Are Self-directed IRAs safe? American IRA-a National Provider of Self Directed IRAs answers this frequently asked question in light of the recent NASAA Investor Alert to warn investors of the potential risks associated with investing through self-directed Individual Retirement Accounts (self-directed IRAs).
Jim Hitt, CEO of American IRA, explains “Self-directed IRAs and other retirement accounts are not inherently more or less safe than conventionally administered accounts. For the most part, investments derive their safety and risk characteristics not from the way the account is taxed, but from the properties of assets it contains. If you invest in low-risk assets, your investment risk in your IRA will be low. If you invest in riskier assets, your investment risk will increase – depending on how you combine those assets.”
What is Risk?
Theoretically, risk is the uncertainty of a given investment result. However, academicians and investors look at risk in two different ways. The theorist views upside gains as volatility – and calls it risk. Investors call upside volatility a bonus.
The investor doesn’t balance his return expectations against risk, in the clinical sense. The investor balances return expectation against the possibility of loss. And the fundamental driving force behind the risk-return calculation is not whether the account is self-directed or not, but in the nature of the asset.
Mr. Hitt interjects, “Self-Direction Puts You in the Driver’s Seat. Choosing to self-direct means you have a much broader menu of options to play with – at all points along the risk spectrum. You can choose to invest in cash and cash equivalents – with little or no investment risk, but a lot of inflation risk. You can also choose to speculate in leveraged commodities futures, with significant investment risk, but also with significant potential returns. In practice, though, few prudent investors elect for one extreme or another. The vast majority are looking for some safety of capital.”
Consider the example of a blue-chip stock. These have long been mainstays of IRA investing. But as any Enron or WorldCom investor can tell them, a share of stock could become worthless overnight. Once the bondholders get paid off, there may be precious little left for the stockholder in the event of bankruptcy. This is why prudent investors look carefully at underlying assets and book values, as well as income and potential for growth.
With real estate, things are different. If they have title to land, that is something of lasting value, no matter what happens to the economy. If they own a house and a stock in their IRA – and both assets become worthless on the market, their stock will go to zero. But at the end of the day, they will still have a house. Their investment has intrinsic value, no matter what happens to the stock market, or the currency, or the economy at large. People still need a place to live.
We have all seen homeowners struggle with trying to refinance a deeply underwater mortgage. But here’s one thing homeowners aren’t: Homeless.
Related Asset Classes
There are other derivative investments that also have intrinsic value, precisely because they are secured by an interest in property or other asset of value. For example, the self-directed IRA owner could choose to lend money to home buyers at interest, or to commercial developers (for even more interest!), or invest in tax lien certificates, which are also ultimately secured by a claim on the property itself.
While the market price of these investments could rise and fall based on interest rates, market sentiment, or any number of reasons they can’t control, and while they may be illiquid, real estate is unlikely to go to zero.
Gold and Precious Metals
Choosing self-direction also allows them to take a more direct ownership of gold coins, bullion and other forms of precious metals – within their IRA. These assets don’t generate a current income. But we have thousands of years of experience observing how gold behaves in relation to overall economic conditions. Throughout history, whenever there have been times of uncertainty, strife and chaos, gold becomes more and more valued.
Yes, the price of gold rises and falls based on market sentiment. But the times when things are bleakest are the very times when gold is most valued.
Because gold frequently moves in the opposite direction from stock prices, gold is a useful hedge against the possibility of a big decline in equities, and against the possibility of inflation. The same is true of other precious metals, and many commodities in general.
Mr. Hitt speaks about expertise, “One of the great advantages of self-direction is it allows investors to focus on what they know best. If someone knows real estate inside and out, but doesn’t even know how to assess stock market risk, it makes little sense for him to divert precious retirement assets to stocks – and waste that hard-won expertise. While for some people, real estate may be riskier than a portfolio of stocks, for some of our clients, real estate is much safer: Our investor can control more of his risk in his own circle of competence than he can outside of it. Self-direction allows you to stay with what you do best.”
While IRS rules prevent them from pledging their IRA as collateral for a personal or business loan, they can, in fact, have their IRA take out a loan to make investments. The more they leverage, the greater their potential gains. But leverage magnifies losses as well as gains. Leveraged investments are intrinsically more risky than unleveraged investments, in that they theoretically could lose more than they had invested in the first place. However, IRAs can only take out nonrecourse loans. If their IRA borrows money, the lender cannot have any claim on any asset outside of the IRA. They cannot sign a personal guarantee on a debt incurred by their IRA. Debts incurred by a self-directed IRA, then, are generally self-contained. They do not normally blow up into claims against them, personally, or their business.
Obviously, self-direction isn’t for everyone. There are a lot of benefits to it, but they need someone in their corner who knows the rules and regulations specifically. The penalties for failing to abide by them are steep and may involve a tax and penalties.