Taxes

Know The Risks Of Self-Directed IRAs

A coalition of regulators recently issued warnings about the risks of some self-directed IRAs that many investors aren’t aware of.

There are a couple types of self-directed IRAs. Most mutual fund companies and brokers say their IRAs are self-directed. By that, they mean that your IRA can buy any investment on their investment platforms, which usually means all publicly-traded securities.

A true self-directed IRA may acquire any asset that IRAs are permitted to own under the tax code. Under the code, an IRA can own anything other than life insurance and collectibles. The list of permissible investments includes non-publicly-traded assets, such as real estate, mortgages, small businesses, and more.

The warning was directed at owners of the second category of self-directed IRAs.

The point of the warning is that an asset isn’t a good investment simply because the tax code allows an IRA to own it. And the regulators are right on this one.

The custodians of true self-directed IRAs generally don’t evaluate or screen the investments purchased by IRAs. It’s up to the IRA owner to be sure the asset is real, it’s actually owned by and set aside for the IRA, the fees and expenses are reasonable, the price is fair, and there eventually will be a market to sell the asset.

The assets purchased in self-directed IRAs often don’t have liquid markets, because they aren’t publicly traded. That means the IRA might not be able to find a buyer for the asset when the IRA owner wants to sell. Or the price a buyer wants to pay might be considerably less than the IRA paid for it or the owner believes it is worth.

The regulators highlighted that many of these risks are high when the IRA invests in cryptocurrencies.

Perpetrators of Ponzi schemes and other frauds often make self-directed IRAs part of their scams. Some set up their own self-directed custodians (or fake custodians) to receive the deposits. Others refer clients to IRA custodians they know won’t ask questions or closely scrutinize transactions. Ponzi king Bernard Madoff was known for referring potential clients with IRA balances to a particular self-directed IRA custodian.

Fees often are higher on self-directed IRAs, whether the investments are legitimate or not. That’s because the custodian has to do more work to make transactions and obtain the value of assets, since they aren’t publicly-traded.

A true self-directed IRA can be a valuable financial tool for investors who want to invest in unconventional assets. But successfully using a self-directed IRA requires the IRA owner to be more sophisticated and do more work than when a conventional IRA is used. Be sure you do the extra work before investing your self-directed IRA.

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