Should You Invest Your I.R.A. in Friends, Family or Charitable Work?
By Abby Ellin
About five years ago, a good friend of William C. Brown, a tax lawyer in Des Moines, lost his job. The friend’s wife ran a child-care center in a building she owned — but because of their financial difficulties, the couple fell behind on their mortgage payments.
Their bank threatened to foreclose.
Despondent, the couple went to Mr. Brown for assistance. Mr. Brown, who is now 63, decided that the best way to help them would be to buy the child-care center and then rent the property to them on a long-term lease, with an option for them to buy it back. So he did.
Here’s the kicker: Mr. Brown used funds from his self-directed I.R.A., which allows investments in “alternative assets” and not just traditional stocks, bonds and mutual funds. Self-directed individual retirement accounts offer the same tax benefits as government-sponsored retirement plans — that is, deferred tax payments until retirement on gains from traditional I.R.As, and no taxes on any profits from Roth I.R.A.s.
Investments can be made on everything from real estate and precious metals to racehorses, airplanes, musical instruments and Broadway shows. Or, as in the case of Mr. Brown and many others like him, they can have a philanthropic leaning, with the idea of “doing well” while also “doing good.”
“We’re hearing that our clients are excited to be making a difference in a local community in a way that they didn’t know was possible,” said Matt Wilson, the chief executive officer of Equity Trust Company, a custodian of self-directed I.R.A.s in Westlake, Ohio.
One Equity Trust client used his I.R.A. funds to issue a promissory note, so his friend could acquire a property to start a group home for veterans suffering from post-traumatic stress. Another provided capital for small businesses seeking to expand. A third helped medical offices purchase X-ray and imaging equipment. “It’s also inspiring other people to find a mission to diversify or expand their retirement portfolio but also giving back,” Mr. Wilson said.
Many people aren’t aware of self-directed I.R.A.s, although they have been around since 1974, when the I.R.A. was established. Statistics are hard to come by, but of the $8.35 trillion dollars in I.R.A. funds invested in the United States, only about 3 percent to 5 percent are self-directed, according to the Retirement Industry Trust Association, a self-directed I.R.A. industry trade group.
“Most people know that they can make charitable contributions via their distribution,” said Curtis Glovier, chairman and chief executive of Pensco Trust Company, an alternative asset custodian in San Francisco that specializes in self-directed I.R.A.s. “We’d like to get the word out that you don’t need to just invest in plain vanilla mutual funds.”
Howard Teich, a psychologist in private practice in San Francisco, got the memo. Eighteen months ago, Dr. Teich, 76, invested his self-directed I.R.A. in Geostellar, which markets solar systems online. “It’s the future,” he said. “To be able to invest in something healthy that you’re passionate about, like alternative energies — it doesn’t get any better. I’m taking a risk like any entrepreneur, but this is one way to take some action.”
A large part of the attraction to a self-directed I.R.A. is that the investor is in control. This is also the challenge.
Clearly, this kind of investing is not for everyone. No investment is a sure thing, but investing precious retirement money in neighborhood businesses, or a pal’s peanut farms, comes with risks far beyond the usual volatility in the stock market. You could lose it all — and lose a friend in the process.
In September 2011, the Securities and Exchange Commission issued a fraud alert on self-directed I.R.A.s. Among the commission’s concerns: it is easy to exploit self-directed I.R.A.s. Since the investments aren’t publicly traded, it can be harder to get the information needed to make smart investing decisions, raising the chances of fraud.
“Every investment has different risks,” said Kirk Chisholm, a wealth manager in Lexington, Mass. “The obvious risk is making a bad investment,” he said. After all, that’s the whole point of investing for retirement — to build a nest egg. “If you’re doing it just to help someone out, that’s not a good investment. You want to make sure it makes your retirement money grow, or why invest at all?”
He also suggests people invest in areas in which they have some expertise rather than operating blindly, even if they have the desire to do something good for another person or the community.
“You can be well intentioned and still be misguided,” said Nevin Adams, chief content officer at the American Retirement Association, a nonprofit member organization in Arlington, Va. “But the reality is, this is your I.R.A.; the reason it has protections is because it’s something you are investing for retirement. It might be a good cause, but it might not be good for your retirement.”
Mr. Brown — the man who invested in his friend’s child-care building — has a big advantage in this dangerous game: Because he is a tax lawyer by profession he is well aware of the potential risks and how to avoid them.
In his case, he structured a lease and option to buy back that would provide him with a fixed 10 percent annual return, regardless of how long he owned the real estate and when his friends exercised the option. He is aware that commercial real estate investors normally expect a greater return (rent plus appreciation), he said. But “I didn’t feel right doing it in the manner most real estate investors would do it, in light of my relationship with this friend.”
“The option was structured at a price equal to my purchase price, with a portion of their rent payments being credited against the purchase price if and when they exercised the option,” he said. That structure gave his friends an incentive to exercise the option as soon as they could, while still giving Mr. Brown the 10 percent annual return he was seeking.
“It also worked so that I did not feel I was gouging them, while still protecting my retirement-plan assets,” Mr. Brown said.
To read this story on the New York Times website, click here.