At least half a million retirement accounts – worth $50 billion – hold unconventional assets including real estate, private equity and hedge funds, according to a new GAO report aiming to quantify the prevalence of these accounts and determine what risks account owners face. Other investments include energy investments, equipment leasing, foreign exchange currency, farming interests, precious metals, promissory notes, church bonds, tax liens, private placements — even Bitcoin. So much for index funds.
Retirement savers choosing these unconventional assets in self-directed individual retirement accounts and solo 401(k)s face big risks and need hand holding, according to a new GAO report, Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets.
“Some view the self-directed IRA world as the wild west,” says Ryan Carey, a staffer for Sen. Ron Wyden (D-OR) who called for the report as a sequel to a 2014 GAO report that dropped the bombshell that 314 taxpayers have IRAs averaging $258 million each. Investing in unconventional assets can supercharge your retirement kitty—especially if it’s a Roth account where all growth is tax-free–but at the same time, the strategy can doom it.
The danger for individual investors is that investing in unconventional assets may jeopardize the accounts’ tax-favored status, placing their retirement security at risk. Tricky tax rules regarding prohibited transactions, unrelated business income tax and valuation issues all trip up investors. The punishment for “prohibited transactions” is brutal: Your entire IRA is disqualified, and its assets are considered distributed and taxable as of Jan. 1 of the year of the forbidden transaction.
In its latest report, the GAO got data from 17 custodians of self-directed IRAs and solo 401(k)s, interviewed experts like Warren Baker, a tax lawyer who has built a practice around advising owners of these accounts (see IRAs Gone Wild), and reviewed hundreds of investor complaints filed with federal agencies and watchdog organizations.
Account owners (that is the individual taxpayers) who invest in unconventional assets are responsible for account management and compliance—and they bear the consequences of any mistakes. It’s the account owner who has to determine the appropriateness of an asset, review for potential prohibited transactions, and arrange for the purchase. Ongoing duties include monitoring the account for possible unrelated business income tax liability, preparing Form 990-T to report taxes, directing the custodian to disburse funds to pay tax liability, providing the custodian with an annual fair market value update for all hard to value assets in the account, and determining the amount of any required minimum distributions.
A lot can go wrong. The difficulty in verifying fair market value can expose account owners to fraud and allow losses to remain undetected for some time, the report says. (The SEC issued an investor alert on self-directed IRAs and the risk of fraud back in 2011.) Some account owners mistakenly expect the custodian to provide due diligence, monitor investments, or compensate them for investment losses, the report says. In one case, an account owner lost contact with the company in which he had invested $46,000 in private stock. Unable to retrieve his investment from the company, he expected the custodian return the full amount of the investment. In another case, an account owner expressed concern when the company from which he purchased private stock stopped providing updated valuations, and he thought the custodian could transfer his original investment amount back to his previous custodian.
Investors also face distribution problems. In several cases cited, a custodian initiates the in-kind distribution of the asset to the account owner for failure to pay account fees or failure to provide the custodian with the fair market value of the asset. The custodian uses the last known fair market value, triggering tax liability for a worthless asset. One case involved a $140,000 private stock investment; another case a $25,000 real estate investment.
There are also challenges with liquidating assets when you need retirement income—or have to take mandated required distributions once you reach 70 1/2. In one complaint a widow tried unsuccessfully to obtain income from her late husband’s account, but the investment sponsor said it was illiquid. Another potential trap: you may have to accept in-kind distributions of unconventional assets rather than cash as your RMDs but you’ll still owe income taxes on the distributions.
The IRS says it agrees with the GAO’s recommendations to improve guidance for retirement account owners with unconventional assets. It says it will add updates to Publication 590-A on IRAs, cautioning IRA owners about the possibility of unrelated business taxable income. In addition, the IRS will recommend that the Treasury include guidance to IRA owners and custodians on valuation issues as part of IRA guidance currently on the 2016-2017 priority guidance plan. And the IRS will modify its model custodial agreement for self-directed IRAs to make it clear that only certain articles have been pre-approved by the IRS.
Separately, the IRS is also ramping up its current information collecting efforts on unconventional assets in IRAs. Starting this past season (for tax year 2015), the IRS makes IRA custodians report whether IRAs own non-publicly traded assets on new boxes on Form 5498, an annual form filed with the IRS. That’s in addition to reporting the value of the IRA. So there’s an easy way for the IRS to target high value IRAs with non-publicly traded assets and look for overvaluation or self-dealing issues. There are also new boxes on Form 1099-R, so the IRS can track IRA distributions and theoretically check whether IRA owners are underreporting taxes by undervaluing the distribution amount.
In 2015, the IRS added an explicit caution to IRA owners in Publications 590-A and 590-B about the heightened risk of engaging in a prohibited transaction—but it hasn’t compiled data yet to help provide targeted outreach to those holding nonconventional assets. The IRS did say it could refine its outreach to using the new asset type data once compiled electronically, the GAO report says.
There are likely many more than the 500,000 accounts identified in the report as trust companies and other financial services providers accommodate high-net-worth clients who wish to invest in unconventional assets. Also, some individuals with solo 401(k)s act as trustee and don’t use a custodian, so these accounts aren’t reflected in the data. Also not included are employer-sponsored plans that use IRAs such as Saving Incentive Match Plans for Employees or a Simplified Employee Pension, which may also allow account owners to invest in unconventional assets.
The GAO report notes that solo 401(k)s are generally not required to report their investment holdings; they’re required to report only total plan assets, and aren’t required to identify or report separately on investment in unconventional assets. And if the solo 401(k) assets are less than $250,000, there is no reporting requirement.
This article shows that while alternate investing is valuable strategy, it’s best to have a trusted person handling your money. Please contact one of the IRA Experts at the IRA Financial Group for more info!