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How to Invest in Private Equity With a Self-directed IRA

Rebecca Lake

When saving for retirement is the order of the day, you may think your options are limited to stocks and bonds. Investing in a self-directed individual retirement account, however, can open up new possibilities.

Self-directed IRAs allow you to invest in alternatives like real estate, precious metals and an asset class that's typically the domain of the uber-wealthy: private equity.

From an investment perspective, private equity can be lucrative. According to the Private Equity Growth Capital Council, private equity outperformed the Standard & Poor's 500 index by 5.2 percent during the 10-year period ending in 2015. Private equity investments are not without certain risks, though, and they may not be appropriate for every investor.

Hunter Unschuld, president of Albuquerque-based Fractal Profile Wealth Management and founder and CEO of the American Society of Fiduciary Education, cautions that investing in private equity is the epitome of all or nothing.

[See: 10 Tips to Boost Your IRA Balance.]

"It's a home run or a strikeout in investing," Unschuld says. "The main advantage is if you hit the home run, all of those gains are much bigger than what you would get in the stock market and they grow in your account tax-free."

On the other hand, the big disadvantage of investing in private equity via a self-directed IRA comes if you strike out.

"If you take a loss, you can't write that off on your taxes like you can with a loss in a regular investment," Unschuld says.

If you're considering an investment in private equity through a self-directed IRA, here are some best practices to observe.

Get familiar with the self-directed IRA guidelines. Self-directed IRAs share the same tax advantages as a traditional or Roth IRA but the Internal Revenue Service imposes certain restrictions on the management and use of these accounts.

Adham Sbeih, CEO and founder of Socotra Capital in Sacramento, California, says investors sometimes have a tendency to overlook the importance of these rules.

"I think the one that's broken most frequently is that you can't personally benefit from your self-directed IRA -- only your IRA can benefit," Sbeih says.

The IRS specifically prohibits self-directed IRA investors from conducting transactions that result in an indirect benefit. For example, you're not allowed to lend yourself money from the IRA or use IRA funds to purchase a vacation home. These kinds of activities fall under the umbrella of self-dealing, which is a major no-no in the eyes of the IRS.

Jeffrey Kelley, senior vice president and chief operating officer at Equity Institutional in Westlake, Ohio, says investors should also be aware transactions involving certain individuals are verboten. That includes transactions between an IRA and disqualified persons, which covers fiduciaries, certain family members, and businesses that are controlled by the investor who owns the IRA or another disqualified person.

If your investment activity moves beyond the scope of what's allowed by the IRS, the result could be damaging to your bottom line. In the worst-case scenario, your IRA could lose its tax-advantaged status and you may incur taxes or penalties on prohibited transactions. That could wipe out any gains you've made by investing through the IRA in the first place.

Understand the risks associated with private equity investments. Private equity can add diversification to your investments but it's important to understand where it fits in terms of your risk tolerance.

"Investing in private equity through a self-directed IRA will raise an investor's risk profile," Unschuld says. "There's a higher risk, but also a higher reward and to offset that, the investor should be more conservative with other investments in his or her portfolio."

Erik Davidson, chief investment officer for Wells Fargo Private Bank in San Francisco, says investors should take a holistic view when introducing private equity investments through a self-directed IRA.

"It's very important to look at investments in the context of the entire portfolio," Davidson says.

[See: 12 Great Things About Retirement.]

Davidson says investors should be focused on balancing private equity with investments that offer greater liquidity and a different risk-and-return profile. He also encourages investors to consider their broader timeline until retirement.

"Investors who need liquidity soon, as well as those who lack substantive other assets for diversification, wouldn't be appropriate for this strategy," Davidson says.

He says that investors who are pursuing private equity investments through a self-directed IRA should perform exhaustive due diligence beforehand. Davidson further recommends diversifying within private equity investments to avoid significant deal-specific exposure.

Sbeih says investors should consider diversifying into an investment that counterbalances any weaknesses a particular private equity investment may bear. Investors also need to understand how the investment winds down, as well as the process and timeline involved to make an exit, he says.

Compare the costs to any potential upside of investing in private equity. Anthony Glomski, principal and founder of Los Angeles-based AG Asset Advisory, says the cost of private equity in a self-directed IRA can be prohibitive for some investors.

"Many private equity investments that our firm would advocate require the investor to be a qualified purchaser (QP)," Glomski says, meaning an individual with at least $5 million in investable assets.

"As you go down the food chain, away from investments that do not require an individual to be a QP, fees and expenses are increased and performance can be compromised," Glomski says.

If you're planning to invest through a private equity fund, venture capital fund or funds of funds, scrutinize the fee schedule carefully so you have a realistic picture of what the investment will cost on an annual basis. You can then compare that to the fund's performance to determine whether it's worth any gains you anticipate over the long term.

Beyond that, you'll also need to consider the tax implications.

"Returns from a self-directed IRA investment can be tax-deferred or tax-free, depending upon the account type," Kelley says. "However, some investments made using self-directed IRAs, such as limited partnerships, limited liability companies and other entities, may also generate unrelated business taxable income."

Don't assume that your IRA custodian will do the legwork of managing your tax burden.

"If you're in a self-directed IRA, it's your responsibility to be aware of tax liabilities," Unschuld says. "For example, if you invest in private equity in a manufacturing business that generates income and it's not paid out as a dividend, you have to pay tax on that income or face a penalty."

Even if the money is in your IRA in that scenario, it's still subject to tax in the year it's distributed. It's advantageous to know beforehand how private equity could reshape your tax outlook.

[See: 10 Steps to Max Out Your IRA.]

"The potential tax implications that can come with private equity can be a big problem for some people," Unschuld says.

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