This article appears in the June 25, 2012 investment guide issue of FORBES magazine with the headline, “Go Rogue With Your IRA.”
Renovations are underway at the historic building Laura Harth Rodriguez bought with an inherited IRA. Credit: Scott Goldsmith for Forbes
Sidney Harth, an acclaimed violinist and conductor, died last year at the age of 85, leaving $5 million in assets, including musical instruments, a New York City apartment and $2 million in retirement accounts to his daughter, Laura Harth Rodriguez, a pianist in her mid-50s. She decided to use part of her inheritance to buy a historic three-story building in an up-and-coming section of Pittsburgh’s East End.
“My father’s investments were tied to the stock market, and it’s been so volatile,” Rodriguez says. But she worried that to swing the $595,000 purchase—an all-cash deal—she’d have to take money out of the inherited IRA, paying income tax immediately on whatever she withdrew. Then her lawyer suggested an alternative: Leave the money in the tax-deferred retirement wrapper and have the IRA itself buy the property. The deal closed in February.
Yep, an IRA can legally own real estate and a lot of other alternative investments, too, ranging from private equity and promissory notes to gold, oil and gas and cattle. (It can’t own insurance, collectibles or stock in S corporations.)
Interested? The big financial institutions that act as custodians for most IRAs generally limit investments to publicly traded stock, bonds, mutual funds and bank CDs. So you’ll first need to move your IRA to one of about two dozen smaller custodians offering “self-directed IRAs.”
This is still a niche business. As of May 2011 only $94 billion (2% of total IRA assets) was in self-directed IRAs, according to the Investment Company Institute, the mutual funds trade group. Some belong to the very wealthy—Mitt Romney’s holds offshore investments, including one worth between $5 million and $25 million in a Cayman Islands entity, according to his financial disclosure forms.
But ordinary folks have gotten into the act, too. John Mitchell, a manufacturer’s rep for software companies, is investing $50,000 of his self-directed IRA in precious metals—primarily gold and silver. He uses the Entrust Group in Oakland, Calif. as custodian, but the metal is stored with a bullion dealer near his Tampa, Fla. home. Mitchell, 37, says he likes being able to drop by to admire his metals.
Matt Lutz of Bethel Park, Pa. owned a chain of dry cleaning stores in 2006 when he rolled over a $70,000 IRA into a self-directed account at Equity Trust Co. in Elyria, Ohio. Since then he has more than tripled its value—mostly by making loans from his IRA to car dealers to finance their inventory. Three years ago Lutz, 38, sold his dry cleaning business to work full-time putting together similar loans for other people to use as IRA investments.
Despite such success stories, there are risks to getting creative with your IRA. “Self-directed IRAs are not for the faint-hearted,” says Patrick J. Felix III, the Pittsburgh lawyer who helped Rodriguez. “You better damn sure know the rules.” These pointers should help keep you safe.
This is a legal principle that prevents IRA owners from making investments (or loans) that benefit themselves or certain family members, even indirectly. It also bars mingling of your IRA and nonretirement funds. Run afoul of the self-dealing rules and your entire IRA could be immediately taxed.
So, for example, Rodriguez couldn’t write a $10,000 personal check for the down payment on the building her IRA was buying. Instead, she had to first transfer her father’s IRA to a self-directed IRA trustee, San Fransisco-based Pensco Trust Co. (this must be done in a so-called “trustee-to-trustee” transfer) and then have Pensco cut a check to the seller.
Another complication: Rodriguez’s husband, Francisco, a recording artist, wanted to use the second floor of the building for his studio. But he couldn’t do that if her IRA owned the space. Felix devised a workaround: Create three limited liability companies (LLCs)—one for each floor.
The IRA owns two floors, Rodriguez and her husband the floor with the recording studio. Each LLC paid one-third of the purchase price and has $250,000 of spare cash for expenses. There’s an electric and gas meter on each floor, and the LLCs split the real estate taxes, the fee for a property management firm and bills for renovations, now under way.
