Depending on the profile of the investor, alternative assets can be a good diversifying strategy when incorporated into IRA allocation. Alternative investments can include things like real estate, precious metals, cryptocurrencies, and hedge funds, amongst others. Investors are advised to research alternative investment options prior to narrowing down the selection. It is also important to consider if the alternative asset is best placed inside an IRA, or not. There are both advantages and drawbacks to including these sorts of investments in a retirement vehicle like an IRA.
In this article, 5 financial professionals discuss whether or not you should consider alternative assets in an IRA.
Held In A Self-Directed IRA, Alternative Assets Can Provide A Tool For Portfolio
“Held in a self-directed IRA, alternative assets can provide a tool for portfolio diversification, a hedge against stock market risks, and to increase overall returns. Alternatives, such as real estate, agriculture assets, timberland, private equity, and interest in start-up companies, can be held in an IRA as a hedge against inflation and market volatility. Most alternatives are illiquid and uncorrelated, so during a rapidly correcting stock market they tend to hold their values.
Because of the tax benefits of an IRA, recognition of capital gains in these assets is deferred. Since IRAs are designed to be long term holding vehicles for retirement, investments that are structured to perform over the long term make sense. As an example, it can take decades for timberland to mature enough to produce outsized returns, but during the holding period, the asset held in an IRA will not obligate the investor to pay any taxes. A caveat for investors holding alternatives in their retirement tax is to understand if their investments are impacted by unrelated business income taxes (UBIT). The rules for UBIT can be complicated, so it is best to consult a CPA experienced in alternatives to help determine if the tax will be an issue and its potential impact to an investment’s performance.”
Chris Rawley, CEO, Harvest Returns
There Is No Universally Applicable Answer As To Whether Alternative Investments Should Be Held Inside An IRA
“I think the first decision to make is whether alternative investments are appropriate for the person and his or her financial and risk profile. At that stage of decision making, the account type which would hold the investment should not really come in to play. For example, alternative investments typically are not able to be easily sold, generally have less (if any) regulatory oversight or protection, often have minimal (if any) ongoing reporting or information disclosures, etc. Those risks are the same whether such positions are held in an IRA or other account types. Therefore, first determine that it would indeed be prudent to invest in alternatives before deciding which account type will hold the positions.
Assuming you determine the investment would, in fact, be in your best interest, then you should decide where to hold it. However, even with that said, the decision of IRA vs non-IRA is really more about taxability and less about the investment itself. This is because, regardless what is held inside it, an IRA is nothing more than a bucket that has certain income tax treatment (i.e. money inside of it was put there prior to paying income tax, and all money which comes out will then be taxed accordingly). So, if your overall tax profile and tax planning lean toward you being better off by owning investments on a tax-deferred basis as opposed to a currently taxable basis, then yes, it may be wise to hold the position inside a traditional IRA.
There are in fact some investment-specific tax-related considerations which can help guide the decision of whether to hold alternatives in an IRA. Generally speaking, investments which produce a lot of current distributions which would be taxed as ordinary income may be better in a tax-deferred account like an IRA. On the other hand, investments which do not produce a lot of ordinary income may potentially be better placed outside of the tax-deferral wrapper of an IRA. For example, investors in private equity funds often receive most of their returns in the form of long-term capital gains, which are taxed more favorably than ordinary income. Therefore, it may make sense to pay the lower capital gains taxes on such investments by holding them outside of an IRA than it would to house them inside an IRA and ultimately have to pay the higher ordinary income tax rates on all of the investment’s distributions.
Another factor to consider in deciding where to hold alternative investments is the ability to find an IRA custodian who will allow you to own such positions. The IRS allows IRAs to hold basically anything except collectibles or insurance. However, in practice, most custodians will limit IRA accounts to only holding traditional marketable investments such as stocks, bonds, mutual funds and exchange-traded funds. This is because there is often a lot of operational difficulties in properly handling alternative positions. Because of this, only some custodians offer the ability to hold alternatives. Those that do typically specialize in dealing with those investment types. Considering the limited availability of custodians and the increased amount of work they need to do to properly custody the positions, the fees involved in having such an IRA can be fairly high. This is another factor to consider when deciding where to own an alternative investment.
