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Your Money
Instead, Mr. Harris, a music teacher from Tucson, owns about 25 marimbas, xylophones and timpani. Using the money in his retirement account, Mr. Harris buys the instruments for less than $1,000 each. He then rents them to his students for up to $60 a month. The rental income flows straight back into the I.R.A.
“It’s a good way for me to have income without paying tax on it,” said Mr. Harris, 38, who played with the Tucson Symphony Orchestra for 12 years before turning to full-time teaching seven years ago.
It may be surprising, but it is true: No law dictates that retirement plans be invested in stocks, bonds and mutual funds. In fact, the government allows investors to put the money in their I.R.A.’s and Roth I.R.A.’s into almost anything, be it condominiums or airplanes. A growing number of Americans are doing just that, through so-called self-directed I.R.A.’s that steer clear of mainstream investments.
There are no official numbers on how much of the country’s $4.2 trillion in I.R.A. funds is invested in nontraditional assets, but four of the largest custodians of self-directed I.R.A.’s — Fiserv, Sterling Trust, Equity Trust and Entrust Administration — together manage about $15 billion in such accounts. They say the volume has soared in the last five years.
Growth is driven by two factors, said Jeff Desich, vice president of Equity Trust. Americans increasingly want to manage their own investments, and they are becoming more comfortable investing outside of stock and bond markets.
“After the tech bubble burst, many Americans saw a large portion of their retirement savings evaporate,” he said. “Many of them are saying, ‘I don’t want to be in this kind of situation, I want to know what my account is being invested in.’”
And, by middle age, many have amassed enough money in their retirement accounts to permit some experimentation.
Most self-directed I.R.A.’s are invested in real estate, like apartment buildings or warehouses, officials at the trust companies say. The rest end up as equity or debt investments in private companies, or in off-beat ways of generating rental income, like Mr. Harris’s musical instruments. Custodians say clients have invested in such diverse properties as private jets that can be leased out, race horses that generate prize income and bulls that are in demand among cattle breeders.
In addition to giving investors more control over their retirement savings, self-directed I.R.A.’s also carry the usual tax advantages that come with government-authorized retirement plans: traditional I.R.A. holders can defer tax payments on their profits until retirement, while Roth I.R.A. holders do not owe any tax on gains. Mr. Harris, for example, who set up his Roth I.R.A. with post-tax dollars, is not taxed on his rental income or any profits he makes if he sells an instrument.
But self-directed I.R.A.’s also pose significant risks. Investing in a marimba requires much more savvy than signing up for a mutual fund and letting professional money managers do their job.
“This is best for people who know what they’re doing,” said Ed Slott, a tax adviser and author of several books on retirement. “If you know real estate and you can treat it as a business, then that’s fine.”
Some financial advisers warn that self-directed I.R.A.’s make it difficult for investors to diversify well, arguing that it is safer, for example, to invest in real estate through a real estate investment trust rather than by buying a single condominium.
Most people manage that risk by putting only a portion of their retirement savings into self-directed I.R.A.’s. Mr. Harris, for example, invests 25 percent of his nest egg in musical instruments.
The biggest risk, however, is breaking the law. No single set of rules governs I.R.A.’s, as the Internal Revenue Service publishes new guidelines whenever a contentious tax case comes up. Individual investors may find it difficult to sort through years of rulings, which makes it especially crucial to hire a specialized accountant or lawyer.
Generally speaking, I.R.A.’s may not be invested in collectibles and life insurance. In addition, accountholders may not personally benefit from their investment in any way other than making legal withdrawals after the age of 59 ½. This means that you may not live in a house you bought with your I.R.A., or put rental income anywhere but back into the I.R.A. Finally, any transactions with a lineal family — like children, parents and grandparents — are prohibited. This means a couple cannot invest in a start-up owned by their son.
When the I.R.S. spots a violation, it shows little mercy, disqualifying the entire I.R.A., taxing it retroactively and imposing a 10 percent withdrawal penalty on account holders under the age of 59 ½.
Hugh Bromma, the chief executive of Entrust, says one client allowed her daughter to live in a condominium owned through her I.R.A. The government forced the client to liquidate the entire $750,000 account and charged her over $1 million in taxes and fines.
Those who know what they are doing, however, can handsomely bolster their retirement savings.
Neil Paulson, a retired lawyer from Orlando, Fla., with a multimillion-dollar I.R.A., says he makes a 15 percent annual return by renting out homes and issuing mortgages to homeowners in his community. Mr. Paulson said he opened a self-directed I.R.A. account after the Internet bubble burst.
“I felt I had to start taking control of my own future,” he said.
Anyone interested in self-directed I.R.A.’s should be prepared to spend time actively managing the investment, because the trust companies that administer the accounts offer few services beyond educating their clients about the rules and then managing cash flow.
Setting up an account is fairly easy. Investors fill out standard forms, transfer funds from an existing I.R.A. account, and then direct the custodian to wire money into various investments. Recurring income, like dividends or rent, flows into the I.R.A. automatically. Annual fees typically are $100 to $2,000, depending on the size of the account and the number of transactions processed.
