In the article IRA Assets And Alternative Investments, we provided an overview of the rules and regulations that apply to non-traditional investments. If this is an area that you want to delve into, ensuring that such investments do not run afoul of the rules is a good place to start. However, if you are considering investing your IRA funds in these assets, there are other factors that you must consider. In this article, we highlight some of the advantages and disadvantages of alternative investments.
The Drawbacks of Non-Traditional Investments for Retirement
Financial institutions that offer non-traditional investments are likely to ensure that their applicable policies and procedures are followed, but it is usually not practical for them to make a determination regarding whether an investment violates prohibited transaction rules. Doing so would require hiring attorneys and reviewing documentation regarding ownership, including determining whether any owners of the business in which the IRA assets are to be invested fall under any category of disqualified persons. This process might even require the financial institution to make additions to staff to handle the extra work. Therefore, the individual investor will usually be responsible for the expense of engaging the services of legal counsel. This can range from a few hundred to a few thousand dollars, depending on several factors, including the investor's location and attorney fees in that area, the size of the investment and the time spent by the attorney reviewing the related documentation. In situations where it is clear that there is no ownership by disqualified persons, legal expenses may be minimal, or even inapplicable. Also note that a financial institution that specializes in alternative investments may charge lower fees, as its resources are dedicated to handling the product.
The individual investor will usually be responsible for the expense of engaging the services of legal counsel. This can range from a few hundred to a few thousand dollars, depending on several factors, including the investor's location and attorney fees in that area, the size of the investment and the time spent by the attorney reviewing the related documentation. Also note that a financial institution that specializes in alternative investments may charge lower fees, as its resources are dedicated to handling the product.
In most cases, earnings on IRA assets are tax deferred, and for Roth IRAs, these earnings can be tax free if distributions are qualified. However, for alternative investments that produce unrelated business income (UBI) of $1,000 or more, the financial institution may be required to file IRS Form 990-T for the IRA and may be required to pay taxes on the UBI from the IRA to the Internal Revenue Service. This payment of taxes on the UBI does not require the IRA owner's approval. Examples of when UBI is usually generated include when businesses are owned by the IRA and when the IRA invests in a limited partnership.
Lack of Liquidity
Because alternative investments are usually not publicly traded, or they're of closely held corporations, liquidating the assets is usually a time consuming process that can take anywhere from a few days to a few months. This can create problems for the investor who needs to take cash from the assets for any reason, including satisfying required minimum distributions (RMD) amounts. (For further reading, see Avoiding RMD Pitfalls and Strategic Ways To Distribute Your RMD.)
The valuation process for these investments is usually not automated, and some investments are valued less frequently - even annually. Furthermore, the financial institution must wait until it receives the valuation from the responsible party in order to update and reflect the correct value of the asset in the IRA. This could mean that year-end valuation is not provided until the next year, which could cause RMD and other calculations that use the fair market value of the IRA to be incorrect. If an incorrect RMD calculation results in a shortfall of the RMD amount distributed, the IRA owner could owe the IRS an excess accumulation penalty of 50% of the shortfall. For substantially equal periodic payments (SEPPs), the delay could result in the IRA owner withdrawing the incorrect SEPP amount.
Investments Are Uninsured
Assets in IRAs are usually protected under the Federal Deposit Insurance Corporation (FDIC), but that is usually not the case for alternative assets. This means that the risk of loss is higher with these assets than with traditional assets. (For more on the FDIC, read Bank Failure: Will Your Assets Be Insured?)
Increased Asset Diversification
Investing IRA assets in these non-traditional investments allows for broader diversification, which helps to offset losses from other investments. (To learn more, see Introduction To Diversification, The Importance Of Diversification and Diversification Beyond Equities.)
Independence from Market Volatility
Usually, the performance of traditional investments moves with the stock market. But this is typically not the case with non-traditional investments; therefore, they can help to balance the overall performance of the IRA.
Potential for Higher Return
As with other investments, the rate of return on alternative forms of investment is not guaranteed. However, many financial professionals project that the rate of return for these investments is usually higher than that for traditional investments.
Investing in these non-traditional asset classes can be tempting for the investor who wants to diversify his or her portfolio. However, as the list above demonstrates, other factors need to be considered. For instance, will the rate of return be enough to offset expenses incurred from UBI taxes and administrative fees charged by the financial institution? Will additional legal expenses apply? You should also remember that, as with other types of investments, the higher the potential return, the higher the risk. And with any form of investment, suitability and risk tolerance must be key determining factors. The investor must engage in serious, in-depth discussions with his or her financial advisor for assistance in making such decisions.