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Innovation: Using Your IRA to Play Venture Capitalist

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12-21-2007

Wednesday, Dec. 12 2007

New York -- John Cicero wanted to lend his friend $100,000 to open up an All State Insurance Agency but didn’t have the cash readily available.

So the financial consultant was surprised to learn that he could do it simply by tapping his individual retirement account or IRA to make the investment.

“I’m part of the 90% of people out there that didn’t realize they can invest in other things," than stocks and bonds with an IRA, said Cicero. “I’m a financial consultant and never knew you can invest in real estate and loans.”

Called a self-directed IRA, this form of investing has been around for more than two decades but hasn’t been widely used by investors. That’s largely because the big investment companies, the custodians of IRAs, are in the business of selling, stocks, bonds and mutual funds. But there are other, more innovative options.

“Investing directly by buying real estate or giving a loan is very labor intensive for the custodian of an IRA,” said Jaime Raskulinecz, chief executive and principal of Entrust Northeast. Entrust was founded in 1981 and is a pioneer in self-directed IRAs. The firm has 30 independently owned and operated branches throughout the country. “Traditional brokerage houses and custodians that hold IRA accounts allow only the usual type of investments —stocks, bonds and mutual funds,” she said.

According to Raskulinecz, there’s anywhere from $4 trillion to $6 trillion being held in IRAs at any given time, but only 1% to 2% of that is in self-directed IRAs. “It’s still a tiny segment of the market but is growing annually as the word gets out,” she said, noting that Entrust holds seminars where they even school certified public accountants and financial planners on self-directed IRAs.

With a self-directed IRA, investors can invest in anything from real estate, to a start-up business to even a personal loan or mortgage. Investors can also invest in a hedge fund, traditionally a no-no with the main brokerage houses, said Raskulinecz.  Firms like Entrust act as the custodian of the investments, with the IRA, not the person making the investment.

Once the person reaches 59-and-a-half years old the self-directed IRA gets treated as a standard IRA, enjoying all the tax benefits as if it was always invested in stocks and bonds.

For Cicero, who invested in the All State business about two years ago, the whole process has been painless.

“It’s been great,” said Cicero of the self-directed IRA investment. “The payment is made directly to Entrust for the benefit of me and it goes back into the IRA account with interest.”

While it may seem an easy way to diversify, experts caution self-directed IRAs are not for everyone. After all, many times people look for alternative investments when their dissatisfied with the current holdings, which in many cases is a decision heavily laden with emotions.

“We generally discourage it because people are attracted to it for all the wrong reasons,’’ said Ray Benton, a certified financial planner out of Denver, Colo.  Investors are usually “driven by dissatisfaction with what they got and without recognizing the real reasons they are dissatisfied which usually means their not well diversified.”

Not to mention that an investor could lose all the tax benefits if the non traditional investment runs afoul of the rules.

According to Robert Brokamp, editor of Motley Fool’s Rule Your Retirement newsletter, the rules governing self-directed IRAs are much more complicated and if the custodian doesn’t keep a close eye on it, it could mean you would get stuck paying taxes on the investments. He advises investors with a lot of money in an IRA to split up the self-directed portion so that if there is a problem not all of the IRA takes a hit.

With IRA’s on average holding about $25,000 in an individual account, Brokamp said the non-traditional investments do become limited.

“If you really want to invest in something significant, the average IRA does not have enough money,’’ said Brokamp, noting that there are smaller investments out there that entrepreneuring IRA investors could find.

“I don’t think it’s a bad idea for a minority of people,’’ he said.