Also, perhaps a person’s only source of investable money is inside an IRA. In that case, the decision is basically already made – they kind of have to own the alternative investment (or ANY investment for that matter) inside of the IRA because they don’t have available funds outside of the IRA. It likely wouldn’t be wise to withdraw money out of the IRA – thereby triggering ordinary income tax and potentially an early distribution penalty – to get the money into a non-IRA account.
To sum up, there is no universally applicable answer as to whether alternative investments should be held inside an IRA. The decision ultimately is more dictated by taxation factors than it is factors unique to the investment-itself.”
Andy Panko, CFP®, RICP®, EA, Owner & Financial Planner, Tenon Financial LLC
I Encourage My Clients With Self-Directed IRAs To Consider Expanding On Their Investment List And Tap Into Alternative Investment Options
“I am an investment analyst and as much I respect the fact that we all have our risk tolerance levels, I strongly believe in the power of investments over savings. I am, therefore, always encouraging my clients with self-directed IRAs to consider expanding on their investment list and tap into alternative and non-conventional investment options like real estate, internet companies and stocks, as well as cryptocurrencies because:
1) They post higher returns: Alternative investments like real estate, precious metals, hedge funds, and cryptocurrencies tend to post higher yields than the conventional IRA investments. And from where I sit, most alternative investments will almost always outdo your conventional IRA basket.
They help expand your portfolio: Any investment analyst will always emphasize the importance of a diversified portfolio. Alternative investments present you with the perfect way to wisely scatter your funds into a basket of highly profitable investments.
2) There are experts to help you minimize risk: After interacting with numerous IRA savers, I realize that they all have something in common – they fear risk at varying levels. But I am always reminding them that there are numerous professionals willing and ready to help them understand and acquire these alternative investments.”
Edith Muthoni, Chief Editor, Learnbonds.com
There Are Several Questions That First Must Be Answered
“For some reason there seem to be certain must-have asset classes in portfolios. Similarly, there also tend to be taboo asset classes in portfolios. There is no asset class that is an absolute must and there is no asset class that is an absolute must not when it comes to investing.
Determining the appropriateness of an asset class in your investment portfolio (like determining the appropriateness for having anything in any area of your life) comes down to answering a few questions about your circumstances and goals:
How expensive is this asset? Do the reasonably assumed returns justify the expense? (Some alternative investments are crazy expensive and some are not)
Is there a cheaper, less volatile or more reliable asset class you can use instead?
What’s the goal of having this in your portfolio? (Every investment you own should fit clearly into your objective)
How do you handle volatility? Does this fit into your psychological tolerance? Can your portfolio financially sustain volatility?
What is the time horizon of your investment?
Is there illiquidity with this investment? Is that okay with you? Does that work inside your portfolio?
Do you understand the investment enough to be able to explain why you own it?
Is tax-management a focus? (For an IRA that answer is no, so there’s no need for a tax-managed investment)
There are other questions that you can ask yourself regarding your portfolio, but these are a good start. We personally have some allocations in alternative investments in both taxable accounts and IRA accounts. But they fit the criteria for the client mentioned above.
Ultimately, the investments you want to have in your portfolio are going to be those that will likely help you to reach your goals as effectively and efficiently as possible with a level of certainty/uncertainty that you’re comfortable with.”
Robert J Forrest, Financial Advisor, Jacobitz Wealth Management Group
You Need To Be Willing To Be Hands-On Because Self-Directed IRAs Can Take More Effort And Knowledge
“Rather than having all of their eggs in the stock market, many investors choose alternative assets as a way to diversify their retirement portfolio. Unknown to most investors, assets such as real estate, notes, private placements, private stock and precious metals can all be held in an IRA. The trick is finding a custodian that is willing to hold these investments.
