Self-directed IRAs are becoming a risky business
At a time when it’s almost impossible to earn much interest on bonds, and equities seem too risky, some retirement savers are investing their individual retirement account in nontraditional investments. But beware of schemes that threaten your retirement, particularly self-directed IRAs.
The North American Securities Administrators Association (NASAA) reports that scam artists pitching self-directed IRAs is now among the top 10 threats facing investors today.
To be sure, self-directed IRAs can be a safe way to invest retirement funds, NASAA said in release. But investors should be mindful of potential fraudulent schemes when considering a self-directed IRA.
By way of background, a self-directed IRA is “an IRA held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians,” according to the SEC. “Most IRA custodians are banks and broker-dealers that limit holdings in IRA accounts to firm-approved stocks, bonds, mutual funds, and CDs. Custodians and trustees for self-directed IRAs, however, may allow investors to invest retirement funds in other types of assets such as real estate, promissory notes, tax lien certificates, and private placement securities.” Read Investor Alert: Self-Directed IRAs and the Risk of Fraud.
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These sorts of investments are not inherently bad, but NASAA, SEC and others warn that such investments have unique risks, such as lack of disclosure and liquidity, that must be considered.
What’s more, NASAA is warning investors “fraud promoters pushing a Ponzi scheme or other investment fraud can misrepresent the responsibilities of self-directed IRA custodians in order to deceive investors into believing that their investments are legitimate or protected against losses.”
For the record, custodians and trustees of self-directed IRAs may have limited duties to investors, and generally will not evaluate the quality, value or legitimacy of an investment or its promoters, NASAA said in its release.
“While a scam artist may suggest that self-directed IRA custodians analyze and validate investments, those custodians only hold the assets in a self-directed IRA and generally do not evaluate the quality, value or legitimacy of any investment,” NASAA said.
In some cases, NASAA said fraud promoters convince investors to move assets from an existing self-directed or traditional IRA into a fake self-directed IRA held by a supposed custodian created and owned by the scam artist.
And, fraudsters also exploit the tax-deferred characteristics of self-directed IRAs, and know that the financial penalty for early withdrawal may cause investors to be more passive or to keep funds in a fraudulent scheme longer than those who invest through other means, NASAA said.
Meanwhile, IRA experts say there is plenty that investors who want to use self-directed IRAs can do to avoid dealing with scam artists.
What are your goals?
The first item on your punch list when thinking about self-directed IRA is this: Does the investment fit in with your overall plan? “Be sure your IRA investment is consistent with your investment goals, risk tolerances and experiences,” said James Jones, founder and CEO of the Self-Directed IRA Investment Institute and vice president of business development for Kingdom Trust Co.
Jeremy Rettick, an investment adviser representative of BCM and the chief marketing officer of Covenant Reliance Producers, says it’s essential that the investment fits in with your risk profile. “As the old saying goes, ‘Don’t put all your eggs in one basket,’” said Rettick. “If you decide that a self-directed IRA is the right option for you consider only placing a portion of you total retirement dollars within the plan. As always consider how much risk you are taking on and if it is in line with your overall risk tolerance.”
Invest your time before investing your money
Next, you have to invest your time vetting everything and anything having to do with your self-directed IRA—the investment, the adviser and the custodian—before you invest your money.
Consider first what Rettick calls the “Warren Rule.”
“As Warren Buffett said, ‘Never invest in a business you can’t understand,’” said Rettick. “This philosophy has worked well for Mr. Buffet and could pay dividends to the investor. There are many nontypical investments available within self-directed IRAs. Bottom line he investor needs to understand what they are investing in.”
Jones holds that same point of view. “The most important advice I give daily for investors of self-directed IRAs is: You should know your alternative asset class and more specifically the actual investment better than your financial planner knows stocks, bonds and mutual funds.”
Whether it is real estate, private equity or debt, crowdfunding, precious metals and the like, Jones said “you should already be investing in these categories with good knowledge, experience, networks and advisers.”
And Rob Spalding, the founder and senior adviser with Alternative Solutions Group, noted the following: “Investors should always be vigilant about any investment they make, whether with mutual fund fees or due diligence on a private investment offer involving a self-directed IRA. Ultimately, investors need to be mindful of the investments they make inside or outside of self-directed IRAs.”
Rettick said investors also need to be mindful of the following:
Liquidity: Find out how liquid the investments are. Do you have to keep money invested for a certain period to avoid any early withdraw penalty?
