A fraud warning for self-directed IRAs

In September, the SEC issued an investor alert warning investors to be wary of fraudulent promoters targeting self-directed IRAs

In September, the SEC issued an investor alert warning investors to be wary of fraudulent promoters targeting self-directed IRAs.

The alert began with a brief overview of conventional individual retirement accounts and self-directed IRAs, and pointed out some key differences, one being that while most IRA custodians are banks and broker-dealers that limit the holdings in an IRA, self-directed IRAs can offer investors the opportunity to invest their “retirement funds in other types of assets, such as real estate, promissory notes, tax lien certificates and private-placement securities.”

Although self-directed IRAs have the potential to offer owners otherwise unavailable investment opportunities, the Securities and Exchange Commission noted that they also can come with unique risks such as “a lack of disclosure and liquidity — as well as the risk of fraud.”

According to the alert, self-directed IRAs account for about 2%, or $94 billion, of all IRA funds. It is possible, however, that the recent volatility and uncertainty surrounding the markets could help foster an increased “grass is greener” attitude with some clients, prompting additional funds to be allocated to self-directed accounts.

WAYS THEY ARE VULNERABLE

The SEC alert explained that promoters of fraudulent investments may seek to target self-directed IRAs in a variety of ways. One way is to misrepresent the custodian’s responsibilities.

Often, these promoters will suggest or even out-and-out state that a self-directed-IRA custodian has done some level of due diligence on its investment to verify its validity.

The alert points out that this is usually not the case, as most self-directed IRA custodians won’t evaluate the merits of an investment its clients make. In fact, in most cases, the custodial agreement signed when a client opens a self-directed IRA explicitly states that the custodian bears no responsibility with regard to an investment’s performance.

The SEC’s investor alert also indicated that fraud promoters are likely to target owners of self-directed IRAs because of the special tax characteristics associated with the accounts. Such characteristics include the 10% penalty for early (pre-591/2) distributions that discourage many IRA owners — both self-directed and regular — from accessing their retirement funds at an earlier age.

The SEC also pointed out that many of the alternative investments that self-directed IRAs typically hold, such as real estate, mortgages, tax liens, precious metals and private-placement securities, don’t have the same types of financial information available to investors as do publicly traded securities.

Although the risk of fraud in any type of account and, in particular, self-directed IRAs can never be completely eliminated, the SEC’s alert provides a number of safeguards that potential investors can employ to minimize the possibility of falling for a fraudulent investment.

One such step is to be cautious of investments that offer high returns with seemingly little or no risk.

As the SEC put it, “low risk generally means low yields, and high yields typically involve higher risk. Fraud promoters often spend a lot of time trying to convince investors that extremely high returns are “guaranteed’ or “can’t miss.’ Don’t believe it.”

The alert also cautions investors to be wary when they receive unsolicited offers, even when approached by someone the investor trusts, such as a co-worker, friend or even a family member.

Other helpful tips included asking the right questions, verifying the information presented on a self-directed-IRA statement and, of course, consulting with a knowledgeable professional.

The SEC alert discusses self-directed IRAs and never makes a distinction between self-directed traditional IRAs and self-directed Roth IRAs. However, from the client’s perspective, a fraudulent investment made in a Roth IRA is far worse.

Not only would the client be out the money they put into the bogus investment, but they could potentially be out the funds used to pay the tax on the Roth IRA funds when they were first contributed/converted to the Roth account.

The full version of the alert at sec.gov/investor/alerts/sdira.pdf also contains a brief description of several recent court cases that involved fraudulent investments made at least in part through self-directed IRAs.

Ed Slott (irahelp.com), a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace.