Alternative asset investments are the fastest growing segment of retirement market. Since the 2008 financial crisis, there has been enormous interest in using retirement funds to make alternative asset investments in order to better diversify one’s retirement portfolio. According to a McKinsey & Company Private Markets Review in February 2017, whether measured by fundraising (firms received $625 billion of new capital in 2016) or assets under management (AUM), now $4.7 trillion worldwide, private markets in 2016 continued an impressive cycle of expansion that began in 2008.
The IRS and the Internal Revenue Code do not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions, such as life insurance, collectibles, or any transaction directly or indirectly involving or benefiting a “disqualified person.” A “disqualified person” is essentially defined as the IRA holder and any of his or her lineal descendants, as well as any entities controlled by such persons. Hence, so long as the transaction does not involve life insurance, collectibles, or violates the IRC Section 4975 prohibited transaction rules, the alternative asset IRA investment can be made. Some of the more popular self-directed IRA investments in 2018 are: real estate, cryptocurrencies, ICOs, notes, private placements, and crowdfunding.
Investing in Alternative Assets
So why are so many retirement investors looking to use some or their retirement funds to make alternative asset investments? Here are the 4 main reasons:
In general, most Americans have an enormous amount of financial exposure to the equity markets. Whether it is through retirement investments, such as IRAs or 401(k) plans, or personal savings, many of us have most of our savings connected in some way to the stock market. In fact, over 90% of retirement assets are invested in the financial markets. With over $30 trillion in retirement assets as of 2018, you can see the scope of that exposure. Investing in non-traditional assets, such as real estate offers a form of investment diversification from the equity markets. In general, the more diversified your portfolio, the greater chance that your assets will offer lower correlation, meaning they are less likely to move in the same direction. However, diversification does not assure profit or protect against loss. The use of non-traditional asset classes can help protect your portfolio when the market is down and help protect you from losing more than the market.
- Invest in Something You Understand
Many Americans became frustrated with the volatility of the equity markets. Many Americans are somewhat shell-shocked from the market swings and not 100% sure what exactly goes on in Wall Street and how it all works. Real estate, for comparison, is often a more comfortable investment for the lower and middle classes because they grew up exposed to it whereas the upper classes often learned about Wall Street and other securities during their younger years and college days. Everyone has heard someone talk about the importance of owning a home or the amount of money that can be made by owning real estate. Reality TV related real estate programming is growing in popularity helping to contribute to real estate quickly becoming a mainstream asset category and one of the most trusted asset classes for Americans. It is, of course, not without risk, but many retirement investors feel more comfortable understanding the real estate market and buying and selling real estate than they do stocks.
- Inflation Protection
Rising food and energy prices, coupled with high federal debt levels, have recently fueled new inflationary fears. As a result, some investors may be looking for ways to protect their portfolios from the ravages of inflation. It is a matter of guesswork to estimate whether these inflation risks are real, but for some retirement investors, protecting retirement assets from inflation is a big concern. Inflation can have a negative impact on a retirement portfolio because it means a dollar today may not be worth a dollar tomorrow. Inflation also increases the cost of things that are necessary for humans to live and enjoy life, such as bread, gas, shelter, clothing, medical services, etc., decreasing the value of money so that goods and services cost more. For example, if someone had an IRA worth $150,000 at a time of high inflation, that $150,000 will be worth significantly less or have significantly less buying power. This can mean the difference between retiring and working the rest of your life. Buying hard assets are seen as one way of protecting your assets against inflation. Many investors have long recognized that investing in commercial real estate can provide a natural protection against inflation, as rents tend to increase when prices do acting as a hedge against inflation.
- Hard Assets
Many alternative assets, such as real estate and precious metals are tangible hard assets that you can see and touch. With real estate, for example, you can drive by with your family, point out the window, and say, “My IRAs owns that”. For some, that’s important psychologically especially in times of financial instability, inflation, or political or global upheaval.
In addition to the 4 main reasons investors are looking to use a Self-Directed IRA to make alternative asset investments, the tax benefits may be the most attractive.
Tax deferral literally means that you are putting off paying tax. The most common types of tax-deferred investments include those in IRAs or Qualified Retirement Plans (i.e 401(k)). Tax-deferral means that all income, gains, and earnings, such as interest, dividends, rental income, royalties or capital gains will accumulate tax free until the investor or IRA owner withdraws the funds and takes possession of them. As long as the funds remain in the retirement account, the funds will grow tax-free. This allows your retirement funds to grow at a much faster pace than if the funds were held personally allowing you to build for your retirement more quickly. And, when you withdraw your IRA funds in the form of a distribution after you retire, you will likely be in a lower tax bracket and be able to keep more of what you accumulated. So, with using a Traditional IRA as a retirement savings vehicle, not only are you not paying taxes on the money you invested, you could be paying them at a lower rate when you finally do “take home” your money. In other words, as long as the funds remain in the account, they grow without taxes eroding their value. This enables assets to accumulate at a faster pace, giving you an edge when saving for the long term. And, when you withdraw funds after you retire, you’ll likely be in a lower tax bracket and be able to keep more of what you’ve accumulated.
Also, a Roth IRA will allow a retirement account holder to generate tax-free growth in their Self-Directed Roth IRA. So long as the Roth account is opened at least five years and the Roth account holder is over the age of 59 1/2, all income from the Self-Directed Roth IRA or Roth 401(k) plan will be exempt from tax. In other words, if you can wait until you are over 59 1/2 before taking a Roth IRA or Roth 401(k) distribution, and the Roth has been opened at least 5 years, you pay no tax on the distribution amount. That means you can invest in alternative assets, such as real estate and cryptocurrencies, and never pay tax on any of the gains.