The IRA industry is dominated by stock brokerages and banks. While they can do a satisfactory job, they also limit your investment choices to the investment offerings they sell. To invest in alternatives, you need a self-directed retirement plan custodian.
These custodians are growing in popularity. Fifteen years ago, of the approximately $3 Trillion in IRA accounts, roughly 1% was invested in alternatives. Currently, of the $8.8 Trillion in IRA accounts, 3% is invested in alternatives. The majority of IRA investments (74%) are invested in mutual funds. (source: Investment Company Institute IRA Owners Survey; Holden and Schrass (2018))
What are the downsides to investing in alternatives?
– Individuals who invest in alternatives have to be tactical with a laser-like focus. It requires you to research the investment opportunity and vet it. These are self-directed investments and are not typically chosen by investment managers.
– Time-constraints can be an issue for some people, especially for those working a regular 40-50 hour/week job. Some alternative assets have management obligations. Real estate, for example, has maintenance, which is often arranged for but cannot be performed by the IRA holder because IRS regulations prohibit this.
– There are rules and regulations that typically don’t apply to traditional investments. For instance, there are certain people that your IRA cannot transact with (disqualified parties). The IRS also forbids any personal benefit from the IRA owned asset. The asset must benefit the IRA and not the individual. It is important to know the rules because it is the IRA owner’s responsibility (not the custodians) to not engage in a prohibited transaction, which could jeopardize the tax-status of your plan and be subject to penalties.
– Valuations are required to be submitted annually to the custodian for proper IRS reporting. The custodian of your IRA is required to file form 5498 to the IRS annually on your behalf. The custodian often has very little knowledge about the investments in your account, and as such, requires that you submit a valuation with substantiating documentation at the end of each year.
– The risk of fraud is as prevalent in self-directed IRAs as the rest of the world of investing, and self-directed investors must conduct their own due diligence on any opportunity they seek to fund. Private investment offerings are not subject to the same reporting requirements that public offerings are. Therefore, a few bad apples can sometimes give the industry a black eye.
– The SEC even created an investor alert for individuals considering self-directed retirement plans.
Given all that, why would anyone want to invest in alternatives?
– Diversity of your portfolio. The stock market often goes through both upward and downward cycles. Putting some of your money in alternatives is often a strategy to minimize the effect of having all your eggs in one basket.
– Alternatives give individuals the ability to invest in what they know and understand. A real estate investor or agent, for example, often knows far less about the stock market than they do their own area’s real estate market.
– Angel investors can use their retirement funds to buy something that they believe in and have some personal knowledge of. Many bank start-ups, for example, are funded through the use of self-directed IRAs.
– Speaking of banks, do you like the idea of your IRA acting like a bank? Through a self-directed IRA, you can loan money on an unsecured or secured basis. Your IRA can actually hold a mortgage and received principal and interest payments. How well you secure yourself is up to you, but if you secure yourself well enough, there can be little to no risk on your investment. Many investors require larger down payments and will loan at higher interest rates because their borrowers may not have the assets or credit to get loans from traditional bank lenders.
The bottom line is that to invest in alternatives within your IRA, you need to be willing to be hands-on because self-directed IRAs can take more effort and knowledge. However, this is your retirement. Only you know your retirement goals and only you know how involved you want to be in your investments. Only you can decide whether you want to control your future goals.”
Brandon Hall, Chief Operating Officer, Midland Trust Company
Incorporating alternative assets into one’s portfolio can be a good diversification strategy, depending on the financial and risk profile of the individual. Based upon the expert commentary provided, that seems to be the general consensus.
There are both advantages and drawbacks to including alternative investments in a self-directed IRA. For American investors interested in including alternative assets in an IRA, have a look at our precious metals IRA reviews, or top Gold IRA companies for more information about the companies in this space and useful comparisons. Always do your due diligence, and consult a financial professional prior to making any investment decisions.