You might have heard the term self-directed IRA (individual
retirement account) before. In recent years, self-directed IRAs have become
more popular. In fact, in my work with a self-directed IRA custodian, they are
talked about so frequently now that some people believe these are a special
kind of IRA. In reality, “self-directed” is a descriptive term that describes
who makes the investment decisions inside the plan.
There are four types of IRAs: traditional, Roth, simplified
employee pension (SEP) and SIMPLE. Any of the four can be “self-directed.” You
can have a “self-directed” IRA at a large brokerage firm where you pick out
stocks, bonds or mutual funds. However, your accounts at a brokerage house
aren’t truly self-directed because brokerages generally limit investments to
the products they sell. A truly self-directed IRA custodian doesn’t sell
investments and therefore doesn’t put limitations on one’s investment decisions
— other than those imposed by the IRS. So, why don’t traditional brokerages
typically allow for self-direction?
Sources Of Revenue
Much of a brokerage’s revenue is tied to the investments it
sells. While commissions have gone by the wayside (for the most part) on
individual stock purchases, this is not the case in the qualified plan world
(meaning 401[k], 403[b] and 457 plans, etc.) where management fees exist and
can be considerable. Furthermore, many investments in the brokerage world have
management fees built into the investment itself (i.e., mutual funds).
Brokerages have no financial incentive to allow investors to buy alternative
investments, such as real estate, notes and private placements.
Administrative Burdens
Even if a brokerage decided it could price a fee on purchasing
an alternative asset, there are administrative burdens to consider. Brokerages
allow clients to buy their own assets with a click of a button. Facilitating
manual transactions requires more staff and time. As an example, a
self-directed custodian assisting a client with owning real estate in their IRA
has to deal with closing dates, wires, deeds, title insurance, rent, evictions
and property taxes. These are labor-intensive jobs requiring knowledgeable
staff. It isn’t an easy transition for large firms that specialize in more
straightforward transactions.
Fair Market Valuations
One responsibility every IRA custodian has is reporting the
end of year fair market value (FMV) to the IRS on Form 5498 on an annual basis.
This is easy for a brokerage, because its systems provide second-by-second
market values. But how would it value a private LLC investment located in Costa
Rica? That would be more difficult. Self-directed custodians have agreements
with their clients that require clients to provide substantiating documentation
of the investments held within their plan. This would require them to reach out
to clients for this information, which is another administrative burden.
Gathering this data and then the labor-intensive entry of this data is a lot of
work.
Differences In Business Models
So now you know why brokerages do not typically custody
“self-directed” alternative assets; let’s talk a little about the differences
in the business model of brokerages and self-directed custodians. In other
words, what are you paying for?
There are multiple ways a custodian can generate enough revenue
to run its business. Brokerages generate much of their revenue through
commissions, management and/or advisory fees, which help cover the cost of IRA
administrative services. Self-directed IRA custodians don’t sell investments or
act as a bank and make loans. They are not fiduciaries and do not provide
investment, legal or tax advice. Their only source of income is administrative
fees for the manual processing of investment transactions that occur inside
accounts.
The bottom line is every financial product comes at a cost.
The IRS requires that a third party administer all retirement plans. Unless
that third party has alternate ways to generate revenue on your IRA funds,
administrative fees are inevitable. You can assume you will be paying some of your
hard-earned money in either administration fees (self-directed IRAs) or
commissions/advisory fees (brokerages). Which option you choose ultimately
depends on your investment needs and goals.
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