As people experience the current state of the economy with the sub-prime mortgage debacle, near collapses by banking and insurance giants, as well as a plummeting stock market and shrinking retirement accounts, they want to take back control of their investments.
Many are also disenchanted with the traditional investments available through typical retirement plans like an IRA or their company’s 401(K) plan. The range of investment options via an employer’s retirement plan is generally restricted to a limited number of mutual funds and/or company stock.
These funds do not provide protection of principal against downward market risks, which can be found among numerous prudent alternatives available today. Furthermore, mutual funds provide limited opportunity for true diversification beyond stocks or bonds.
Additionally, a Harvard University study in 2006 proved that performance of mutual funds managed by investors working on their own is 6.626% and funds provided by financial advisors averaged 2.924%, net of all expenses (Morningstar.com and Harvard Business School website), bringing advisor recommendations under question.
More and more investors are moving away from mutual fund managers and the volatile stock market and making their own decisions using Self-Directed IRAs to invest in traditional and non-traditional assets.
An investment portfolio constructed of uncorrelated assets can achieve an overall stronger rate of return with a lower level of risk, mitigate the volatility of the equity markets and conquer the eroding impact of inflation on purchasing power and long term investment performance. There is a mountain of statistical evidence and Nobel Prize winning research that supports this approach. However, it’s extremely difficult to achieve these results if you invest mainly in one asset class, for example, stocks via the mutual funds offered in an employer’s 401(K).
So what can you do with a Self Directed IRA?
“Everyday Americans are fed up with the failures of so-called financial wizards,” Provident Group Board noted. “People want to be accountable for and control their own investment destinies. With self-directed retirement accounts they can do just that.”
It is a little known fact that Self-Directed IRAs have been available since the creation of traditional IRAs by the Employee Retirement Income Act of 1974. Also, typical traditional and Roth IRAs allow for $5000 to $6000 annual contributions. However, Self-Directed IRAs and Solo 401(K) and Solo 401(K) Roth programs allow for contributions up to $49,000 annually, depending upon age.
In the past, over 97% of retirement accounts have been dictated by the traditional investments available in the market. This has been largely controlled by fear of the unknown. Traditional custodians and brokers have falsely claimed that self-directed IRAs are complicated, risky and illegal. Due to economic concerns gripping America today, people are educating themselves, taking back control and are no longer depending on traditional methods to invest in IRAs.
Investment News (Sept 2007) reported a projection of a 10-12% increase in IRA rollovers from 2007-2010. The trend will likely increase with the collapse of the traditional markets in 2008 and 2009 and as investors look to other means to recover losses and achieve greater financial success and security.
Many people are turning their attention to the variety of investment options available within the self-directed IRA including:
- Residential and Commercial Real Estate
- Life Settlements
- TICs (Tenants in Common)
- Tax Liens, Tax Deeds
- Mortgages, Loans, Notes
- Real Estate Options
- Small Businesses, Franchises
- Private and Publicly Listed Stock
- Limited Liability Companies
- Limited Partnerships
IRA investment regulations are largely regulated by what you can’t do with them rather than what you can. This is what makes self-directed IRAs of non-traditional investments possible. There are very few prohibited transactions:
- life insurance for yourself
- collectibles
- metal, gems, and stamps
- rugs and antiques
- coins
- artwork
- alcoholic beverages
- Sub Chapter S Corporations.
Setting up a self-directed IRA:
The IRS requires a custodian to administer the retirement funds. After the funds are moved to a non-traditional custodian, you direct your funds to the investment of your choosing. The custodian will facilitate the investment purchase as required by IRS code. If setting up legal services, such as an LLC is necessary, they can also assist with that. Once investments are made the custodian will administer the account and hold the investment documents for safe-keeping. Any profit or income from the investment goes directly back to your IRA account.
Two categories to consider for a Self-Directed IRA:
Life Settlements
A life settlement is simply the sale, or transfer of ownership, of an existing life insurance policy to another party. Typically, the individual selling the policy no longer wants or needs or can afford it, and desires to sell it to a third party via a secondary market.
Historically, larger institutions have been the primary purchasers of these policies. Now, fractions of policies may be purchased by accredited retail purchasers. These investors purchase the policy at a discount to its face value, keeping the policy in force until maturity. Upon maturity, the investors receive the full face value of the policy as their return on investment. These funds return to your self-directed IRA and grow tax-deferred in a traditional IRA or tax-free if using a Roth IRA.
The typical policy is purchased from someone over 78 years of age with a definable life expectancy. The owner has decided that the policy is either no longer affordable or necessary, and thus chooses to sell the policy rather than let it lapse, thereby converting the death benefit into a life benefit for their use. These special use policies might be for Estate Planning, Key-Man or Large-Loan policies. Typically, these policies are $1 million – $20 million in face value.
Life settlements provide contractual guarantee of principal and are completely uncorrelated to any other markets. The return on investment is not impacted by the equity, bond or commodity markets, interest rates, oil prices or other economic events. A life settlements investment represents true diversification, principal protection and has delivered a strong double digit rate of return each and every year for over 18 years.
Real Estate
The first thing to remember when your IRA purchases real estate is that the property is for investment purposes only. Your IRA must take title to the property. For example: Custodian Name FBO (for the benefit of) John Smith IRA. Your IRA may purchase property from an unrelated party (anyone who is not disqualified). Any income from the property such as rent goes back into the IRA. Likewise, any expenses, such as property management fees, maintenance etc., are paid from your IRA. It is advisable to use a property management company to avoid any prohibited transactions. When the property is sold, funds also go back into the IRA and remain tax-deferred or tax-free if using a Roth IRA.
There are various ways to purchase real estate. You may form an LLC and pool different funds together to purchase. For instance, you may use your IRA funds together with personal funds, a non-recourse loan, or with other investors. These different entities all own a part of the LLC, percentages being based on the amount of money invested.
Below are just some of the types of real estate you can invest in with your IRA:
- Residential homes, condominiums, duplexes, four-plexes
- Commercial retail, apartment complexes, office condominiums, homes
- Industrial manufacturing, warehouses
- Land
A non-recourse loan may also be secured to purchase investment real estate with your IRA. Typically the down payment for these loans is 30% to 40%. Guidelines for these loans do not normally use credit scores or income for loan qualifications. These loans enable diversification across several properties within an IRA.
Truly Self Directed IRAs:
Where you open your IRA usually determines your available investment options. You may be comfortable with your bank or financial institution, but your investment opportunities may be limited by their own self-interest. A truly self-directed IRA custodian acts as a passive partner in your transactions. They will be able to answer any administrative and legal questions pertaining to your IRA, but the power is in your hands when it comes to investment options and decisions.
Many major employers allow employees to re-position funds they’ve placed in their company’s qualified plans into a self-directed IRA that they can manage themselves. You should observe the prescribed process pertaining to the chosen investment to preserve the tax advantages and avoid any penalties. The process is not complicated and can produce net benefits that make the exercise worthwhile. This enables the individual to have access to a wider range of investment options than may be available via an employer’s qualified plan. Investors can achieve greater safety and performance of his entire investment portfolio with a prudently executed and managed strategy.
