There’s a way for investors to brave the world beyond stocks and bonds of a traditional Individual retirement arrangement (IRA) and venture into real estate, tax liens, unregistered securities and so on. Their avenue is called a self-directed IRA – but it’s not for the faint of heart, and it's easy to make mistakes.
A self-directed IRA is held by a trustee or custodian that permits investments in a wider range of assets than a traditional IRA custodian does. Traditional IRA funds are invested in stocks, CDs, mutual funds and bonds that the custodian’s firm approves.
But custodians of self-directed IRAs have limited responsibility to investors, and generally don’t evaluate investment quality. And few investors fully understand the complexities of these IRAs, says Marc Rosen, CPA, partner in Cameo Wealth and Creative Management in New York.
Take real estate, for example, because that’s what many investors are targeting. It’s challenging to get financing through an IRA. So if an investor figures the usual cash deposit, with bank financing the remainder, will get the deal done, think again: It’s far more likely that the investor will have to put 100 percent down out of the IRA, Rosen says. And that means the entire IRA is then invested in that particular property. The IRS will require annual reporting of the IRA’s value, so an investor will have to pay for an appraisal of the property to give to the IRS.
Self-directed IRAs also can and do leave investors vulnerable to problems ranging from a lack of disclosure by promoters and investments that are illiquid, to outright fraud and Ponzi schemes.
In fact, the SEC issued an investor alert in late 2011 about the risk of fraud in self-directed IRAs. Investors hold more than $90 billion in these IRAs. And while that’s only about 2 percent of the overall IRA market, fraudsters are drawn to these account holders because custodians likely haven’t scrutinized the promoter or promoter’s securities and because those securities can be unregistered, according to the SEC.
So how does the fraud happen? The promoters may tell investors that their custodians actually have approved the investment vehicle, when they haven’t. And self-directed IRAs carry tax penalties for early withdrawals just as traditional IRAs do. So investors may be more passive and less watchful of their holdings than in a managed account. Finally, unlike publicly traded stocks and bonds, financial information about the types of investments available to self-directed IRA holders may not be easily found—or hasn’t been audited.
Here’s an example:
Last year, the SEC charged John K. Marcum of Indiana with violations of federal securities law after he allegedly raised more than $6 million from 37 investors who rolled their existing IRAs into self-directed IRAs that he helped set up or by transferring their assets directly to brokerage accounts controlled by Marcum.
Fake account statements indicated that investors were earning more than 20 percent annually when Marcum actually was using the money to start up his own companies and pay for his personal lifestyle, according to the SEC’s complaint.
The scheme fell apart when investors began demanding distributions. Markum revealed he did not have the funds and devised a plan to solicit funds from new investors in order to pay back existing investors. And, he offered to name some of them as beneficiaries in life insurance policies, saying he would commit suicide if necessary to guarantee their repayment, according to the complaint.
According to court records, Markum did not defend himself in the case and a motion in late March for a default judgment is pending.
About Terry Sheridan
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.