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Depending on the investor’s risk profile, alternative assets can be good diversification tools in a self-directed IRA. Alternative assets can include real estate, precious metals, cryptocurrencies, and hedge funds, amongst other things. It’s vital for investors to research what alternative investments offer the best options depending on individual investment goals. In essence, there are several questions that investors must answer such as the price of the assets, its volatility, or its illiquidity, for instance.
In this article, 5 financial experts chime in on whether or not you should consider alternative assets in an IRA.
There Are A Number Of Questions Investors Must Ask Themselves
“The investment spectrum is quite broad for IRAs. Outside of collectibles, certain coins, and life insurance, IRAs can invest in a wide swath of assets. Public stocks and bonds make up the overwhelming majority of all IRA assets, but investors can choose to place alternative asset classes like real estate, private equity, start-ups, and cryptocurrency in the accounts. But should investors?
The first question to answer is “Why?” Why do you want or need to invest in an alternative asset class? Remember, assets are a tool to help you accomplish your financial goals, something ideally spelled out in a comprehensive financial plan. Make sure you understand why alternative asset classes may fit your situation before looking into the fundamentals of the opportunity and the mechanics of placing it into your IRA. Let’s discuss those latter two points a bit more. While the IRS allows investors to place alternative assets into their IRA (outside of the ones mentioned above), it’s not as easy as clicking the “buy” button like you do when purchasing a stock, mutual fund, or ETF. You will need to be an accredited investor for many of the alternative investment opportunities mentioned, which means you will need to have an individual income of $200,000/year ($300,000/year for married filing jointly) for the last two years, and have a net worth of at least $1millon (not including the value of your primary residence).
Additionally, the due diligence and paperwork requirements to invest alternative assets in your retirement account are considerable. Are you sure you understand that complicated derivative strategy? And what excessive financial leverage can do to the operating company the fund owns? Are you willing to invest your life savings on it? That raised another point – your allocation to alternatives, should you be willing and capable of investing in the asset class, should not dominate your overall portfolio risk. There is no “right” number but alternatives, as an asset class, should be less than 15-20% of your entire portfolio. It should be considerably lower for each individual opportunity.
Alternative assets also typically come with higher fees than public securities. How much upside, over the long-term, is being eroded by the annual fees imposed by the funds? Speaking of long-term, do you have the ability to stretch your investment time horizon to match that of the alternative investment you are considering? Many funds expect multi-year, or decade, payoffs and will commensurately lock up their investment capital to match this. This means you may not be able to liquidate if and when the need arises. Make sure you know when you will require the funds from your IRA before making an allocation to an illiquid asset like alternatives. This brings up another good point about time. As of today (this changes if the SECURE Act passes), IRA owners are required to start taking required minimum distributions (RMDs) at age 70.5. Just because your IRA invested in an asset that is not easily sold doesn’t exempt that amount from consideration of the full value of your IRA when computing your RMD. In an extreme example, if you reach 70.5 and all of your IRA funds are locked up in a private equity vehicle, you have a real problem with liquidity and the IRS.
Not all is negative, however. There are tax advantages to placing assets expected to rapidly appreciate into a tax-sheltered vehicle like an IRA. However, one eventually has to pay the tax piper in the form of ordinary income when RMDs start, assuming you aren’t doing Roth conversions or qualified charitable distributions from the account. And if that alternative asset goes to 0? You can’t write it off if it’s in a tax-deferred account.
The last two points of consideration are whether or not the alternative investment is best placed inside of an IRA or not, and some common pitfalls that can spoil the entire IRA with one bad alternative apple. Perhaps it’s better to use after-tax funds because some features and benefits of the investment are lost when placed in the IRA wrapper. For instance, investing in real estate offers the opportunity for depreciation, deductions, and the ability to take a loss. These don’t occur inside an IRA. Further, one must be very diligent of the rules when placing alternatives like real estate in an IRA. There are strict procedures to follow, or else the transaction will be a disqualifying transaction and may cause the entire IRA to become disqualified, i.e., fully taxable that year. That’s a very expensive mistake to make.”
Mike Hennessy, CFA, CFP®, Harbor Crest Wealth Advisors
Continually Monitor The Methodology And Performance Of Alts To Ensure They Are Sticking To Their Mandate
“As a practitioner who has allocated 10-20% in alternative investments for ALL my portfolio, I am certainly an advocate for incorporating alts into an IRA allocation. First, however, it is necessary to define exactly what is an alt. I do NOT include commodities or real estate in the alt category. Instead, I have four separate buckets that I use. The first three have low volatility – managed futures, long/short or hedged equity funds, absolute return funds. I also include GLD, the gold ETF even though it can be quite volatile. Unlike many in my industry, I allocate 5% to gold as a risk hedge. If we experience another financial crisis as occurred in 2008, gold may represent the ultimate hedge as it performs very well during crises. I have used managed futures for almost 15 years and while performance has been very unimpressive since the financial crisis, it proved its worth during the financial crisis when the fund I used GAINED 32%. Long/short and hedged equity funds can minimize the downside in a deteriorating stock market while absolute return funds seek small steady returns through a series of tactical moves such as investing in negatively correlated asset classes when one appears to be mispriced.
