The SEC issued a formal alert nearly four months ago advising investors to be wary of fraudulent promoters targeting self-directed IRAs. The alert noted that a key difference between IRAs and self-directed IRAs is that while "most IRA custodians are banks and broker-dealers that limit the holdings in an IRA," self-directed IRAs offer investors the opportunity to put their "retirement funds in other types of assets, such as real estate, promissory notes, tax-lien certificates and private placement securities."
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.
If a building, for example, is owned within an IRA account, the ability to deduct depreciation is lost. In addition, while the sale of property within an IRA would not trigger a tax, when the funds are distributed eventually, tax will be due at ordinary income tax rates. Of course, if the property were purchased outside of a retirement account as a capital asset, any gains on the sale of the property could be taxed at lower capital gains rates.
If the property was held outside of an IRA and was not sold during the owner's lifetime, heirs would receive a step-up in basis eliminating any capital gains tax on appreciation that occurred before death. By comparison, there is no step-up in basis on property in an IRA when the IRA owner dies.
As a general rule, tax benefits are better when real estate is held outside of an IRA. Appreciation or gain on the sale of property held in a Roth IRA will generally be tax-free when the property or sales proceeds are distributed.
VALUATION AND LIQUIDITY ISSUES
It's extremely easy to figure out what traditional investments, like stocks and bonds, are worth, but suppose your clients used a self-directed IRA to purchase an office building they intended to lease. When they reach 701/2 years old, they must take required minimum distributions. In order to determine the amount, you need a Dec. 31 prior year-end balance. And you need liquidity in the account to take the distributions.
That means you need a valuation to determine the building's fair market value every year. These valuations are an expense of the IRA, not a personal expense of your client, so the IRA must pay for the valuations.
In addition to required minimum distributions, liquidity may be needed to pay annual maintenance, real estate taxes and other expenses the IRA property incurs if it does not throw off enough income to cover these items. The IRA, not the account owner using assets outside the IRA, must pay these expenses.
Even if a client has a self-directed IRA outside your purview, holding documented discussions of the perils could go a long way to protect you as well as your client. It's a good way to show your IRA expertise.
Ed Slott, a CPA in Rockville Centre, N.Y., is an IRA distribution expert, and author of a monthly newsletter on IRAs as well as several books, including the newly revised, The Retirement Savings Time Bomb and How to Defuse It. For more information, visit irahelp.com. Post questions and comments on the Ask Ed Slott blog at financial-planning.com.