Is Creating a Self-Directed Retirement Plan a Good Idea?
You may not be aware that you can utilize a retirement plan for investments other than stocks, bonds, and mutual funds. There are numerous custodians that will help you take the money in your retirement plan and buy land, paintings, unregistered securities, or even self-finance a new franchise or business start-up. And you get to defer taxes on any future earnings from those investments. The big question, though, is whether or not it’s a good idea to be using your retirement savings for any of those purposes.
The Investment Company Institute reports that as of 2011, some $94 billion had been invested in self-directed IRAs. That’s not small change. Clearly a lot of people are banking their future on asset classes beyond stocks and bonds. And that’s understandable, given the volatility we’ve seen in the capital markets ever since the crash of 2008. The problem, however, is that non-publicly traded securities may be much more speculative than you think, perhaps even more than stocks.
Let’s use an example to illustrate this point. Say you created a self-directed IRA and invested in undeveloped land north of Los Angeles in 2006. The stock market subsequently encounters good days and bad days, and stock prices swing wildly, but your land remains serenely unaffected. As far as you know, its value hasn’t changed from when you purchased it. But you won’t know for sure until you try to sell it. Imagine that it’s now December 2008, and you decide to sell the land in order to fund the margin calls on all those stocks you are holding (you’re clearly a risk taker)! You contact the company through which you purchased the land and are shocked to discover that its value has dropped some 25%! Just because you can’t see daily changes in the price of an asset doesn’t mean it’s not volatile.
Steven M. Davidoff, a professor at the Michael E. Moritz College of Law at Ohio State University, describes in a recent New York Times article how some advisory firms are calling on people to leave their “mind-numbing” jobs and use their retirement funds to start a franchise business. These companies charge a fee to help you start a business, create a 401(k) plan, roll your existing 401(k) plan into the business’ 401(k) plan, then utilize the funds in the 401(k) to invest in the new business. All tax deferred! Sounds great, except for the fact that if the business fails – and according to the IRS, most do – you’ve lost all the money you’ve saved for retirement.
I’m not suggesting that stocks, bonds, and mutual funds are the only investments one should utilize for retirement savings. Certainly diversification is a good thing, and there’s no reason why real estate and commodities shouldn’t be included in the mix. However, nowadays you can invest in almost all of these asset classes through publicly-traded vehicles. By doing it that way, you get two additional benefits: greater liquidity and a much lower chance of being defrauded. Regarding the latter, Davidoff highlights the case of the Securities and Exchange Commission stopping a number of schemes trying to persuade retirees to buy Turkish promissory notes through self-directed IRAs. It would be impossible for such a scheme to succeed through your regular IRA or Roth.
The other issue I have with self-directed retirement plans is the fact that they are really a distortion of the primary purpose of retirement plans, which is to provide an incentive to help people save for their retirement. Not to gamble or speculate with their savings.
There are other risks with self-directed IRAs in particular that would-be investors need to know, according to John Waggoner, a personal finance columnist for USA Today. First, you need to make sure that you are following the IRS regulations against self-dealing. Is the custodian you are utilizing familiar with the rules and in a position to properly advise you? It’s your neck on the line with the IRS, not theirs.
Second, remember that while the IRA will shelter any gains on transactions inside the account, you can’t deduct your losses if you lose money. Also, you won’t get capital gains treatment on profits when you make withdrawals.
Probably the biggest challenge is making sure you’re putting your money into a good investment. Sure, owning an office building can be lucrative. Have you ever invested in one before, and do you understand the deal?
Self-directed retirement plans aren’t illegal. But I would recommend first considering simpler and safer alternatives. And if you do decide to take the plunge, make sure you’re getting trustworthy, independent advice on your investment options. You worked hard to build your retirement nest egg. Please don’t take needless risk with it.