Unconventional Investments in IRAs

As a result, people have been hungry for ideas on how to find better potential returns while still keeping the tax advantages of IRAs. And, naturally, lots of planners, advisers, brokers, accountants, attorneys and other folks have been moving to fill the gap.

Here’s how it works

The IRA was first defined by the Employee Retirement Income Security Act of 1974. The law set some strict limits on how much money you could earn and still take a tax deduction for IRA contributions. But the law didn’t place many limits on what you can invest in. In fact, the only limitations on what you can buy in an IRA are these:

• You can’t buy life insurance in an IRA
• You can’t buy art, jewelry or other collectibles.
• You can’t buy alcoholic beverages.
• You can only buy gold and other precious metals that meet certain standards for purity and standardization.

There are also some other rules against self-dealing or using your IRA for your own personal convenience or to enrich certain relatives or fiduciaries advising you on the plan. Other than that, you can own just about anything you can imagine in an IRA, including these popular asset classes:

• Real estate
• Raw land
• Farms and Ranches
• Small, closely-held businesses
• Private lending securities
• Private equity
• Tax deeds and tax liens
• Foreign investments, including real estate
• Commercial property
• Hard money lending and bridge loans
• Mortgages

Currently, only about 4 percent of all IRAs are used to invest in these kinds of assets, via a special arrangement called a “self-directed IRA.” Basically, you hire a third-party administrator to act as a trustee for you and hold your IRA assets on your behalf. Naturally, you pay them a fee to do so. You just identify what you want to invest in, and you provide your administrator with written, specific direction on what you want your IRA to buy or sell on your behalf.

Is it a good idea?

Well, that depends a lot on the individual situation. Allocating a portion of your IRA to these kinds of assets may make sense if you want to diversify your assets away from stocks, bonds and funds. Most of the assets in the categories above are not closely correlated with the major stock and bond indexes, such as the S&P 500. So they can possibly add quite a bit of diversification benefit, as part of a balanced portfolio.

They also may make sense if you have substantial professional expertise and access to a ready market in any of these arenas. If you have been investing in real estate all your life, and you are simply a much better real estate investor than you are at picking mutual funds, and you believe that leverage is your friend, it makes just as much sense to concentrate on real estate inside your IRA as it does outside your IRA.

Things to Be Aware Of

Once you get down to the brass tacks of execution, there are a lot of rules to be aware of. Running afoul of them could cause the IRS to disallow your IRA. This could result in immediate income tax liability and penalties if you don’t watch yourself.

Not every self-directed IRA planner has the same experience. There’s a lot of case law and private letter IRS rulings that affect how you must handle self-directed IRA transactions, and these are not common knowledge, even among many financial professionals. If you get some bad advice from them, it’s still you that will have to pay the price.

Liquidity is a huge issue with these kinds of accounts. Remember, you can only contribute $5,000 in new money to an IRA in any given year. Which means if you own a home in your IRA, but have little cash, and you need to buy a new roof for $30,000, you are in a tough spot. You can only add $5,000 in cash. You will have to borrow the rest.

You can borrow to fund your IRA investments – including purchasing assets, or maintaining them, as long as you don’t borrow from yourself or a related party (as defined by the IRS in Publication 590), and as long as the loan is a non-recourse loan. That means the loan must be secured entirely by the IRA itself.  In practice, you will only be able to borrow about 65 percent of the purchase price of any asset within an IRA. Your IRA will need to put up about 35 percent equity, so you can’t leverage up the same way you can when you buy residential property outside the IRA and cross collateralize.

Also, if you do borrow within your IRA, you will find that your tax-deferred growth isn’t completely tax deferred at all.  Your IRA will be assessed a special tax called an “unrelated debt income tax” or “unrelated business income tax.” This is just a tax assessed on any profits or income to the IRA attributable to non-IRA (i.e., borrowed) money.

The $5,000 window is a very tight one, unfortunately. You can, however, mitigate that by placing these assets in a self-directed SEP IRA account, with a maximum contribution of $49,000 per year or 25 percent of your compensation, (depending on your employment/self-employment status) or a self-directed 401(k) plan.)

If you use any tax-deferred vehicle, though, you also need to be mindful of required minimum distributions (RMD) later in life. You need to be able to start taking actual income out of the IRA by April 1 of the year after the year in which you turn 70½. So if you get caught with a big, indivisible and illiquid asset, such as a house, and not much cash, you could find yourself painted into an RMD corner.

If you are considering using a self-directed IRA, it’s certainly worth making an appointment and discussing it with us in more detail, in the context of your overall financial situation.

Index Funds … to Index? Or not to Index?

I’ll tell you flat out, I like index funds. I think they are an appropriate holding for nearly any investor who can tolerate a reasonable amount of risk. So let’s take… a closer look!

What’s an index?

An index is simply a selection of stocks, bonds or other securities that represent a given market. For example, the Standard and Poor’s 500 (S&P 500) is simply the 500 largest companies on the New York Stock Exchange, as measured by the total value of all their outstanding shares. And it’s a very good benchmark for measuring the success of large U.S. corporations. It’s weighted by market capitalization. So the largest company in the S&P 500 (currently Apple, with Exxon-Mobile close behind)

Similarly, the Wilshire 5000 is an index comprised of the 5000 largest companies on the NYSE. The Russell 2000 is a proxy for the fortunes of small cap stocks. There are indexes that measure the bond market, the treasury market, the real estate investment trust (REIT) market and the high-yield bond market. There are indexes for Europe, Asia and South America and just about every individual country in them. There are indexes for gold and precious metals, and for separate industries, like utilities, telecommunications. There’s an index that theoretically, if imperfectly, represents just about any asset class.

