For most financial advisers, many of their clients use a retirement account such as an IRA or a 401(k) as part of their investing and retirement savings strategy. These accounts are great for traditional investments such as stocks, bonds, mutual funds and ETFs.
For some retirement savers, investing in alternative assets inside of a retirement plan can make sense. This might be especially true as financial advisers and their clients look to diversify your client’s portfolios during this period of stock market turbulence. For those clients, advisers might consider a self-directed retirement account.
Low Correlations to Stocks and Bonds
Many alternative assets have relatively low correlations to traditional stocks and bonds. In these days of market volatility, these types of holdings can help diversify retirement investments and the overall portfolio. These include:
- Precious metals (subject to restrictions)
- Real estate, including rental properties
- Investments in start-ups
- Private equity
- Private debt
- Structured settlements
- Hedge funds
While there are mutual funds and ETFs that invest in these or related areas, often these formats do not provide the level of diversification that direct investment into these types of assets does.
What Is a Self-Directed Retirement Account?
A self-directed retirement account is a retirement account that allows investors to hold non-traditional assets. Conventional custodians often won’t allow alternatives to be held in either retirement or non-retirement accounts.
The list of alternatives above includes just some of the investments that clients might make inside of a self-directed retirement account. What is and isn’t allowed will vary a bit depending on the custodian used.
Self-directed IRAs are the most common, but some self-directed firms offer other types of options including a solo 401(k), a SEP-IRA or a SIMPLE IRA. Roth accounts are also generally available.
Why use a Self-Directed Retirement Account?
A self-directed retirement account can be an excellent tool for investors for several reasons. For many, their biggest source of investable assets may reside in retirement accounts like an IRA. Using a self-directed retirement account allows them to use some of these assets for direct investments in a retirement account.
Along these lines, using alternative and non-traditional assets in a retirement account allows clients to diversify their retirement investments away from solely traditional investments. This can be a good idea in all types of market environments, but especially during periods of volatility.
Non-traditional and alternative investments are often less liquid than traditional holdings like stocks, mutual funds and ETFs. Investing in these types of assets within a self-directed retirement account can tie into a longer time horizon, leaving assets held in taxable accounts invested in more liquid holdings like stocks, mutual funds and ETFs in case the money is needed.
There may also be tax issues connected with investing in some alternatives. For example, the tax issues surrounding cryptocurrencies are very complex. Holding these assets in a self-directed retirement account can alleviate dealing with these issues for investors. For those who use their self-directed accounts to make mortgage or other loans, the interest paid by the borrowers will be tax-deferred or tax-free in the case of a Roth account. Like any other investment held inside of a retirement account, holding alternatives in a self-directed retirement account allows them to grow until withdrawn in retirement.
Rules to Be Aware of
Investing in alternative assets inside of a self-directed retirement account offers many advantages but there are also a number of rules and restrictions to be aware of so as not to trigger unwanted tax consequences.
Prohibited transactions can include transactions with disqualified persons using funds from the self-directed retirement account. A disqualified person can be the account owner, their spouse, their children or an entity in which the account holder has a greater than 50% interest in.
There are a number of these to be aware of. One example might be selling property to your own retirement account or paying yourself unreasonable compensation for managing an asset owned by the retirement account such as a rental property.
When considering a self-directed retirement account for your clients, be sure to work with a self-directed firm and custodian who is experienced with these types of accounts and who knows the rules. While they won’t be able to provide tax advice, they should be able to provide guidance as to funding the client’s account and to the rules surrounding their use and what can be held in these accounts.