From time to time we hear someone suggest that Self-Directed IRAs are ‘risky.’ Is this true?
Well, yes, and no.
Self-directed retirement accounts – whether they are IRAs, 401(k)s, SEPs or SIMPLES – are precisely as safe or as risky as you decide to make them.
That’s the whole idea with self-direction. You aren’t delegating your risk management decisions to a third party, for the most part. If you choose to self-direct, you are in the drivers’ seat, and the risk-reward balance you decide to take is entirely up to you.
It is true that mutual funds generally give you the safety of significant diversification across dozens, hundreds or even thousands of securities with a single transaction. There is value to that kind of diversification – particularly for novice investors. But there are many times when investors have been blindsided by risks they didn’t know were being taken on their behalf. For example, investors in a certain high yield municipal bond fund woke up one morning to find out that the value of their portfolios had been slashed in half. Why? Not because of any fundamental problem with the underlying securities, but because they had simply been wrongly valued as too high all along.
There have also been instances of people entrusting money they thought was safe to people who turned out to be frauds – such as Bernie Madoff, who preyed on the Jewish community in Palm Beach, costing investors billions.
There are other cases where there is no crime or tort being committed, and no manager is making a mistake, but investors get slammed with unwelcome news anyway. For example: Suppose you find a mutual fund that has outperformed the market for several years running, and you like the investment. So you invest in August, right before there’s a big decline in the market.
Well, that’s bad enough. But suppose further that the fund also had been selling a number of investments over the year that had made big gains for all the investors who had bought in before you. The fund company would then declare a distribution of its capital gains, and hand you a big capital gains tax bill – on profits other people had made! That means unless you are careful and take a look at embedded capital gains and you know when the fund’s ex-dividend date is, you will wind up paying tax on other peoples’ gains even though you lost money in the fund.
Fortunately, you don’t have to worry about taxable mutual fund distributions in a retirement account. But you certainly have to worry about other issues:
- Ongoing 12-b-1 fees that do you no good as an investor
- Ridiculous expense ratios to pay managers to under-perform an index fund
When you choose to self-direct, on the other hand, you are choosing to take charge of your own retirement money rather than entrust it to a fund manager or group of fund managers, who may make decisions that are at variance with what you expected.
You are also bypassing a number of middlemen, and potentially reducing the overall costs of carrying investments, if you are careful with your expenses.
Do you want a risk-free investment? You are perfectly free to park your Self-Directed IRAs funds in a money market or in CDs. Do you want to be aggressive? You can take some or all of your position and commit it to private equity, venture capital, or leveraged anything you want. There are very few limits, other than you can’t own life insurance, gems, jewelry, collectibles or alcoholic beverages, and you can’t use those assets to benefit yourself in any way, other than to provide eventual retirement income for yourself and your family.
Self-direction isn’t for everyone. It works best for independent, experienced investors who don’t have to have their hands held. You should have a solid business sense and have some experience or advantage in the areas in which you plan to invest, even without going through a fund manager.
If this is you, we’d like to help you. American IRA, LLC, is one of the leading authorities on self-directed retirement investing. We are a recognized third party administrator of Self-Directed IRA assets. We help you execute your decisions and help you ensure that you are acting within the regulatory framework surrounding Self-Directed IRAs. Call us today at 866-7500-IRA (472), or visit us at www.americanira.com. We look forward to working with you.