Harnessing the Power of the Anything-Goes IRA

Tired of the stock market's wild ups and downs, a growing number of investors are opening self-directed IRAs, which allow them to hold real estate, precious metals and other alternative investments.

These individual retirement accounts can be a good way to diversify a retirement portfolio, say advisers.

But they can also put investors at risk of violating the complicated tax rules that govern IRAs. What's more, the Securities and Exchange Commission and the North American Securities Administrators Association, which represents state securities regulators, recently issued an "investor alert" warning of a growing number of fraudulent schemes tied to investments in these accounts.

The use of an IRA can "lend credibility" to a fraudulent scheme, says Matt Kitzi, Missouri's securities commissioner and the head of Nasaa's enforcement section. Because IRAs are administered by custodians and sanctioned under the tax code, they can give investors a false sense that a financial-services firm or the IRS is evaluating the quality or legitimacy of their holdings, he says.

Self-directed IRAs are attractive because of their wide latitude. While many banks and brokerage firms limit IRA investors to stocks, bonds, mutual funds and certificates of deposit, the only assets off-limits in individual retirement accounts, per the U.S. tax code, are life-insurance policies and collectibles, including some types of coins.

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People who want alternative investments can open a self-directed IRA at a custodial firm that handles nontraditional assets.

Tony Farwell, 55, holds about 45% of his retirement savings in a self-directed account that owns shares in privately held companies. The La Jolla, Calif., resident, who runs a venture-capital company, estimates the account—which is administered by San Francisco-based custodian Pensco Trust, one of the industry's largest—has earned a compound annual return of 65% over the past four years.

"A diversified portfolio doesn't allow you to earn a superior return," he says. "You have to invest in a concentrated way in the areas you know well."

According to the SEC, self-directed IRAs hold about $94 billion, or 2% of the assets in all IRAs. Neither regulators nor the Retirement Industry Trust Association, which represents administrators of self-directed IRAs, could say whether the amount in these accounts has grown in recent years. But Mary Mohr, executive director of RITA, says the group's 25 members "are growing and adding employees."

An Influx of Assets

Though there are no hard data on growth in self-directed IRAs, custodians say they have seen an influx of assets in recent years. Assets at the Entrust Group, based in Oakland, Calif., have grown 10% a year during the past five years, to $4 billion, according to the company. Pensco Trust says assets have doubled to $3.6 billion since 2005.

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While many people in these accounts use them to invest in private companies and real estate, custodians say a growing number are buying precious metals. Some have even held racehorses, bowling alleys and pet cemeteries.

"An IRA can hold almost anything as long as you can get title to it," says Pensco Trust Chief Executive Kelly Rodriques.

Yet such investors run a greater risk of violating the complicated tax rules that govern IRAs, partly because of the ability to buy stakes in closely held companies and real estate. Violators can be forced to close their account and pay income taxes on its entire value—plus a 10% penalty for people under age 59½.

The accounts also can prove tricky when an IRA owner starts taking annual distributions. If the IRA owns a home, for example, the owner may be forced to sell it to withdraw the required amount.

Many rules are designed to prevent "self-dealing," or the personal use of IRA assets until the owner must withdraw them, starting at age 70½, and pay the income taxes due. For example, the rules bar IRA owners and most relatives from living in an IRA-owned property or investing in their own companies, says Ed Slott, an IRA expert in Rockville Centre, N.Y.

Fraud Targets

Regulators warn these accounts have become targets for fraud, though data aren't available. This is due in part to the flexibility investors have to buy unregistered securities, which aren't subject to many of the SEC's disclosure requirements.

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Patricia and Harold Scott of Independence, Mo., say they lost their retirement savings after employees of Pop N Go, a Whittier, Calif., seller of popcorn vending machines, persuaded them in 2007 to transfer $62,880 from their IRAs into a self-directed account in order to invest in Pop N Go's unregistered convertible bonds. (The couple also transferred another $25,000 from a separate account.)

Patricia Scott, 70, says the couple was attracted by the promised 14% interest rate. But after a year, she says, the company stopped making payments -- and returning phone calls.

On Nov. 1, Missouri regulators issued a cease-and-desist order against Pop N Go and two employees, including CEO Melvin Wyman. Among other things, regulators say the men "misled" the Scotts about the company's finances. Mr. Wyman and the company didn't return repeated calls for comment.

Custodians who handle self-directed IRAs say they aren't seeing a significant amount of fraud. But Retirement Industry Trust Association members are seeking to "do what we can to reduce and eliminate fraud" by working with regulators and one another to communicate "suspected fraudulent activity," says Tom Anderson, the association's president.

Mr. Anderson says investors should use custodians regulated by federal or state banking authorities and consider hiring an adviser registered with the SEC or the Financial Industry Regulatory Authority to vet investments.