EDITOR'S NOTE: This article was originally published in the December 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.
Have your IRA investments shrunk over the years? You may be tempted to forgo plain-vanilla stocks and bonds and roll your money into a "self-directed" IRA. Perhaps you could juice up your retirement savings by plowing some money into real estate, tax liens, franchises or precious metals.
Before you move your retirement savings into a self-directed IRA, though, take note: Federal and state securities regulators warn that a growing number of promoters, recognizing the popularity of these accounts, are steering investors into fraudulent investments. "Folks who are looking to perpetrate a fraud have identified self-directed IRAs as a way to lend credibility to their schemes," says Missouri Commissioner of Securities Matthew Kitzi.
Even if the investment is on the up-and-up, an investor can easily run afoul of tax laws governing self-directed IRAs. One big hazard is "self dealing," which prohibits an investor from using tax-advantaged assets for personal use. An example: buying a rental vacation property inside the IRA and renting it out, even for a week, to your daughter's family. "These structures are not for the faint of heart," says Warren Baker, an estate-planning lawyer with the Amicus Law Group, in Seattle. "They are inherently more complicated to operate than a mutual fund IRA."
Only a small percentage of IRAs are self-directed, but their numbers are growing, especially as many investors lose confidence in the stock and bond markets. For example, Pensco Trust Co., in San Francisco, one of the custodial firms that handles record-keeping for these accounts, has $3.6 billion in assets, according to Tom Anderson, vice-chairman and founder of the company. That's up from $1.6 billion five years ago.
Because you can invest in just about anything, there are plenty of opportunities to be deceived. Noting an increase in complaints of fraudulent schemes related to these IRAs, the Securities and Exchange Commission and the North American Securities Administrators Association in September issued an investor alert, "Self-Directed IRAs and the Risk of Fraud" (find it at http://investor.gov/news-alerts/investor-alerts).
Consider the fate of Tom Zibton, 59, who lives in Garland, Texas. He began investing in real estate around 2005, buying single-family homes and renting them out. A couple of years ago, he heard a pitch for a program promising annual returns of 8% by making "hard-money loans" to home buyers who couldn't get bank loans. Intrigued, Zibton watched an online video produced by the company promoting the program, Warr Investment Group, and visited its office. "I met with the employees," he says. "I thought this was the real deal." He rolled $20,000 from his IRA to a self-directed IRA controlled by the Warr group.
Now Zibton thinks that the only thing real about this deal is the hole in his savings. In January 2011, after an investigation by the Texas State Securities Board, a state court shut down the company and placed it under receivership. Zibton says the receiver has been able to recoup a small portion of his money so far.
In advertisements on Craigslist and radio, Warr Investment Group encouraged investors to roll 401(k) money into a self-directed IRA that would invest in real estate notes, according to documents filed by the Texas state attorney general's office in state district court in Austin. The firm guaranteed that its "safe savings account" would provide 8% annual returns.
Starting in April 2010, at least 30 individuals gave the Warr firm about $972,000, but the firm only invested about $511,000, according to the filings. The state charges that the rest was spent on commissions, a Mercedes and personal expenses. The state attorney general accused the firm and its salespeople of fraud and of selling unregistered securities without a license.
In an e-mail to Kiplinger's Retirement Report, James Warr, chief executive officer of the firm, wrote that it was his "intent to give people a place to earn a good return on their money backed by hard assets." Warr says he believes the investments he sold were exempt from securities regulations and, thus, sellers did not have to be licensed. "I believe the notes we bought were good notes and everybody will get their money back," he wrote.
Doing Due Diligence
A basic rule -- don't invest in anything unless you understand how it works -- applies in spades if you're thinking of going the self-directed route. "Real estate developers are in a position to know what good deals are and what bad deals are," says Baker. "They do well because they know what they're doing."
You also need to check out the background of any promoter, says Joseph Rotunda, director of enforcement for the Texas State Securities Board. "The company and anyone selling on behalf of the company would have to be registered," he says. Call your state securities regulator for help.
Securities regulators note that investors need to understand how illiquid alternative investments are valued. While the custodian may list the value provided by the promoter, the price may not necessarily reflect the price at which the investment could be sold.
Be sure to get advice from a lawyer or accountant to avoid legal and tax pitfalls. It's easy to trip over one of the IRS's numerous "prohibited transactions" inside these plans. If you cross the legal line, the IRS could disqualify the IRA's tax-deferred status and force you to pay income tax on the full value of the holdings.
To set up a self-directed IRA, you can go directly to a custodial firm that specializes in these vehicles to make the transactions you want. Or you can set up a limited liability corporation, which will be owned by the IRA. As manager of the LLC, you can pay for investments directly from a bank account without having to go to the custodian for each transaction.
Either way, custodians are not required to evaluate the quality or the suitability of any investment. "We make it clear to our clients that we do not perform due diligence on their behalf," says Pensco's Anderson. "We encourage them to get a financial adviser."
Still, the direct-custodian route could add an extra layer of protection. T. Scott McCartan, chief executive officer of Millennium Trust Co., in Oak Brook, Ill., says, "If there is something obvious -- such as buying a vacation home for yourself -- we will tell you," he says. If the firm notices that an investment may border on self-dealing, he says, it will alert the investor to get advice. To find a custodian, call the Retirement Industry Trust Association, a custodian membership group, at 941-724-0900.