Rents for the IRA-owned first floor will generate about $40,000 per year, Rodriguez figures. She hopes the third floor, with its city views, can be rented for parties.
Plan for distributions
Satisfying the requirements for IRA payouts can get more complicated with illiquid assets in your IRA. An IRA owner must take an annual required minimum distribution (RMD) starting at age 70½ unless the account is a Roth. Nonspouse heirs, regardless of age, must begin withdrawals from both regular and Roth IRAs by Dec. 31 of the year following the IRA owner’s death. Miss an RMD and the IRS could hit you with a penalty equal to 50% of the required payout.
The RMD is based on the account balance on Dec. 31 of the previous year divided by life expectancy, as listed in IRS tables. Rodriguez will need to have the building reappraised each year to calculate her RMD. For now there are plenty of liquid assets in the inherited IRA to make the payout. But if the cash runs dry, the IRA would have to distribute an interest in the LLC instead, Felix says. “It’s a bit of a pain in the butt.”
Go Roth, if you can
Distributions from a traditional IRA are taxed at ordinary federal income rates, which top out at 35%. That includes long-term gains, which outside an IRA are currently taxed at a 15% top rate. In other words, you might undercut the benefits of tax deferral by paying a much higher rate than needed on your gains. With a Roth, all withdrawals by you or your heirs are tax free. That’s why an investment that might appreciate greatly belongs in a Roth IRA.
A striking example comes courtesy of Max R. Levchin, chairman of social review site Yelp. According to Securities & Exchange Commission filings, he has 3.9 million low basis shares of Yelp in his self-directed Roth IRA at Pensco. With Yelp now trading around $18, his kitty is worth at least $70 million.
For IRA owners a Roth also avoids the requirement to take yearly distributions after 70½. Not only can that leave more for beneficiaries if you don’t use the money yourself, but with assets that are partly or totally illiquid it also avoids the cumbersome calculation of RMDs that someone like Rodriguez will have to make.
If you earn too much to make annual contributions to a Roth IRA (there are income limits), consider converting a traditional IRA to a Roth. To do this you pay tax on a traditional IRA, then shift the money to a Roth where all future growth is tax free. Inherited traditional IRAs aren’t eligible.
Don’t get snookered
Both federal and state regulators note a recent increase in complaints of fraudulent investment schemes that have a self-directed IRA as a key feature. In fact, fraudsters often steer potential marks to self-directed IRAs.
Among those who got burned that way are 120 IRA investors in a promissory notes Ponzi scheme run by USA Retirement Management Services between 2005 and 2010. The SEC sued to recover the $20 million IRA owners lost, plus interest, and got a judgment from the U.S. District Court in the Central District of California in April. Whether the scammers will actually cough up the money is another matter.
Several investors in that case are suing Entrust. But don’t count on an IRA custodian to cover your losses; contracts say they aren’t on the hook if you pick a bad or bogus investment.
Just last year a Colorado federal district court judge dismissed a class action filed against four independent custodians by IRA owners who invested with Ponzi schemer Bernard Madoff. The lawsuit claimed the trustees breached their duty to hold IRA assets safe. But the judge found (among other things) that the IRA agreements clearly stated that investors were “solely responsible for making investment decisions in connection with their funds.”
In a separate case defrauded investors whose IRAs were at Equity Trust and Entrust filed a class action suit in April charging that those custodians “encouraged, facilitated, aided, abetted, promoted and consummated” fraudulent schemes while giving investors a false sense of security. According to that complaint, investment promoters required exclusive use of these custodians, and the account statements the custodians sent out showed high returns even though “the fraudsters had absconded with the victims’ investment monies within days or weeks.”
In a statement Entrust said, “It does not provide any investment advice or endorse any investment product provider or service—it simply follows the investment directives of its clients.” Equity Trust CEO Jeff Desich said in a statement that clients “should always ask a trusted financial professional such as their accountant, financial planner or lawyer for a second opinion before investing.”
The new JOBS Act, which makes it easier for some startups to raise money online with little SEC oversight, could tempt even more retirement savers to switch to self-directed IRAs. Buyer beware.