Investment values: Ask how the value of your investments will be calculated on your statements. Custodians may list the value as reported to them by the promoter but the price may not accurately reflect the price at which the investment could be sold.
“Guaranteed” returns: Is the investment FDIC-insured? If not, what is guaranteed and how is it guaranteed?
Fees/commissions: They must share commissions, fees and loads that may apply. Make sure you know what you are paying and if the amount is competitive.
Tax consequences: Talk to an accountant to understand fully the limitations within the plan. The IRS has numerous prohibited transactions that could disqualify the IRA’s tax deferred status forcing you to pay income taxes on the full value of the IRA.
Jones also recommends asking a trusted professional, such as your accountant, lawyer or ﬁnancial adviser, for a second opinion about the proposed self-directed IRA investment by having them review of the investment offering or subscription agreement.
Know your custodian
Besides knowing your investment, it’s imperative that you get to know your custodian and the people behind the investment. “Remember, you are now the investor and adviser,” said Jones. “Due your own extensive due diligence to start, not only the investment offering, but the company and its officers even though you likely know them. You should only invest in asset classes you know, with people that you know. You should never invest with strangers.”
Rettick also recommends you make sure your funds will be held by a credible independent trustee/custodian. “Typically you can talk to your bank, credit union or a well-known custodian,” he said. “If the promoter holds the funds directly that is a huge red flag.”
The trustee/custodian isn’t required to conduct due diligence with respect to the quality or suitability of the investment, but they should have in place fraud detection measures. “Ask your IRA custodian what fraud detection measures they have in place, such as checking the company’s good standing with regulators and authorities in the state they do business,” said Jones.
What’s more, Jones noted that neither your IRA custodian nor any governmental agency endorses or guarantees non-FDIC insured investments. “While an IRA custodian can educate investors on alternative asset classes, they can never advise, direct or steer them to an investment,” said Jones. “If an investment sponsor is promoting self-directed IRAs, check with that IRA custodian to see if they in fact have a relationship.”
Additional resources for investors who want to vet their custodians for self-directed IRAs can be found at the Retirement Industry Trust Association (RITA). RITA, according to Spalding, is a trade association for custodians that aims to enhance industry best practices and fight investor fraud.
Work with experienced professionals
The self-directed IRA business has been around for a while, but it’s growing rapidly and there are plenty of newcomers to the business. That’s why Spalding recommends that you work only licensed and regulated advisers.
“Beyond healthy skepticism, self-investigation and asking the investment sponsor for substantial due diligence items, investors should consider working with a licensed financial advisers, especially registered investment advisers or RIAs, who have experience with financial due diligence and alternative investments,” Spalding said. RIAs are generally regulated by the SEC or their state securities division.
Few would argue with the need to vet advisers pitching self-directed IRAs. “They should be properly licensed to sell securities in their state,” said Rettick.
At a minimum, the SEC suggests that you make sure your brokers, investment advisers, and investment adviser representatives have not had disciplinary problems or been in trouble with regulators or other investors before you invest or pay for any investment advice. Read Protect Your Money: Check Out Brokers and Investment Advisers. Other resources include the SEC, NASAA, and the Financial Industry Regulatory Authority.
Watch for red flags
Jones also suggests looking out for fraud red ﬂags including but not limited to an unknown solicitation coming to you, guaranteed investment returns, high pressure sales techniques, short investment decision time lines requiring immediate action to complete the transaction, and too-good-to-be-true statements. “Scam artists know investors decide too often on emotional decisions and not careful analysis,” said Jones. “Be prepared to walk away from every deal, and trust your gut.”
Additionally, with the pending Federal JOBS Act legislation and the formalization of real equity-based crowdfunding, Spalding said the need for investors to be watchful of their investments is only going to intensify.
After you invest
After you’ve opened a self-directed IRA, Jones recommends that you carefully review each account statement and follow up with questions to the investment sponsor if you do not understand it or something doesn’t make sense or seems suspicious. “Review these statements with your advisers and never alone,” he said.
Remember too that the IRA custodian maintains your account and forwards account information to you but it is not responsible for any proﬁts or losses on your investments, said Jones.
And, if ever you suspect some suspicious activity related to the investments in your self-directed IRA, Jones says you should report it to your IRA custodian as well as state and federal authorities.