By Benjamin Stubbs, Spring 2014 Student Intern
Self-directed IRAs came in fifth on NASAA’s list of most common investment frauds of 2013. For some help conceptualizing today’s tip, think about your next meal. First picture going to a restaurant to order from a prix fixe menu. You can choose anything you want from the list, but the list is short and was chosen for you by the chef. Though it’s limited, the risks that the restaurant will be out of those items or that the chef won’t know how to prepare them are slim.
Now picture yourself at the grocery store shopping for your next meal. The options for what food you put in your cart are virtually limitless, and you get to choose. Generally, you have a lot more freedom eating out of your own kitchen than ordering from a prix fixe menu, but there are risks to buying and cooking your own meals. You may buy some bad fruit, you may let some cheese spoil or you may misread a recipe and ruin the whole dish.
Both the prix fixe menu and the grocery store enable you to decide what ends up on your plate, but the grocery store scenario requires much more planning, attention and effort on your part. Though things can go wrong in each scenario and chefs make mistakes, generally, there is more risk that something won’t end up quite right when you do it yourself.
What is an IRA, and what is a self-directed IRA?
As a start, consider Individual Retirement Accounts (IRAs) generally. FINRA defines IRAs as “investment accounts that provide the incentive of tax deferred or tax-free earnings on assets in the account.” There are two main types of IRAs—traditional and self-directed—and the difference between the two lies in what the custodian of the account allows. As the Securities Exchange Commission (SEC) explains, in all IRAs, the funds an individual invests are held by a trustee or custodian.
Traditional IRAs are like a prix fixe menu. For traditional IRAs, the custodian is usually a bank or broker-dealer that limits the types of investments available for the account to “firm-approved stocks, bonds, mutual funds and CDs.” Like the prix fixe menu, the menu is limited, but its items have been approved by the chef.
Self-directed IRAs are more like the grocery store. According to the SEC, self-directed IRAs are “held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians.” Rather than limiting your options to the firm-approved prix fixe menu of investments, custodians of self-directed IRAs “may allow investors to invest . . . in other types of assets such as real estate, promissory notes, tax lien certificates, and private placement securities” and alternative investments. Though self-directed IRAs offer more options, they also offer more and unique risks. You should consider those risks carefully before putting money in a self-directed IRA.
What are some of the risks?
The SEC reports generally that the risks of self-directed IRAs “can include a lack of disclosure and liquidity—as well as the risk of fraud.” This means that there may not be much information available about some of the products and that you may not be able to sell some of the products after you buy them. The three specific risks listed by the SEC are: (1) misrepresentations regarding custodial responsibilities; (2) exploitation of tax-deferred account characteristics and (3) lack of information for alternative investments.
According to NASAA, though scammers may tell you otherwise, custodians of self-directed IRAs “generally do not evaluate the quality, value or legitimacy of any investment.” To run with our menu analogy, this means that often, unlike the prix fixe menu, no cook—broker or bank—has approved the items that are offered through self-directed IRAs, and they may be too risky for you, or worse fraudulent. This means that if you decide that a self-directed IRA is right for you, you have to do the research to make sure the products are legitimate and appropriate for you—something like making sure the fruit you get from the store isn’t bruised or rotten.
How can you protect yourself?
To protect yourself, the SEC recommends a few things. Verify the information in self-directed IRA account statements. In other words, be skeptical because the person posing as a chef may not be a chef and may be misleading you. Also, avoid unsolicited investment offers, regardless of who they’re from. Always ask yourself why that person is telling you about the opportunity.
Like we’ve said many times before on our blog, ask questions. Always ask if the person offering the investment is licensed and registered, and confirm his or her answer by conducting a BrokerCheck on that person. The SEC has a brochure to help know which questions you should ask. Further, like I said a couple of weeks ago, don’t believe impossible things, because all investments involve risk. So if anyone tells you that returns are guaranteed, don’t listen. Lastly, ask a professional for help if you’re uncomfortable or unsure about something. It never hurts to get a second opinion.
What if you think you may have already been scammed?
If you think you may have been scammed by someone who sold you a self-directed IRA, gives us a call. You can find our information here. If you’re considering opening a self-directed IRA, but are uncomfortable about it, don’t rush into anything, even if someone is urging you to act now. Make sure you protect yourself by following the SEC’s advice above. Be sure to check back in next week for another tip on how to protect yourself from fraud.