The Do-It- Yourself IRA
About six years ago, John Peterson pulled his retirement accounts out of mutual funds. As owner and president of Profitable Property in Rockville he knows a thing or two about the real estate market. So Peterson took his retirement assets and invested them in property.
"When I was investing in mutual funds of stocks, that was not my expertise," said Peterson, who added that his returns have soared since he made the switch.
Peterson was able to shift his assets from stocks to real estate thanks to a little-used type of retirement savings account called a self-directed IRA.
The benefits sound tantalizing. But while a self-directed IRA was the perfect solution for Peterson, it is not for everyone. The accounts allow retirement investors a wider menu of choices, including real estate, mortgages, private placements in limited liability corporations such as start-up banks, bowling alleys or small restaurant chains. Some investors even take a chance on racehorses.
Self-directed IRAs are best for hands-on investors who intimately know the industries in which they place their retirement accounts. Although their numbers are growing, self-directed IRAs represent only about 1.5 to 2 percent of the $5.7 trillion IRA market, yet that still amounts to "several tens of billions of dollars," said Hugh Bromma, chief executive of Entrust Group, which has about 500,000 clients and accounts for about $2.7 billion of the self-directed IRA market.
For the less experienced investor, self-directed IRAs can be laden with traps. The big catch is that you can't invest in anything that may be construed to be self-dealing, that is, creating a benefit for yourself rather than for the retirement account. If you do that, the entire IRA becomes taxable, not just the money used in the prohibited transaction, said IRA expert Ed Slott. If you're under 59 1/2 , add a 10 percent penalty.
The general rule is that your investment can't benefit you, your spouse, your antecedents or your descendants. In other words, you can't use a self-directed IRA to invest in a condo near campus for your kid or in your sister-in-law's new restaurant chain.
"The intent of the retirement account is supposed to be to accumulate wealth over time, as opposed to enhancing a family member's ability to start a business," said Bromma. If the company that handles your self-directed IRA becomes aware of the prohibited transaction, it is required to notify the Internal Revenue Service, which will then investigate.
It's sometimes trickier than you might think to avoid self-dealing. Say you buy a house with a self-directed IRA and rent it to a disinterested party, and then the roof springs a leak. If you hire a roofer but don't have money in the IRA to pay for the repairs, and you pay with a personal check, it's a prohibited transaction, said Slott, because you have personally paid the IRA's bill. The payment has to come out of your IRA.
Slott said he knew of a case in which a contractor in Florida bought vacant land with IRA money. So far, so good. But eventually he started parking his trucks and equipment on the vacant land, a fact that came up in an audit with the IRS, which found his use of the IRA-purchased land to be self-dealing.
Peterson, who has in the real estate business for about 14 years, said he errs on the side of caution. "That's where it gets ridiculously complicated, and you have to make sure you're doing it right," he said.
Peterson feels he has more control over his assets now. "A lot of these brokers, some of these so-called experts at managing money, aren't doing a lot. They aren't adding much value," he said. Because he knows the real estate market, the downturn has not discouraged him from continuing to invest, although "I may have to recalculate the numbers and analysis, and it may take longer to sell," he said. But since the money is invested for the long term in his IRA, he can afford to wait.
Not everybody has the expertise required. "Unless somebody really knows what they're trying to do," said Slott, "I try to discourage it -- if only because I don't want to be the adviser that said it was okay, and they go mess it up.
"And there are so many ways to mess up."
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