Self-directed IRAs have the potential to offer owners obscure but highly profitable opportunities. But they also come with unique risks, such as "a lack of disclosure and liquidity - as well as the risk of fraud," the SEC said.
Although the majority of IRA owners are content with more traditional investment options, self-directed accounts still represent a sizable portion of IRA savings - about $94 billion, according to the agency. Some worry that volatile and uncertain markets could prompt additional money to be allocated to self-directed accounts.
HOW FRAUD PROMOTERS WORK
One way fraudulent promoters operate is to misrepresent a custodian's responsibilities. They may suggest, or even declare, that a self-directed IRA custodian has done some level of due diligence on an investment to verify its validity. The SEC alert noted that this is not usually the case.
Most self-directed IRA custodians will not evaluate the merits of an investment clients make. In fact, in most cases, custodial agreements explicitly state that the custodian bears no responsibility with regard to an investment's performance. Clients should view their self-directed IRA custodians as nothing more than record-keepers.
The agency also warned that fraud promoters are likely to target self-directed IRA owners because of special tax rules, especially the 10% penalty for early distributions before age 591/2 that discourages many IRA owners (both self-directed and regular) from withdrawing their retirement accounts at an early age. The SEC points out that many of the alternative investments self-directed IRA accounts typically hold, such as real estate, mortgages, tax liens, precious metals and private placement securities, do not always provide the same type of financial information to investors as publicly traded securities. The alert cautions that, even in cases where financial information is disclosed, the same level of scrutiny, such as an audit by a CPA, may not exist.
BE ON THE LOOKOUT
What are some of the danger signs? As the SEC put it, "Low risk generally means low yields, and high yields typically involve higher risk. Fraud promoters often spend a lot of time trying to convince investors that extremely high returns are 'guaranteed' or 'can't miss.' Don't believe it." The alert also notes that investors should be on guard even when approached by someone the investor trusts, such as a friend, co-worker or even a family member.
For additional information, visit sec.gov/investor/alerts/sdira.pdf. This document also contains a brief description of several recent court cases that involved fraudulent investments made through self-directed IRA accounts.
The SEC alert doesn't distinguish between self-directed traditional IRAs and self-directed Roth IRAs. However, from a client's perspective, fraud involving a Roth IRA is far worse. Not only would a client be out the money put into a bogus investment, but he or she could potentially lose the money to pay the tax on the Roth IRA when it was contributed or converted to the Roth account.
If a client discovers such a fraud before Oct. 15 of the year after a Roth conversion, recharacterizing the IRA may be the best course of action. Clients beyond this window may be able to claim a loss on their tax return to the extent of their basis (contributions and conversions) withdrawn from the Roth account.
Even if an IRA is not victimized by fraud, challenges can also arise when legitimate nontraditional assets are purchased in a self-directed IRA account. Although these accounts can give IRA owners access to additional investment options beyond that of the typical IRA, there are still a number of investments that are off-limits. For instance, IRA regulations prohibit life insurance; collectibles such as antiques, rugs, artwork and stamps; and coins other than U.S.-minted gold, silver and platinum from being held in an IRA.
Another worry: Certain tax benefits that would be available in a non-IRA are lost if the same investment was made in an IRA account. For example, real estate is one of the more common holdings in self-directed IRA accounts.