In recent years the self-directed IRA has become a popular alternative among taxpayers seeking to grow their retirement accounts outside of common stock and bond investments. Self-directed IRAs, or "checkbook" IRAs, as they are often called, can help investors take advantage of opportunities outside the equity and bond markets, but they're also fraught with potential complications.
The self-directed IRA explained
A self-directed IRA results when a taxpayer places IRA funds with a custodian, which allows and facilitates nontraditional IRA investments. The taxpayer may then direct the custodian to invest in a broad range of assets, including partnerships, real estate, commodities, currencies, tax liens, and hedge-fund investments. The IRS specifically prohibits IRA investments in collectibles and insurance instruments.
The most prominent benefit of the self-directed IRA is its extreme flexibility. But for many investors, retirement-fund balances often far exceed personal, non-IRA funds. And the ability to legally access retirement savings to conduct, for example, a real-estate transaction that might otherwise be out of reach, proves irresistible to some. If this describes your current finances and inclination, should you go out and open an account with a qualified custodian today?
Don't rush in
The first thing investors should be aware of is that the IRS doesn't maintain a specific code section that governs self-directed IRAs. Rather, these IRAs came into vogue relatively recently as the result of the 1996 tax court case Swanson v. Commissioner. In this case, the taxpayer, Swanson, was ruled to be within the bounds of U.S. tax code when he directed his IRA to invest in two companies he owned, the profits of which flowed back into his IRA. This case set a precedent for a now common arrangement in which a taxpayer instructs the custodian of his or her self-directed IRA to invest in a limited liability company, or LLC, which then acquires real estate, purchases an interest in a running business, or makes other types of investments.
Due to the pass-through structure of an LLC, profits from the LLC flow back into the account held by the custodian. Yet managing a self-directed IRA properly using this structure isn't easy: Transactions must be kept at arm's length from the taxpayer to avoid IRS prohibitions against "self dealing." Custodians of self-directed IRAs promote their expertise in guiding a taxpayer through these waters, yet most of them also simultaneously disclaim that the guidance they provide constitutes tax or legal advice. As in most every area under Uncle Sam's domain, the taxpayer is responsible for his or her own compliance.
In addition, many taxpayers don't realize that it's quite easy to trigger taxable income in a self-directed IRA. For example, if your self-directed IRA owns an LLC with a business interest, and the IRA receives pass-through profits each year from the LLC, it may be exposed to "Unrelated Business Income Tax," or UBIT. U.S. tax law is designed to prevent nonprofits and retirement accounts from having an unfair advantage over the rest of us by avoiding the taxation of business income. If a self-directed IRA triggers UBIT, a tax return will need to be filed, and the income will be taxed not at the taxpayer's income tax rate, but at the current U.S. trust tax rate, which is equivalent to a 39.6% tax bracket for income exceeding $12,150 in 2014.
Another way to liven up your traditional or Roth IRA
The potential for noncompliance is not the only factor that might make "checkbook" IRAs less appealing to some investors. When these IRAs were first introduced in the 1990s, investors had a limited range of investment options in their IRA accounts via the then-existing flavors of stocks, bonds, and mutual funds. But over the last 20 years, with the explosion of exchange-traded funds, or ETFs, one would be hard-pressed to find an investment theme or idea that can't be traded like a stock within an existing IRA account.
Suppose a taxpayer wants to capitalize on a well-reasoned hunch that over the long term the price of silver may increase from its current level. The ability to buy precious metals is a much-cited advantage to a checkbook IRA. The taxpayer could open a self-directed IRA account with a qualified custodian, purchase silver (as long as the silver is in the form of bullion or government minted coins, and not prohibited "collectible" silver coins), and hold the asset for several years. But this would incur yearly holding fees from the custodian for the physical asset, as well as the initial cost to deliver the silver to the custodian's designated third party. The asset maintenance fees would be separate from any yearly administrative fees assessed by the custodian for the overall IRA account.
As an alternative, the investor could simply purchase the equivalent dollar amount of iShares Silver Trust (NYSEMKT:SLV) shares. The price of one share of this ETF is closely correlated with the spot price of silver, making it a reasonable stand-in for this popular precious metal. Of course, the ETF also has fees, but its expense ratio of 0.5% makes for a very modest annual expense.
When it comes time to close the trade, if our hypothetical investor had simply bought SLV, a single commission to sell the ETF would be incurred. Conversely, exiting his or her holdings in the self-directed IRA account would involve the costs associated with a physical metal sale, as well as potential costs to remove the metals from the designated third party.
The same line of thinking can be used for a number of other investment strategies. If you're hankering to participate in the volatile world of currency trading, you could undergo the administrative expense of opening a self-directed IRA, and then open a foreign currency trading account with a bank or an online currency broker, funded via the IRA custodian. But you'd pay the custodian annual fees for the honor of trading in another institution's account, and you would also incur the commission cost of the "spread" -- the difference between the target currency's bid and the ask price -- on every trade you placed.
Or you could avoid these various expenses and simply purchase a currency ETF, say the CurrencyShares Australian Dollar Trust (NYSEMKT:FXA), out of your existing traditional or Roth IRA account. The FXA tracks "long" exposure to the Australian dollar and features a dividend of nearly 2%, which is generated by the Australian Dollar's interest rate versus that of the U.S. dollar. This attractive dividend is paid out on a monthly basis.
For those who are aware of the risks and are willing to spend time, money, and effort on the appropriate guidance from a knowledgeable CPA and/or attorney, a self-directed IRA may make sense given one's individual circumstances, investment goals, and account balances. But in most cases, turning to ETFs can be a simple, effective investment strategy that avoids both the costs and the potential tax and legal pitfalls that accompany the self-directed IRA.
Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.