So what’s an index fund?

An index fund is simply a mutual fund (or exchange-traded fund) that tracks a given index. Meaning, they hold the same stocks or other securities in the fund that are in the index, and in the same proportion – almost always weighted by market capitalization.

Why index funds?

Well, to understand why people use index funds, it helps to understand a little bit about the theory of markets and investing. Index funds are based on a couple of postulates:

1. Markets are efficient. That is, the securities markets factor all known and knowable information about a security into the price of a security very quickly. News is “baked in” to the price of a stock before the news even becomes widely known.
2. It is therefore very difficult for individual investors to find bargains at any kind of advantage.
3. Money managers, in the aggregate, will tend to underperform their benchmark indexes by roughly the amount of their expenses.
4. You can increase your returns, therefore, by decreasing your expenses.
5. If you simply have a portfolio that replicates an unmanaged index, you don’t have to pay a professional money manager or a staff of overpaid research analysts to pick what securities to buy and sell.
6. Index funds tend to be more stable than actively managed funds – with fewer trades and lower turnover.
7. They therefore incur fewer internal trading costs, such as commissions to brokers and bid-ask spreads.
8. Because index funds have low trading activity compared to most actively managed funds, they also rack up fewer capital gains distributions. They are therefore more tax efficient than most similar actively-managed funds in the same categories.
9. The combination of lower management fees + lower trading expenses + higher tax efficiency is a compelling advantage, over time.

And so, led by a Princeton graduate named John C. “Jack” Bogle, who came up with the concept (though building on some other theoretical work by Harry Markowitz and Eugene Fama), a company called the Vanguard Group rolled out the first index funds.

Now you can buy index funds from just about any major mutual fund company with a fully diversified line-up, and you can buy ETFs via any brokerage company.

Does it work?

Yes. The concept works extremely well. Indeed, in 2011, 84 percent of actively-managed funds underperformed their benchmark indexes, according to a recently released study by Standard & Poor’s. That means that if you picked an actively managed fund to hold for the year, it only stood a 16 percent chance of being a good idea. After all, if your active manager can’t beat the index on a risk adjusted basis, over time, there’s absolutely no sense in paying the manager to do something you can do better on your own, by investing in index funds.

Does indexing always make sense?

No, not for everyone. Index funds are also risky – in that you can lose money in index funds, like with any mutual fund. Some people just cannot tolerate the prospect of losses at all. In these cases, you may be better off in risk free products, such as fixed annuities, GICs (guaranteed investment contracts), money markets, and CDs.
In other cases, an active manager may have a specific strategy that you cannot replicate in an index fund. For example, funds that specialize in arbitrage situations or turnaround situations.

In most cases, though, we do lean towards creating an index fund core to an investment portfolio, and building out from there, depending on the client’s individual situation and risk tolerance.

Small Cap Stocks are Rockin’ – But Steady the Course

The gains come on the heels of a huge move in October of 2011, when the Russell 2000 rocketed up 15 percent. Things bumped around in November and December, then took off again in January (+7 percent) and February (+2 percent), for a total change of 15 percent in the last six months.

Traditionally, small cap stocks have been extremely sensitive to economic cycles. They take the biggest bruising when the economy slows down – but they also tend to come back strong when the economy begins to recover.

Investors are beginning to notice: Net inflows to small-cap funds and ETFs were north of $1.8 billion in February.

Does that mean we’re backing up the truck to buy all the small-cap shares in the Russel 2000 index?

No. We don’t quite work that way. If anything, the opposite is true: If you bought a bunch of small cap stocks back at the beginning of October, when the Russell 2000 Index was taking a bruising, your portfolio may have been thrown out of whack by the rise in small cap stocks.

If the rally continues, it may be prudent to balance things out a bit. After all, economic cycles come and go. Just as the great Pete Seeger song “Turn, Turn, Turn” implies, there is a time for bulls and a time for bears, a time you may purchase small caps, and a time to gather bonds together.

We’re still pretty early in the economic recovery, so we’re not too concerned about small-caps taking it on the chin just yet. Although they’re not exactly cheap at current valuations (the average P/E is about 17) have room to run. But no one knows the future for certain. We don’t like our clients to make gambles they can’t afford to lose.

Strategy Trumps Tactics

Batters keep their eye on the ball; hitters keep their eyes on the game. Take a look at your portfolio as a whole. If you are willing to accept risk at all (and that’s not a given!), then you should probably maintain a healthy split between small caps and large cap stocks – as well as U.S. and overseas stocks. You should also maintain a healthy diversification across industries, as well.

What does that mean? It’s a little different for everyone.

The easiest way to do that for most people is to use index funds, or their close cousins, ETFs.

The execution: Keep things balanced. Investing is like flying a multi-engine airplane: You want to keep an eye on all the dials. You want to keep engine output as balanced as possible. When one engine begins to overheat, or is pulling too much of the load, it will begin to become inefficient – and at an elevated risk of a flame out. So you back off the throttle a bit, and distribute the workload among the remaining engines.

The same with investing: At some point, you’re going to want to back off of small-caps, or back off of gold and precious metals. You start with a target allocation, and when any one asset category takes up too much of your portfolio, back it off some.

In our view, the time is long past to back off long-term bonds, including long-term treasury bonds. Those yields have gotten miniscule, compared to the risk you incur when a long bond collides with a rise in interest rates. It’s not pretty.