As the President of a Self-Directed IRA custodian, it surprises me how often I am asked by clients, friends and colleagues what is a Self-Directed IRA custodian and how it differs from a traditional bank or financial institution.
Pursuant to Internal Revenue Code (IRC) Section 408, an IRA can only be established and administered by a bank, financial institution, or authorized trust company pursuant to state law. An IRA trustee, also known as a custodian, is the institution that administers your retirement account. By law, every individual retirement account must have either a custodian or trustee.
Currently, the majority of approximately 50 million IRAs invest in traditional asset investments. This includes stocks, mutual funds and ETFs. However, since the 2008 financial crisis, retirement account investors have become aware of the advantages of alternatives assets. They’re beginning to see it can better diversify their retirement account investment portfolio and act as a hedge against inflation.
Other than life insurance, collectibles, and certain self-dealing and conflict-of-interest transactions outlined under Internal Revenue Code Section 4975, alternative assets are permitted for an IRA.
Most banks and financial institutions that offers IRAs only allow their IRA clients to invest in traditional assets, like stock and exchange traded funds for one simple reason: this is how they earn their fees. The IRA custodian has a right to choose what types of IRS approved investments it allows their clients to invest in.
What is a Self-Directed IRA Custodian?
On the other hand, a Self-Directed IRA custodian (also known as a passive custodian) allows IRA holders to engage in non-traditional investments and never offers investment advice or sells investment products. A Self-Directed IRA custodian earns its fees from the custody and administration of alternative asset investments the IRS approves, and is owned by an IRA or other retirement plan.
In other words, to establish an individual retirement account, one must open the IRA at a bank, financial institution or authorized trust company, such as IRA Financial Trust. Essentially, the IRA custodian is responsible for maintaining and administering the IRA. The IRA custodian is tasked with the responsibility of complying with all IRS reporting requirements regarding the IRA. This includes filing IRS Forms 5498 and 1099-R.
For most IRA holders who have an IRA with a bank or financial institution and currently make traditional investments, the IRA custodian could have a fiduciary, or at least a “best interest” responsibility depending on whether a registered investment advisor is involved.
However, for IRA investors who wish to make alternative asset investments with their IRA, such as real estate, the IRA custodian is not considered a fiduciary because it does not provide investment advice. The primary responsibility of the self-directed IRA custodian to facilitate transactions based off the direction of the IRA holder, as well as take custody of the IRA owned alternative asset investment.
The Self-Directed IRA custodian is not responsible for reviewing the transaction or performing any due diligence. Hence the name “Self-Directed.”
Below is a list of three important things one should know about the role of a self-directed IRA custodian:
Open a Self-Directed IRA with a Self-Directed IRA Custodian
You must open a Self-Directed IRA with a special custodian called a passive custodian or Self-Directed IRA custodian that will allow for alternative asset investments, such as real estate.
The self-directed retirement industry was born in order to serve the need for retirement investors to have the ability to make IRS approved alternative asset investments using their retirement funds. The reason for this is that not all IRA custodians allow their clients to make alternative investments. In fact, almost all banks and financial institutions, which are IRA custodians, do not allow their clients to use IRA funds to make alternative asset investments for the simple reason that they do not make any money from those investments.
Each IRA custodian is free to determine what IRS approved investments will be available to their clients. In other words, because banks and financial institutions generate a good amount of their IRA related revenues from investment related fees, allowing their clients to invest in assets they do not earn fees on, such as real estate, just does not make much financial sense.
A Self-Directed IRA Custodian Has Less Responsibility
The Self-Directed IRA custodian is not treated as a fiduciary by the U.S. Securities and Exchange Commission (SEC), does not sell investment products, or provide any investment advisory services. Its sole responsibility is to facilitate non-prohibited alternative asset investments based on the exclusive direction of the IRA holder.
In other words, the self-directed retirement custodian serves the growing demand from retirement account holders who wish to make IRS approved alternative asset investments, such as real estate, hedge funds, private equity, private placements, notes, etc. that are not being served by the traditional financial institutions.
The Self-Directed retirement custodian will make the alternative asset self-directed retirement investment on behalf of the IRA owner as well as provide custody services. In addition, a Self-Directed IRA custodian is not permitted to offer legal or tax advice.
Responsibilities of the Self-Directed IRA Custodian
The Self-Directed IRA custodian is responsible for taking care of all IRS reporting with respect to the IRA, including filing IRS Form 5498 and 1099-R. In addition, a Self-Directed IRA custodian will also take care of paying all expenses, such as property taxes on a real estate investment, with respect to the IRA transaction.
If you are interested in having a Self-Directed IRA with “checkbook control,” make sure the Self-Directed IRA custodian you select has the experience to custody and facilitate such investments. A “checkbook control” Self-Directed IRA is an investment solution that involves the IRA being the owner of a special purpose limited liability company (LLC) that is managed by the IRA holder and which offers the IRA holder limited liability protection in connection with the IRA alternative asset investment.
It is important that any investor who is interested in investing in alternative assets with their retirement funds understand that a Self-Directed IRA custodian is not treated as a fiduciary by the SEC. Accordingly, it is important that the retirement account investor perform their own due diligence on the investment and seek the advice of a financial professional where appropriate.