It is very important to continually monitor the methodology and performance of alts to ensure they are sticking to their mandate and generating the returns they seek. For example, most absolute return funds define their performance objective as a base rate (Fed funds discount rate, 10 year Treasury, etc.) plus a premium such as 5%. Of course, in any particular year, they may miss their mark and the reasons for under-performance need to be examined, understood and accepted in order to continue with the fund.
Alts have been a difficult conversation to have with clients since 2008 since it has been a risk on environment for equities and alts have been a drag on performance. However during the next bear market, they should, once again, prove to be of great benefit as they should limit the downside.”
Cliff Caplan, CFP(r), AIF(r), Neponset Valley Financial Partners
Everyone Should Have Alternative Assets In Their Overall Portfolio
“It depends on what kind of Alternative Assets you choose to hold in your IRA. With the availability of new alternative assets that are publicly traded and their added benefit of diversification, everyone should have alternative assets in their overall portfolio. The decision to hold it in your IRA or elsewhere depends entirely on taxes that these investments produce. Most alternative assets tend to be very tax-inefficient. A great example of this is Real Estate Investment Trusts. All the dividends they produce are taxed as ordinary income and do not get the lower tax rate of qualified dividends. To get the most out of these valuable yet tax-inefficient investments you should put them in your IRA. Other alternative assets are not as advantageous to hold in IRA’s. An easy example would be gold or silver funds, specifically those that don’t produce any dividends. For funds like that you are better off leaving them in taxable accounts. You also want to be careful putting any type of limited partnership funds or MLP’s, very common among energy funds, in your IRA. These types of funds produce a K-1 due to Unrelated Business Taxable Income. At the end of the year, you may get a nasty surprise when you realize you have to pay taxes on gains made in your IRA.”
Alex Caswell, Wealth Planner, RHS Financial
You Should Consider Alternative Assets In Your IRA
“In my opinion, you should consider alternative assets in your IRA. What offers a better cushion for your portfolio than having assets other than stocks, bonds and mutual funds! Historically the stock market has been going through the ups and downs. So, unless you’re very active when it comes to Wall Street trading and can foresee when significant market fluctuations may happen, you will be impacted no matter what. Hence having a well-diversified portfolio not only among various stock market products but also outside of it is essential.
However, before you start investing in the alternative assets, you need to take the time to educate yourself on the options out there to decide which alternative assets to invest in and when. Keep in mind there potentially could be tax consequences of investing in the alternatives. So always discuss it with your CPA. For example, a more known potential tax is called Unrelated Business Income Tax (UBIT).
UBIT applies when the following conditions are met:
· Income is derived from trade or business activity.
· Business activity is not substantially related to exempt status.
· Business is regularly carried on by organization.
UBIT may be triggered by either Unrelated Business Taxable Income (UBTI) or Unrelated Deft-Financed Income (UDFI). Hence, you must study the scenarios when these types of income may be incurred. Bottom line, you should study various alternative investment options prior to narrowing down your focus on one or more.”
Alina Trigub, Managing Partner, SAMO Financial
An IRA Is The Best Way To Go If You Want Exposure To Cryptocurrencies
“One type of alternative asset that certainly belongs in an IRA is cryptocurrencies. On January 1, 2017 Bitcoin traded at $963; today it’s trading at nearly 10 times that amount. It’s not surprising, then, that investors are paying attention to Bitcoin, Ethereum, XRP, and other digital currencies (“cryptocurrencies”).
In the U.S., the IRS has ruled that cryptocurrency is to be treated not as currency but as property for tax purposes, making it subject to tax rules that apply generally to property transactions — including capital gains tax. This ruling imposes extensive record-keeping requirements including tracking each purchase (tax basis), amount realized, tax lots, and gain or loss on each sale (not aggregate). The IRS is making tax enforcement of cryptocurrencies a high priority, and the penalties are steep, so transactions in taxable accounts should be undertaken only when the record-keeping burden is worthwhile. The rules provide a favorable tax environment for retirement account investors. When a retirement account generates income or gains from the purchase and sale of cryptocurrency, the retirement account does not pay any tax on the transaction. Any tax would be deferred to the future when the retirement account holder takes a distribution. In the case of a Roth IRA or Roth 401(k) plan, no tax would be due if the distribution is qualified.
If you want exposure to cryptocurrencies, an IRA is the best way to go.”
Robert Elwood, Chief Operating Officer and Partner, Practus LLP
Based upon the expert commentary, alternative assets seem to be a good option for investors wanting portfolio diversification. Yet, it’s important to be aware that the IRS does have precious metals IRA rules and regulations. Moreover, there are things to consider when adding Bitcoin or other cryptocurrencies for your IRA. If you are interested in including alternative assets in your IRA, factor in what these financial advisors have discussed, consult a financial professional, and always do your due diligence before investing your hard-earned money.