Can Retirement Capital Invest Beyond Stocks and Bonds?

For many investors, one of the largest pools of long-term capital they own is sitting inside retirement accounts. Yet many assume that retirement money has to remain invested in some combination of stocks, bonds, mutual funds and cash.

That is not necessarily true. Certain retirement structures can hold a considerably broader range of investments. But this is also an area where understanding the rules matters just as much as finding the investment.

The IRS does not maintain a simple “approved investment list”

IRAs are subject to restrictions, but federal tax law does not say that an IRA may hold only publicly traded securities. The IRS notes, for example, that IRA law does not prohibit owning real estate, although an IRA trustee or custodian may choose not to offer it because of the administrative burden. IRAs are prohibited from investing in life insurance and generally cannot invest in collectibles, subject to limited exceptions for certain qualifying precious metals.

This is where self-directed IRAs enter the conversation. A self-directed IRA is still an IRA. The difference is generally that its custodian permits a broader range of assets, potentially including real estate, private-placement securities, promissory notes and certain other alternative investments.

That flexibility can be useful. But flexibility also creates more responsibility for the investor.

A custodian holding an investment is not an endorsement of it

This point is extremely important. The SEC, FINRA and state securities regulators have specifically warned investors that self-directed IRA custodians generally do not evaluate the quality or legitimacy of an investment, verify the financial information provided by a promoter or provide investment advice about the asset. The custodian's job is primarily custody and administration.

“My custodian allows it” should never be interpreted as “my custodian has determined this is a good investment.”

The due diligence responsibility remains with the investor and their advisers.

Prohibited transactions can create serious consequences

This is where self-directed retirement investing becomes much more technical. An IRA owner cannot simply treat IRA assets as personal assets. The IRS prohibits certain transactions between a retirement account and what the tax code calls disqualified persons. Examples identified by the IRS include:

• borrowing money from the IRA;
• selling property to the IRA;
• using the IRA as security for a loan; or
• purchasing property through the IRA for the owner's personal use.

Certain family members and fiduciaries can also fall within the disqualified-person rules. The consequences of getting this wrong can be substantial. The IRS states that if an IRA owner or beneficiary engages in a prohibited transaction, the account can cease to be treated as an IRA as of the first day of that tax year, potentially creating a taxable distribution.

That is why structure needs to be reviewed before the transaction occurs.

Tax-deferred does not always mean no current tax

There is another issue sophisticated investors should understand: unrelated business taxable income, or UBTI. An IRA can potentially incur UBTI when it participates in certain operating businesses through partnerships or other applicable structures.

The IRS states that an IRA with $1,000 or more of unrelated trade or business gross income may have a Form 990-T filing requirement. Debt-financed investments can introduce additional tax considerations as well.

This does not mean those investments should never be held inside retirement accounts. It means the tax consequences need to be evaluated as part of the investment decision rather than discovered afterward.

Ask the structure questions before the return questions

Before using retirement capital for a private investment, I would want an investor and their advisers to work through questions such as:

• Is this asset permitted inside my specific type of retirement account?
• Will my custodian hold it?
• Does the transaction involve me or another disqualified person?
• Is leverage involved?
• Could the investment generate UBTI?
• How will the investment be valued?
• How will required distributions be handled when applicable?
• Is there enough liquidity elsewhere in the retirement account?
• What documentation will the custodian require?
• Who is reviewing the investment itself, separate from the custodian?

For more complicated transactions, this is an area where involving a knowledgeable CPA, attorney and qualified custodian before funds move can be far less expensive than correcting a structure later.

Retirement capital can have a broader investment universe

The larger lesson is not that everyone should move retirement assets into alternatives. Most investors probably shouldn't make dramatic changes simply because an investment happens to be available through a self-directed account.

The lesson is that the investment universe inside retirement planning can be broader than many people realize. Once an investor understands that, the conversation becomes much more interesting: What should remain liquid? What belongs in public markets? What, if anything, deserves a long-term private allocation? And which assets are most appropriate inside a tax-advantaged account versus a taxable account?

Those are much better questions than assuming retirement investing begins and ends with stocks and bonds.