If you’ve been chunking money into your retirement account for years, the last thing you want to do is watch it shrink to nothing when the stock market goes south. Just ask any 65-year-old, who is now having to work for 5, 10 or even 15 years longer than he expected thanks to the big hit his IRA took a few years ago.
Fortunately, there are now a few alternative options when it comes to investing your IRA, but like with any investment, they come with their own set of risks and rewards.
The Way It Was with IRA Investments
For decades, IRAs (i.e. traditional vs Roth IRAs) and other tax-deferred retirement plans like the 401k have been used to fund the retirements of millions of Americans. In most cases, these accounts are funded with investments such as stocks, bonds, mutual funds, unit investment trusts, CDs, treasury securities, and fixed, indexed, and variable annuity contracts. Other less common investments such as mortgage-backed securities, real estate investment trusts (REITs), and covered calls have also been used by more savvy investors in some cases.
But certain types of investments have always been prohibited inside IRAs and qualified plans, such as life insurance, collectibles and antiques, and real estate that is being used by the IRA owner. These restrictions are found inside the Internal Revenue Code and cannot be breached under any circumstances. Many IRA custodians have traditionally also prohibited most alternative types of investments and restrict the range of investment vehicles to publicly-traded securities that can be easily tracked and valued at all times.
A New Trend with Alternative Investments in Your IRA
However, a growing number of independent IRA custodians have begun allowing investors to hold various types of alternative investments inside their accounts, such as private equity, options and futures contracts, direct ownership of real estate, foreign investments, hedge funds, partnership interests, working interests in oil and gas leases or other energy properties, and venture capital.
Although this category of investments is hardly appropriate for everyone, it has become appealing for more and more investors in the wake of the market meltdowns over the past few years. Those who have seen their retirement account balances shrink to a fraction of what they were in the ’90s have become more inclined to seek alternative avenues that have little or no real correlation to the stock and bond markets. These investments offer the potential of substantial gains for those who are able to absorb their risks.
Of course, the majority of these investments are only available to investors who are considered to be accredited by the SEC. Under Regulation D, an accredited investor must meet one of the following criteria:
- Has an individual income of at least $200,000 per year or joint income of at least $300,000
- Has a net worth of at least $1,000,000
- Is partner or executive associated with the security or investment in question that is being offered or issued.
Even with this restriction, most investors are advised to limit their alternative investment holdings inside their IRAs (or their general investment portfolios, for that matter) to five or ten percent of their total account value at most.
No Free Lunch
Of course, the IRA custodians that are willing to house alternative vehicles like these will usually charge substantially higher fees than other custodians. Investors can typically expect to pay anywhere from a few hundred to a few thousand dollars per year in custodial fees in contrast to the $50 charge assessed by more conventional custodians, such as banks or mutual fund companies.
For example, when we were trying to start our oil and gas company a few years ago, one of our prospective clients was considering purchasing a small interest in a lease inside an IRA. I researched a list of IRA custodians and came across Pensco, an independent custodian that was willing to hold this asset for $200 a year. Other firms such as Milennium Trust, Entrust and IRA Services charge similar investment fees, dependent upon various factors such as account size and the type of investment used.
Remember, however, that because these fees are considered to be an investment expense on the Schedule A of the 1040, those who qualify may be able to deduct a portion of these expenses if they are able to itemize deductions when they file their tax returns.
Limitations of Alternatives Investments
Investors who participate in alternative investments should take care not to get caught up in any type of transaction or arrangement that is prohibited by the IRS. Prohibited transactions begin when the owner of the IRA, family member, investment advisor or custodian of the IRA performs certain types of transactions, such as the transfer, exchange, sale, or loan of property between any of the parties listed above and the IRA account.
Failure to adhere to these rules can result in not only the transaction in question becoming taxable, but conceivably the entire IRA as well. There are other types of prohibited transactions as well; the IRA custodian should be able to advise you what you need to do to avoid them.
Although alternative investments can be an important part of an investment portfolio, investors need to be aware of the risks and rules that come with them. In many cases, an ERISA or tax attorney should probably be consulted before investing.
Do you have experience adding alternative investments to your IRA? Share your thoughts in the comments below.