Self-directed individual retirement accounts (IRAs) are growing in popularity as more individuals seek alternative methods to save for retirement. Although these IRAs provide investors with increased control over their investments, they also carry with them potential risks and the possibility of financial losses.
The Division of Financial Regulation (DFR) is advising investors to be careful when considering self-directed IRAs. Although self-directed IRAs can provide the opportunity for greater returns, they also carry additional risks such as fraudulent schemes, high fees, and volatile performance that can lead to financial loss.
Investors have the opportunity to hold alternative assets, including real estate, precious metals, private equity, and cryptocurrency, in their retirement accounts through self-directed IRAs. While this flexibility can be attractive, it also exposes investors to potential risks that they might not fully comprehend. The responsibility of evaluating the quality and legitimacy of any investment in a self-directed IRA, as well as its promotors, lies solely with the investor, as self-directed IRA custodians do not perform such assessments.
Investors who hold a self-directed IRA bear the entire responsibility of assessing and comprehending the investments within the account. Unlike custodians of other types of IRAs, who are subject to federal laws and regulations concerning the sale of investment products and provision of investment advice, self-directed IRA custodians are not restricted to firm-approved stocks, bonds, mutual funds, and certificates of deposit.
Custodians of self-directed IRAs:
- DO NOT sell investment products or provide investment advice
- DO NOT evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters
- DO NOT verify the accuracy of any financial information that is provided for an investment in the account
Self-directed IRA custodians have the sole responsibility of holding and administering the assets in the account. Additionally, the majority of custodial agreements clearly state that the custodian bears no responsibility for the performance of investments.
Investing through self-directed IRAs poses a significant risk as fraudulent schemes are more likely to occur. These schemes come in various forms, such as Ponzi schemes where new investments are used to pay off previous investors to deceive them about the investment’s profitability, or investments in assets that do not actually exist. Sadly, due to the absence of regulatory oversight and limited vetting by self-directed IRA custodians, investors find it challenging to safeguard themselves against fraudsters.
Self-directed IRAs can come with high fees, in addition to the risk of fraud. These fees can be related to the alternative assets or the custodians who have possession of the assets. It is important for investors to thoroughly evaluate all the fees connected to a self-directed IRA before making an investment decision.
In conclusion, alternative assets have the potential to experience volatile performance, which can result in financial loss. Unlike conventional assets like stocks and bonds, alternative assets might lack a well-established market, making it challenging to ascertain their true worth. This can leave investors with assets that are hard to sell or have depreciated in value over time.
TK Keen, DFR administrator, advised that investors should be aware of the risks associated with self-directed IRAs and conduct thorough research on any alternative assets they intend to hold in their IRA. Additionally, it is crucial for investors to carefully review all fees related to their account.
Investors who are thinking about opening a self-directed IRA should seek advice from a licensed financial advisor in order to assess the risks and potential rewards. By adopting a prudent and knowledgeable investment strategy, investors can mitigate the possibility of financial losses.
If individuals suspect that they have fallen victim to a scam or fraud, they can always reach out to our consumer advocates for assistance. The toll-free number to contact these advocates is 888-877-4894. The website of DFR also provides financial services support.
What is a self-directed IRA?
A self-directed IRA is a traditional or Roth IRA that enables individuals to save for retirement with tax advantages and adhere to the same contribution limits as other IRAs. The sole distinction lies in the assets held within the account.
Understanding a self-directed IRA (SDIRA)
Regular IRAs usually contain stocks, bonds, mutual funds, and other commonly found investments, while self-directed IRAs provide a wider range of possibilities. These include investing in real estate or privately held companies. The only requirement is to find a custodian who agrees to the arrangement, and then you can proceed with your investment. (A custodian or trustee is necessary for any type of IRA to manage the account on your behalf.)
Risks of self-directed IRAs
Prohibited transactions
If you do not adhere to the rules, the IRA tax benefit will disappear, and you may also be required to pay penalties and interest.
One mistake that can occur is when the “no self-dealing” rule is disregarded, which prevents you from taking a loan from your IRA, selling assets to it, or engaging in other forms of interaction. For instance, if you decide to invest in a rental property using your IRA and then the kitchen faucet in the unit breaks, you might think, “I can personally fix it and save a significant amount of money!” However, this is a violation of the rules since you have provided services to the IRA, which is prohibited by the IRS. If the IRS discovers this, the entire account will be considered distributed to you and subject to taxes, along with a penalty. Therefore, attempting to save a small sum of money can result in significant consequences.
To prevent breaking the “self-dealing” rule, regard your IRA as the owner and operator of its assets. This means that in the mentioned scenario, it is your IRA that should pay someone else to perform the tasks, not you. Also, never stay overnight in a rental property owned by your IRA.
It is against another rule to engage in transactions with certain relatives, such as parents and children, as well as other individuals. For further information regarding prohibited transactions, please refer to the IRS page mentioned.
Due diligence
You are responsible for comprehending the investments you choose for a self-directed IRA.
Chisholm says that even though the custodian and administrators clearly state that they cannot offer financial advice, investors often struggle to heed this message.
John H. Bishop, a certified public accountant and principal at Wellington Capital Advisors in San Francisco, advises clients on investing in self-directed IRAs. He adopts an operational audit approach during the due diligence process, mapping out future revenue and expenditures to assess the financial viability of each investment.
Fees
The fees for self-directed IRS can be steep and numerous, like $250 or even higher to transfer your IRA to a new custodian. Additionally, these fees differ depending on the custodian and the type of investment. Bishop explains that he has noticed that each offering has a different fee structure.
Lack of liquidity
When you have a self-directed IRA, you have the opportunity to invest in various assets; however, these assets are often difficult to convert into cash quickly. In the case of an unexpected emergency, it could be challenging to retrieve funds from your IRA since you would need to locate a buyer for your investment. Traditional self-directed IRA owners also face a similar problem when they reach the age of 72 and need to make required minimum distributions.
Lack of transparency
Do you have knowledge about the investment? Are you aware of its actual value? The Securities and Exchange Commission cautions investors that self-directed IRA promoters may sometimes provide the valuation of the investment as either the purchase price or the purchase price combined with expected returns. However, this valuation does not reflect the actual amount you will receive for the asset.
The agency advises individuals to independently verify information, such as prices and asset values, provided in account statements if it is possible to do so.
When considering an investment, it is essential to think systematically and consider possible exit strategies in case you decide to change your mind.
According to Bishop, there have been instances where individuals purchase a building collectively. One of the investors proposes selling the entire building, while the rest suggest converting it into condos. These conflicting opinions can lead to complications when attempting to dispose of the property. Therefore, it is crucial to establish a clear exit strategy in order to avoid such problems.
Fraud
Fraudsters have employed self-directed IRAs as a means of bestowing a semblance of credibility onto their fraudulent schemes. A popular deception entails asserting that the IRA custodian has thoroughly examined or given endorsement to the underlying investment. However, the Securities and Exchange Commission (SEC) clarifies that custodians usually do not assess “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”
Concentrated portfolios
While proponents argue that self-directed IRAs enhance diversification by allowing investments beyond the mainstream, it is essential to note that these accounts can also lack diversity in a similar manner as any other retirement account.
According to Christine Benz, the director of personal finance at Morningstar, the mutual-fund research company, these investments are often lacking the same level of diversification as the ones typically found in an IRA. Instead of a diverse basket, it usually consists of just one investment.
According to Benz, exchange-traded funds provide a simpler option for investors looking to diversify. She explains that investors can purchase a collection of various security types, such as private equity, commodities, and metals, in a more diversified and safer manner.
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