Many investors mistakenly believe the only options for their individual retirement accounts (IRAs) are standard equity and fixed income products typically purchased through traditional IRA managers such as the large brokerage firms. Large brokerage firms, and the financial advisory network that has developed around them, have a vested interest in perpetuating this belief as it tends to be quite profitable for them while typically delivering middling returns for you. With a little more effort and research, you will find there are options well beyond stocks and bonds which you can introduce to your portfolio to improve returns and diversify risk.
If you study the portfolios of sophisticated investors, you will see they typically have a high level of diversification. While most individuals may have cash, stocks, bonds, and a primary home, the sophisticated investor will often have one or more of the following among their holdings: precious metals and other commodities, income-generating real estate, equity or loan investments in early stage private businesses, and crypto-currencies such as Bitcoin (though not recommended for a secure retirement). What will typically be a common thread between the sophisticated investor and her less sophisticated counterpart is that neither will be aware they can invest in those alternative asset classes within a retirement fund.
A new way to diversify
Most of us came to have a retirement account in one of two way: a dutiful parent set one up for us and seeded it with a small amount of capital, encouraging us to add to it regularly as we were able, or we opened one ourselves around the time we started out in the work force. For another group of us, a job change required we move funds out of a 401K into a personal account. However we came to have one, the account was almost always opened at a large retail brokerage such as TD Ameritrade, Charles Schwab, or Fidelity. The primary incentive for those managing our accounts at these firms was to hawk mutual funds that were kicking back large sums of money to these brokers to drive business to their funds. Later, ETFs with lower commissions became more popular as investors started to wise up to the fact that actively managed funds rarely returned growth beyond typical market movements. As such, we have assumed that our retirement accounts are only good for holding cash, stocks, bonds, or mutual funds and ETFs.
Fortunately for us, this is not the case. All of us can in fact legally hold most manner of “alternative investments” in our IRA accounts. This is as simple as opening an account with an IRA management company who specializes in managing alternative investments. Once you have opened an account with a self-directed IRA company (there are many to choose from) you can, with few exceptions, invest in pretty much anything you would outside of your IRA account. This includes precious metals such as gold bullion, investment properties such as houses, condos and multi-tenant properties, shares in a private business such as a retail store or chain of cafes, and even loans to businesses or real estate sponsors. In fact, the only two asset classes prohibited by IRA laws are life insurance policies and collectibles.
Two IRA restrictions to know
There are two important restrictions to be aware of as you consider alternative asset classes in a tax-advantaged account. The first is a restriction on what is called “self-dealing”. As your IRA account becomes a legal entity separate from you and your non-IRA finances, any business transactions within the IRA account need to remain within that same account and cannot benefit you or your non-IRA finances. As an example, if you own a rental property in an IRA account, the rent from that property has to be paid directly into the IRA account, not to your personal checking account. Also, you cannot use the property for your own personal use and you may not invest any “sweat equity” into the property. The second restriction is in dealing with disqualified persons. In essence, a disqualified person is a close family member or relative. Spouses, parents, children (and children-in-law) fall into this category. As an example, if your spouse starts a business where he or she is a majority owner (greater than 50%), you are prohibited from investing in this business through an IRA account.
A good rule of thumb
Outside of these two restrictions, you are able to put your money to work in many more creative ways than you likely thought were possible. A good rule of thumb in considering your IRA savings is, almost anything you know how to make money at outside of your IRA, you can make money at within your IRA. The corollary to this rule is that by veering away from more standard investment options such as stocks and bonds, you may introduce additional risk to your portfolio if you aren’t careful about how you select from available investment opportunities. Your retirement accounts are intended to provide for your non-earning years and as such, you should exercise caution in the decisions you make with these funds.
Your retirement accounts are intended to provide for your non-earning years
Many of us at some point in our lives have come across an investment opportunity we really liked for some reason or another. This could be an opportunity to buy an income producing property at a low cost following a market downturn. Or a friend starting a business we believed in who was looking to raise capital. Or a dip in the price of gold. And most of us, in trying to manage our cash flow and struggling bank accounts had to walk away from the opportunity as we didn’t have the funds available at the time, only to look back later at how well the investment would have turned out if only we had the cash available. Meanwhile, our retirement accounts which we religiously continued to fund sat around muddling along at an underwhelming rate.
In my next article, I will go into some of the more common investments made through a self-directed IRA and cover the mechanics of how you can set up, fund and begin to invest from your alternative investment IRA account.
Planning or In Retirement?
Get Your Retirement Readiness Score