Don’t Risk Your IRA on Greed

by Marc Bastow | November 5, 2012 1:45 pm

An excellent article[1]¬†written by Ohio State University Professor Steven M. Davidoff for The New York Times’ DealBook provides retirement investors with words of caution about using IRA funds on risky investments.

Davidoff cites a troubling pattern of retired or close-to-retiring people using money set aside in 401k and other retirement funds to speculate in precious metals, startup companies and franchise opportunities, among others.

The rub is that investors are led to believe rolling their IRA monies into these investments can help shelter those investments from taxes through legal (but not by much) machinations, with nothing but pots of gold available at the end of the rainbow.

In one instance, “investors” can start up a business, and in doing so adopt a 401k plan for that business. The investor’s existing 401k savings are then rolled into the “new” 401k plan and — just like that — the money is sheltered, as an investment in the startup. However, Davidoff cites an Internal Revenue Service study showing that this type of plan — termed a Rollovers as Business Start-Up Plan, or ROBS (what’s a government study without an acronym?) — led to investors losing all their money since most of the startups went bankrupt.

Again, those were people’s retirements going down the toilet.

Perhaps the most abused retirement savings mistake is through the self-directed version of the IRA, in which funds ($94 billion worth in 2011, according to the Investment Company Institute) are put in play for what is in some cases simply speculation, and in others, creative ways to try to generate tax-free income.

First a quick word on the self-directed IRA: The IRS requires that a trustee or custodian like a bank or trust company hold all the self-directed IRA assets on behalf of the account owner, which is easily accomplished by opening an account with bank holding companies such as Wells Fargo (NYSE:WFC[2]) or Morgan Stanley (NYSE:MS[3]), brokerage firms including T. Rowe Price (NASDAQ:TROW[4]), or mutual fund groups like Vanguard.

The investment adviser maintains a fiduciary responsibility on your behalf, and IRS rules provide a guideline for what assets/investments are considered permissible inside the IRA, but in essence, you can drive your own investments. Of course, these advisers are paid to steer you toward certain investments, but it is your money … so think about how you want to deploy it over time.

Do you really want to bet the farm on gold or silver futures? What about real estate, such as historic property? The good news: If these investments pan out for you in a big way, you win because the gains are not taxed. The bad news: If they fail, so do you.

One last note of caution from Davidoff: Protect yourself from straight-up fraud. Self-directed IRAs are offered online through a number of companies, and the vast majority are legitimate. But do your research: All it takes is one big transfer to a company that tries to sell you a completely out-of-your league investment (say, collateralized mortgage obligations), and you can lose that money. Worse yet, according to Davidoff, these IRAs have become a target of Ponzi schemes — and we know how that works out for most of the bricks in the pyramid.

Let’s be clear: IRAs are a tremendous investment vehicle, and every retiree should plan on using them throughout their working (and post-working) lives. Just be careful with that money, don’t put it all in one basket, and make sure you know exactly what you’re investing in.

Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing, he did not hold a position in any of the aforementioned securities.

Endnotes:
  1. excellent article: http://dealbook.nytimes.com/2012/10/30/the-risks-of-tapping-a-retirement-fund-for-an-alternative-use/
  2. WFC: http://studio-5.financialcontent.com/investplace/quote?Symbol=WF
  3. MS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MS
  4. TROW: http://studio-5.financialcontent.com/investplace/quote?Symbol=TROW

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