What is a Self-Directed IRA? What are Alternative Assets?

The term Alternative IRA, which has been in the news so much recently, is frequently misunderstood. It is often thought to be an IRS designation that signifies an account type that is different from a traditional IRA or a Roth IRA, which are designated IRS account types. It is also not unusual for people to be under the impression that self directed means that the IRA owns an LLC which holds the IRA assets. Neither of these is the case.

“Alternative” as well as “Self Directed” are descriptive terms, not legal distinctions, and are used largely as marketing tools. (In fact, terms such as “Rollover IRA”, “Real Estate IRA”, and “Gold IRA” are also descriptive and used primarily for marketing.) The only consistent meaning that alternative IRA might have is that the assets held by the account include something other than stocks, bonds, mutual funds, etc. And the meaning of self directed IRA is basically that the IRA holder will have some choice in terms of what assets the account will hold. That may be a choice between two or three publicly traded stocks or bonds or funds, or it may be the ability to choose real estate, gold, private lending, investment in private companies, and more. IRA providers are not bound by the IRS to offer any particular suite of assets. It is incumbent upon the IRA holder to choose a provider that services the desired asset types.

The IRS, which governs IRAs, allows two basic tax arrangements for retirement accounts:

1) With a Traditional IRA, the IRA holder contributes money to the account “pre-tax”. While that money is in the account, it performs tax-deferred, meaning that the increase or decrease in its value does not have an effect on the IRA holder’s personal annual taxes. The only time that the IRA holder’s personal taxes are affected are when they make a contribution or take a distribution. A contribution will decrease the amount of earned income that the account holder declares for a tax year. And when a distribution is taken, the amount of the distribution is then added to the person’s annual income for that tax year and taxed accordingly.

2) In a Roth IRA, contributions by the IRA holder are “post-tax”; the investments in the account perform without tax consequence; and then can be distributed tax free to the IRA holder after the age of 59.5. These two basic arrangements, along with the associated rules for contributions and distributions, are the same for all IRAs, alternative or not, self-directed or not. For example, if a person opens a traditional IRA that is self-directed with a provider like New Direction IRA, which handles a wide array of alternative asset types, that account holder could have that IRA invested in a couple of rental houses and some gold bars. The rental income and appreciation of the real estate and the appreciation of the gold would constitute the performance of the assets. Regardless of what the assets were, the IRA holder could continue to make contributions per IRS regulations.

With any IRA, there are two dynamics occurring that affect the account’s balance. The first is the pattern of contributions and distributions. These are governed by IRS rules and the IRA holder’s strategy. The second is the performance of the money/assets that are in the IRA. This is governed by the economic factors associated with each particular asset. In other words, was it a profitable investment or not. The two dynamics are only related in that they are functions of the same account and are guided by the IRA holder. These dynamics are not affected by whether an IRA is self directed or not and whether the assets are publicly traded securities or alternative.

In the case of IRA terminology, it may be that marketing attempts to make the consumers’ options more understandable have back-fired and actually created less understanding. It can be helpful to remember 3 categories of terms:

1) IRS designations are account types (Traditional, Roth, or an employer plan). These account types have rules associated with them about taxation and contributions/distributions.

2) Asset terms are simply that, the type of asset in which the IRA is invested: real estate, gold, loans, stock (public or private), etc.

3) Descriptive terms are used to help lead the consumer to the service that they desire (i.e. an IRA that has gold or real estate or an IRA as a result from a 401(k) rollover) and do not affect tax status.

All of the current conversation regarding “Alternative” and “Self Directed” IRAs may seem confusing unless one is familiar with the terminology. Whether it is the success of Mitt Romney’s IRA or the Jean Chatzky report on the Today Show that is fueling interest in retirement investing, what is certain is that IRA account holders are becoming more and more aware of the choices that they have when it comes to their retirement funds.
 

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