA articles. But for now I will simply state that alternative asset investments are ideal for investors already confident vetting these opportunities.
1. Real Estate
Most real estate investors I speak to aren’t aware that they can own rental properties within their retirement accounts. However, so long as the rules are followed and the IRA custodian allows for it, holding real estate in an IRA can be an phenomenal way to preserve your capital while collecting rents.
General Guidelines for Holding Real Estate in your IRA:
- Choose a custodian that allows your self directed IRA to hold real estate
- Avoid activity that would personally benefit you, like using personal funds or sweat equity to improve the property.
- Avoid transactions with any disqualified person, such as a parent, spouse or child (siblings are not disqualified people for whatever reason.)
- All rental income, sales profit and expenses must flow back to the IRA
- The property must either be purchased in full or leveraged through a non-recourse loan. That is, you cannot be held personally liable in the case of a default because your IRA is a separate legal entity and your personal involvement would be characterized as self-dealing.
If you are already a confident real estate investor you can hold rental properties within your IRA and avoid paying income tax on the rental income. If your property is leveraged, you will be responsible for a separate tax, referred to as UBIT (Unrelated Business Income Tax), which I will cover in depth in an article dedicated to IRA real estate.
2. Private Equity
If, instead of owning a piece of every business in the country (through a total US market mutual fund, like VTSAX) you think you can spot the next Facebook, private equity investments may be an excellent alternative. Well-vetted PE investments yield much higher returns than a mutual fund could. However, your risk increases significantly so you must complete extensive due diligence when evaluating private equity investments.
Because of the risk I would recommend allocating a small portion of your total retirement portfolio to PE investments, and perhaps only after the accumulation phase. Again, to avoid having your account forcibly distributed, you shouldn’t invest in a business you are compensated by, your own business, or the business of a prohibited person.
3. Precious Metals: Gold, Silver and Palladium
Don’t want to own a gold fund or to bury your treasure? You can have your self directed IRA hold your gold, silver, platinum and palladium for you! Of course you will need a qualified IRA custodian, a precious metals broker and a depository. And the more people you put between you and your investment the tighter your profit margin becomes.
Further, not all precious metals are allowed in a self directed IRA. The IRS determines the level of purity as well as the acceptable forms of precious metals you can hold. Your coin collection, even if certified or “graded”, is not allowed in an IRA. In fact, the IRS specifically disallows any type of collection in retirement accounts. You can, however, own Hawaiian koa trees, among other unusual investments.
4. Secured & Unsecured Notes
Your IRA can also lend funds to a non-disqualified person or business entity. You or your attorney would write up the note, choose whether or not you want it secured by property, determine an interest rate and then instruct your self directed IRA custodian to use your IRA funds for lending.
However, your IRA custodian will most likely not be giving you advice or aiding you with any legal paperwork. For a note to be profitable they have to be structured intelligently and underwriting a note is not easy. For the record, I don’t know why anyone would use their IRA for an unsecured note. If your IRA has no recourse you should have a very good reason (i.e. a high interest rate with reputable company).
5. Your Own Business
Referred to by many names- the Closely Held LLC, the Checkbook IRA, the IRA-LLC- owning a business within a retirement account is essentially an advanced way to facilitate making payments for your alternative investments. Though you cannot bring a previously formed business under the umbrella of your IRA, you can invest in vacant shares of a new LLC within your IRA and then use a business bank account to receive rent or note checks and pay out expenses. This option can be attractive for investors with multiple rental properties because self directed IRA custodian cannot process payments as quickly or conveniently and the paperwork can become cumbersome.
The danger here is that the IRS has not provided clear-cut rules regarding these entities and you may be at greater risk for audit.
Some tips for closely held LLCs:
- Secure an attorney’s opinion letter
- Title everything in the name of the IRA
- Review recent US Tax Court cases
- Keep an arms-length/ do not take compensation from your LLC
Following these guidelines may put you in a better position if an audit is conducted. The other potential for disaster in this arrangement is that your self directed IRA custodian will not be monitoring business activity. Therefore, anyone interested informing an LLC within an IRA should consult with an attorney who is familiar with this niche, as well as a qualified tax professional.
Through my new position educating investors on the intricacies of self directed IRAs at a trust company, my eyes have been opened to a huge number of new opportunities. Here I only covered 5 of the numerous ways that you can invest through an IRA. However, I’m still evaluating whether to get involved with my own retirement funds.
Because I am still accumulating the core of my portfolio and, as someone inexperienced in evaluating alternatives the risks are so high, for now I will stick with mutual funds. My 100% allocation to stocks is not without it’s own significant risk but it is an investment that I understand. I will however, continue evaluating alternative investment opportunities as I become more familiar with the industry. Maybe one of the clients I assist will return the favor and school me on evaluating alternative assets.
Did you know you could invest in rental properties through a retirement account?