Most physicians have probably not heard of Self Directed IRAs (“SD-IRAs”). However, because they are becoming more popular in the investment world, and because they carry significant risks, it is important that you are aware of them.
Are they legit? Yes, if handled appropriately.
Are they for you? Highly unlikely, unless you have hundreds of thousands or millions of dollars in tax-advantaged accounts and you want to use some of that money to make alternative investments.
Self Directed IRAs are just like the regular IRAs that you get at Scottrade or any other brokerage, except that you can use SD-IRAs to make investments that most brokerages do not permit, such as private equity, private loans and real estate. Sometimes you will see the term “Checkbook IRA” or “LLC IRA”, since most IRAs are set up using LLCs and give the owner of the IRA access to the bank account to make investments. Similar options exist for 401(k) and Roth IRA accounts. Although there are multiple paths to forming a SD-IRA, one of the more common paths is to form a LLC, deposit money with the custodian of the SD-IRA, have the custodian then transfer that money into the LLC in exchange for the IRA being the sole owner of the LLC. If the investor is the manager of the LLC, then she has control of the bank account and the investments made by the LLC.
The major appeal of Self Directed IRAs is the ability to make investments with your tax-deferred money that are not available with most IRAs at a traditional brokerage. This can provide significant diversification to your more traditional stock and bond investments, and as an IRA, you can defer the income on your investment gains. Another advantage is that, if structured correctly, you can minimize the costs associated with having to pay someone a high fee to manage those alternative investments, since you would have control of the IRA’s funds.
There are major pitfalls with using a SD-IRA. The first is that this is a fairly new concept, such that the law is not well settled, and there is significant risk of IRS audit even if you use it correctly. The second is that if you violate any of the IRA rules, such as by taking a salary from the LLC or engaging in any self-dealing, you can invalidate the entire IRA, making all of its assets taxable. The third is that even though you are using an IRA, some of the income can be taxable if it is considered unrelated business income. In short, the rules are complex and the consequences of not following them are significant.
As a result, Self Directed IRAs are not for the faint of heart. Your accountant and financial adviser should be on board with the process and the intended investments. You should be aware of the self-dealing and unrelated business income rules. Also, this is not the type of investment that you make with $10,000, or perhaps even $100,000, due to the high fees involved. Further, any money you transfer to a SD-IRA should be a small percentage of your portfolio, meaning that it is best suited for investors with significant assets.
Finally, you should not invest in a SD-IRA at the request of someone selling SD-IRAs to you. I’ve written before about adviser fraud, and how to avoid it. One of the best ways is to avoid salesmen and only deal with fiduciaries loyal to you.