A self-directed individual retirement account, or IRA, gives its owner the ability to invest in many things other than the usual stocks, bonds, mutual funds and CDs.
Some investors think they offer a great opportunity to get a better return on retirement savings, especially in today's low-interest rate environment. But setting one up and following the rules isn't nearly as easy as setting up a conventional IRA.
For one thing, the Internal Revenue Service requires that either a qualified trustee or a custodian hold these assets on behalf of the IRA owner. That part of the deal adds a layer of costs that will add up quickly and eat up your profits if you're not careful.
While self-directed IRAs can be used for an array of investments, including commodities, commercial paper, tax lien certificates and precious metals, the most popular investment to put in them is real estate, says David Nilssen, CEO of Guidant Financial, a self-directed IRA custodial firm based in Bellevue, Wash.
If you choose to buy real estate in a self-directed IRA, the legal title of the property you buy must be in the name of the IRA. The owner of the IRA must be strictly hands-off, which means that if you own property in your IRA, you generally can't do any of the chores associated with real estate ownership such as collecting rents and mowing the grass. Under most interpretations of these rules, you can't even pay the bill yourself when you hire somebody else to do the work. The custodian or trustee has to handle all those duties.
Those fees add up. Every time you authorize the custodian of your self-directed IRA to pay the guy who mows the grass or the plumber who unplugs the commode, he'll tack on a service charge of, say, $25 -- on top of what you pay for the service.
Nilssen of Guidant Financial advocates a solution using a limited liability company, called a self-directed IRA LLC. In this arrangement, an IRA owner sets up a limited liability company to be owned solely by the IRA. He directs his IRA custodian -- in this case, Guidant -- to invest his IRA in his limited liability company, which he manages himself. That way the IRA account holder can have what is known as "checkbook control" over his self-directed IRA, handling all the practical details himself.
A supporter of the LLC self-directed IRA approach is C. Diana Webb, assistant professor of finance at the Midland, Mich., branch of Northwood University. "As the owner of the IRA LLC, you have complete control over that checkbook," she says. "You can't compensate yourself, but you aren't having out-of-pocket fees every time you make a transaction."
The IRS has never ruled directly on the legality of these IRA LLCs, although proponents point to related decisions and private letters as proof that the IRS approves. But Bill Smith, an attorney who is managing director of the CBIZ MHM National Tax Office, is dubious. He says that even approaches that appear to meet IRS approval have pitfalls.
"If the IRS audits you and disallows it, there is no administrative appeal. The only way to fight it is to go to court. So the amount of the transaction better merit the $200,000 it will take to slug it out with the IRS," Smith says. "My advice is, don't do it."
The fine print
The cost of setting up an IRA LLC ranges from a low of $600, Webb says, to as much as $10,000. You also can find the paperwork and do it yourself, she says, although she doesn't advise it. "This is only for people who understand the tax laws."
Guidant charges $2,800 to set up one of its IRA LLCs. Its set-up fee includes two consultations with an attorney. After that, there is an annual renewal fee.
More conventional self-directed IRA custodians have lower-cost initial structures. For instance, the initial set-up fee for a self-directed IRA through Sterling Trust, one of the better-known custodial companies, is $50. The ongoing costs vary, but can add up. Here's a sampling from the company's rate sheet:
- One-time establishment fee: $50.
- First-year annual fee: $75.
- Annual renewal for an account holding $100,000 to $249,000: $300.
- Pay bills with cashier's check, certified mail or overnight mail service: $25 each.
- Pay bills via wire transfer: $30 each check.
If you decide to give a self-directed IRA a try, here's some advice for minimizing the fees. Most of these tips are from Laura Stover, an investment adviser and president of Laura H. Stover Financial Group.
- Shop around for a custodian who handles the kind of investment you plan to pursue. Make sure you understand all the fees associated with that investment type before you sign up.
- If you're planning to invest in rental real estate, find out how the custodian handles rent collection and the other duties of being a landlord.
- If the custodian charges a percentage of your total investment, a commission or a wrap fee, make sure you understand what's included and negotiate.
- Ask about cash-management options within the IRA. Find out what the interest rate will be and if there are cash-management fees.
- Do the math. Sometimes self-directed IRAs sound like a much better deal than they turn out to be once you figure out the costs compared to more conventional arrangements.
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