Watch Out for This IRA Trap
If you want to retire rich, then one of the best tools you have at your disposal is your IRA. The tax benefits that the tax-favored retirement accounts offer can give you a big leg up in building a nest egg for your golden years.
But with millions of middle-aged savers scrambling to catch up with their retirement savings, there's a big temptation to go for the big score by looking beyond traditional investments for IRAs. A special kind of retirement account known as a self-directed IRA can legitimately allow you to go beyond stocks and other mainstream investments, but the SEC recently warned investors that self-directed IRAs often end up tied to fraudulent investment schemes.
Why taking charge can be smart
The first thing you have to understand is that the term "self-directed" is misleading. One of the main advantages that all IRAs have over employer-sponsored retirement plans like 401(k)s is that there are very few limits on what investments you can make in an IRA. Moreover, with an IRA, you always have the ability to direct how you want your money invested -- and you typically have the ability to change your mind at will and shift your money into a different investment without penalty.
But most financial institutions prefer to draw the line well short of what can legally go into an IRA. While stocks, bonds, ETFs, and mutual funds may be among the easiest investment vehicles to put into an IRA, they're definitely not the only ones. If you follow IRS rules to the letter, you can often put a wide range of other assets into IRAs, including real estate, ownership stakes of privately held businesses, and precious metals.
During the financial crisis, self-directed IRAs gained substantially in popularity. With mainstream investments almost across the board losing immense chunks of their value, the idea of alternative investments that would hold more of their value had huge appeal. As the stock market once again starts to get choppy, interest in self-directed IRAs has remained high, with nearly $100 billion invested in the retirement vehicles according to the SEC.
The problem with self-directed IRAs, however, is that you're often on your own to figure out whether an investment is on the up-and-up. Unlike regular stocks and funds, private investments often don't require SEC-regulated disclosure. Moreover, as TheWall Street Journal reported over the weekend, some unscrupulous sellers of investments for self-directed IRAs take advantage of a false sense of legitimacy that the IRA wrapper lends.
Furthermore, exchange-traded funds now give investors many more investing choices than they used to have. For instance, for precious-metals investing, ETFs ranging from the traditional SPDR Gold (NYS: GLD) to the leveraged ProShares UltraShort Silver (NYS: ZSL) are perfectly permissible investments for regular IRAs at traditional brokers. Similarly, mortgage REITs like Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) share many attributes with the privately offered mortgage notes that became popular self-directed IRA investments during the housing boom.
The net result is that you may not truly need a self-directed IRA to accomplish what you want. And with extra hoops and sometimes higher fees associated with self-directed IRAs, if you can get by without one, your life will probably be a lot easier.
What you should do
At the same time, though, there are situations in which a self-directed IRA makes sense. For instance, with real estate investments, unique characteristics of a particular piece of property can make it impossible to use a more generalized investment like Health Care REIT (NYS: HCN) or Weyerhaeuser (NYS: WY) and expect anything close to the same return. The same goes for business opportunities; for instance, the return from a coffee franchise may look nothing like what shares of Green Mountain Coffee Roasters (NAS: GMCR) will do in the coming years.
The key is to know that self-directed IRAs require more effort on your part. If you're willing to take on the extra due diligence, though, you may well be very happy with the nearly limitless flexibility that self-directed IRAs give you.
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At the time this article was published Fool contributor Dan Caplinger knows greed can be a big trap. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Health Care REIT and Green Mountain Coffee Roasters as well as creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy helps you steer clear of traps of all sizes.