Let’s face it: The vast majority of us tend to only think about our Individual Retirement Accounts--more commonly referred to as IRAs--during tax season. That’s because the deadline for making a contribution for the previous year coincides with deadline for filing your income tax return. (1)
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However, you need to be aware that some folks are thinking about your IRA year round--and you should not take comfort in that. Criminals are using your IRA to separate you from the hard-earned money you've spent years accumulating for retirement.
I’m not talking about the vast majority of ethical, experienced investment professionals. Believe me, they hate these scam artists just as much as everyone else. Especially because these crooks tarnish the image and reputation of legitimate financial advisors and make their jobs a lot harder.
An IRA account offers a tax break for those who want to invest money for retirement. With a “traditional” IRA, your tax-deductible contribution grows on a tax-deferred basis.(2) With the newer “Roth” IRA your contribution is not deductible, but all earnings can be withdrawn tax-free if you meet certain conditions. (See IRS Publication 590 for information about both types of IRAs)
The tax break that both IRAs offer is what makes us vulnerable to scam artists. Imagine a pitch that sounds something like this:
“Protect your retirement assets from inflation! Invest your IRA in gold and pay no income tax on the appreciation until you take the money out!!!”
Or how about:
“Think real estate prices have bottomed? Use your IRA to turn rental property into your retirement nest egg!!!”
The other ingredient in this scam is the frequent use of non-traditional IRA investment: real estate, precious metals, etc..., instead of CDs or financial assets such as stocks, bonds, or mutual funds.. Using your IRA to own more unusual types of assets isn’t illegal, it just takes a special type of IRA account called a “self-directed” IRA and a custodian that specializes in these assets.
For example, in a lawsuit filed against a firm called United American Ventures, the SEC alleges investors were “promised guaranteed returns in purported investments in medical technologies. However, several large cases involved the use of ordinary types of investments. In one, the SEC filed charges alleging “at least $20 million” was stolen from investors who had been told that the money in their self-directed IRA was invested in foreign bonds.
Last year the North American Securities Administrators Association (NASAA), which is made up of investment regulators from each state, issued a joint warning with the federal Securities Exchange Commission (SEC) about scam artists using self-directed IRAs to steal tens of millions of dollars from consumers. According to Matt Kitzi, commissioner of securities for the state of Missouri, there are legitimate self-directed IRA custodians, and says,“I suspect the vast majority [of these accounts] …are being run properly by good administrators.”
Kitzi adds that the problem is that crooks sprinkle their pitch with words from the Internal Revenue code and promote self-directed IRAs “in a way that gives investors a false sense of confidence,” suggesting that the custodians have evaluated and are monitoring the investments inside these IRAs. “They imply that these accounts have greater financial oversight. That’s not the case.” In fact, all any IRA custodian does is hold the asset on behalf of the investor (as required by law) and keep track of money that flows into and out of the account.
Flexibility = Opportunity… for Crooks
The difference is that IRA accounts offered by mutual fund managers, banks, or brokerage firms tend to have less flexibility than self-directed IRAs- both in terms of the investments you can own and how the account is structured.
According to Kitzi, who heads up the enforcement section of NASAA, scam artists convince investors to legally appoint them as trustee of the self-directed IRA, giving them control over control of the assets. This enables them to liquidate the account and literally take the money and run.
Pitfalls of Self-Directed IRAs
Self-directed IRAs are not for everyone.
Correction. Self-directed IRAs are not appropriate for most of us! CPA and IRA expert Ed Slott says that even if the investments are legitimate, dangers lurk for the uninformed. That’s because the tax code outlines a laundry list of “prohibited transactions,” things you must not do when it comes to your own IRA. This includes “self-dealing.” In layman’s terms, it means you cannot have direct control over or involvement in the assets in your IRA account.
You know that rental property you invested your IRA in? Don’t even think about having the monthly rent check made out to you. Instead, it needs to be made out to your IRA and, ideally, sent directly to the custodian of your account. If you pick up a new faucet for the rental, do not pay for it with your personal credit card or co-mingle this expense with the light bulbs, grass seed, and paint you’re buying for use at your own home. In fact, you should have a separate checking account just for expenses associated with your IRA-owned real estate.
Slott points out that if you’re considering whether to own a piece of real estate inside your traditional IRA versus owning it outside the IRA, the latter has more tax advantages. While you own it you get to write off depreciation and when you sell, you’re taxed at lower, long-term capital gains rates (provided you’ve owned the property for more than a year). In contrast, withdrawals from a traditional IRA get hit with ordinary income tax rates. If you want to go to the trouble and expense (self-directed IRA fees are higher) of owning real estate in your IRA, Slott says a Roth IRA makes the most sense because “all of the upside is tax-free.”
He also points out another “trap” of owning illiquid assets in a traditional IRA: Required Minimum Distributions or, RMDs. Those withdrawals you have to start taking once you reach age 70½. If your IRA owns shares of stock or mutual funds, you can simply sell as many as you need in order to come up with the cash required to meet your RMD. But with real estate you can’t simply sell off a bathroom! Slott advises, “you had better make sure you left yourself some [cash]” in your IRA in order to take your required withdrawal.
1. Because April 15 falls on a weekend, this year the deadline for both is midnight, April 17. The maximum contribution you can make to your IRA for 2011 is $5,000. You can add an additional $1,000 if you are age 50 or older.
2. If your income exceeds certain amounts, you do cannot deduct your contribution. However, all earnings that your contributions generate grow tax-deferred. In addition, you do not have to pay income tax again on your after-tax contributions when you begin withdrawals from your IRA once you retire.
Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content.
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