Recently I have been hearing more and more people talk about Self-Directed IRAs. This idea has been spreading among entrepreneurs and investors all over the country in recent years.  More accountants and lawyers are starting to become aware of this phenomenon.  But what is it?  And how can it help you?

I first encountered the concept of Self-Directed IRAs in the early 2000s while studying real estate investing.  I learned that it is not only possible to invest retirement accounts in real estate, but it is 100% legal and commonly practiced.  You could also invest your retirement money in loans to your neighbor or a local business, or owning a franchise.  Some of you may have heard of this idea.  Some of you might be thinking, “What are you talking about? My broker said that I can only buy stocks, bonds, and mutual funds with my retirement money.”

This is NOT a new idea. It’s been available since 1974 when Congress passed the Employee Retirement Income Securities Act (“ERISA”).  Before that time, almost all large companies paid a pension to their loyal employees upon retirement.  Ever since then, it has been up to us to save for our retirement for the most part with an IRA or 401k.  When ERISA was passed as a new law, of course nobody knew about it so the Wall Street Investment Banks took it upon themselves to educate the public.  They spent lots of advertising money telling everybody that there was a way you could save on taxes by putting money into an IRA.  The catch is it has to be held by a bank or IRS approved Custodian.  The financial institutions act as custodians to hold our retirement funds and invest them in their business model—the financial markets.  However, it has always been legal to invest your retirement funds in other assets such as real estate, private businesses, private loans, and other investments with a potentially better, more predictable return than Stocks, Bonds, and Mutual Funds.  It’s just that the banks don’t make money when you invest in those things, so they don’t let you do it.

However, you are not allowed to invest your IRA funds in life insurance or collectibles, which include artwork, rugs, antiques, metals or coins (with exceptions—you can buy a certain approved gold, silver or other bullion), gems, stamps, and alcoholic beverages, among other prohibited items.  If you do invest in these items, the IRS will consider the amount invested in the prohibited investment as distributed to you in the year of the investment.  If you are under age 59.5 years old that year, you will likely be subject to a 10% early distribution penalty in addition to the income tax owed on the deemed distribution.

But the field of investment possibilities is wide open other than life insurance and collectibles.  I have seen first-hand success stories where clients have started with a $5,000 traditional or Roth IRA and grown it to $350,000 in 2 years; or even up to $5,000,000 within 6 years!  The most common investment I see is buying & selling real estate or making loans to people who buy & sell real estate.  However, you can take any skill you have or hobby that you’ve developed and leverage your knowledge to make money for your retirement accounts.  Some unusual investments people have made include:  Buying dairy cows and leasing or selling them to farmers; buying and selling trailer homes, cars, prize race horses or dressage show horses, and purebred dogs.

Another important pitfall to watch out for is the prohibited transaction rules.  In Part II of this article next month, I’ll discuss the prohibited transaction rules, how to steer clear of them, and give you specific examples of how you can best structure a self-directed retirement account and start making investments.