Image source: Getty Images.
Stocks. Mutual funds. Cattle?When it comes to investing in individual retirement accounts (IRAs), you might have more options than you think. But those options may come with additional risk.
Some retirement savers want to look beyond stocks, bonds, mutual funds, and other conventional investments offered by standard IRAs. For those interested in investing their IRA dollars in alternative investments, whether it be real estate,private placements, or even livestock, there's another choice: self-directed IRAs.
According toIRS rules, IRAs can invest in just about anything with the exception of life insurance, most types of collectibles, andS corporationshares -- that is, shares in a company that elects to pass corporate income and losses through shareholders for tax purposes.
"Want to own cattle? A condo?" said Jeffrey Levine, chief retirement strategist and director of retirement education at Ed Slott and Co. That's all possible, said Levine. But if you do, it's important to understand what you own and how you can make, or lose, money.
A self-directed IRA can be set up as either atraditional IRA or Roth IRA. The same potential tax benefits of tax-deferred growth, or tax-free growth, apply.
The same rules and restrictions associated with standard IRAs apply to self-directed IRAs, too. For example, while you can technically withdraw money at any time, taking distributions before age 59-1/2 can trigger hefty penalties.
Sometimes people choose to save for retirement using a self-directed IRA because they're an expert in a certain field and want to capitalize on their expertise while garnering the tax benefits of an IRA. For instance, if you know a lot about real estate, you might believe buying a building with your IRA could be worthwhile.
The Retirement Industry Trust Association (RITA), a self-directed IRA industry trade group, estimates that assets in these types of retirement accounts represent 3% to 5% of total assets held in IRAs.
"Based on our members, it looks like the self-directed part of the [IRA] market is increasing," said RITA executive director Mary Mohr. "People want more diversification of their assets. They want more control."
But before you think of using your hard-earned retirement dollars to purchase even a single cow with a self-directed IRA, it's important to know the following four things.
Do your due diligence, and don't expect an IRA custodian to do it for you
When you open any kind of IRA account, you must find anIRS-approved institutionthat will serve as the account's custodian. With standard IRAs, this might be a bank or a brokerage firm that offers investment options.
With a self-directed IRA, there is a third-party custodian, too, but this company simply serves as anintermediarybetween you and the investment. The custodian holds and administers the assets, and handles recordkeeping, but generally doesn't assess the investment's value or legitimacy.
You, the account owner, are responsible for choosing investments, evaluating them, and keeping tabs. Don't expect the custodian to do any of this work for you.
"The custodian doesn't do the due diligence," said RITA president Tom Anderson, the founder and former president of Pensco Trust Co., a custodian firm that handles self-directed IRAs. "The client makes the decisions."
If you decide to open a self-directed IRA, it might make sense to work with a financial professional who can help vet and monitor your investments.
Certain transactions are prohibited -- and breaking the rules can cost you
You might have more control over what you invest in with a self-directed IRA, but you have to be careful about what you do with those investments. TheIRSprohibits transactions between an IRA account and the account's owner, its beneficiary, or other "disqualified persons," such as certain family members.
The reasoning behind this: IRAs were created with the idea of ensuring future retirement stability. Any transactions conducted by an IRA must be for the exclusive benefit of the retirement plan.
"There can be no self-dealing," Mohr said.
For instance, if your self-directed IRA account owns a condo, you can't live in it. Nor can your child live there, even if that child is paying rent.
What happens if you don't follow the rules? Even if you make an unintentional mistake, it will cost you. Typically, if an IRA owner or another disqualified party engages in a prohibited transaction, the IRA account loses its IRA status as of the first day of the year that the transaction took place.
"Your entire account balance is immediately taxable," Levine said. And you might have to pay a 10% penalty as well.
There is potential for fraud
The Securities and Exchange Commission (SEC) and the North American Securities Administrators Association (NASAA) issued aninvestor alertin 2011 warning investors of the potential risks associated with investing via self-directed IRAs.
The reason: the NASAA and the SEC had noticed an increase in reports of investment scams involving self-directed IRAs.
"The large amount of money held in self-directed IRAs makes them attractive targets for fraud promoters," the SEC and the NASAA said in the alert.
"In particular, fraud promoters who want to engage in Ponzi schemes or other fraudulent conduct may exploit self-directed IRAs because they permit investors to hold unregistered securities," the alert noted.
Fraudsters try to trick investors by claiming that custodians have validated the investments in a self-directed IRA, when in reality custodians have no obligation to do so.
How do you avoid getting trapped? Be wary of unsolicited investment offers, ask questions, and always be skeptical of anyone who promises "guaranteed returns," the SEC advised.
Understand what you're investing in and know the risks
With self-directed IRAs, you're in control. But with control comes responsibility.
"Know what you are investing in," Levine said."If you are really knowledgeable,a [self-directed IRA] could be very valuable." But it's important to ask yourself whether the freedom of picking and choosing investments in your IRA is worth the potential risks involved.
Because of the tax implications of a self-directed IRA, you may want to consider consulting with a tax specialist.
The $15,834 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.