For investors considering investment in alternative asset classes generally held for longer periods, such as private equity, investing through a self-directed traditional or Roth IRA can offer the potential for certain tax benefits. On the self-employed and employer-sponsored side, SEP (simplified employee pension) and SIMPLE (savings incentive match for employees) IRAs may offer similar benefits – subject to the structure and administration of the plan. In the past, we’ve talked about the process of using a self-directed IRA to invest in startups. Aside from how that works, we also receive a lot of questions on how to choose a custodian and what that relationship looks like.
Why You Need a Custodian
Per the IRS, all IRAs must be held by a custodian. A custodian in this context is defined by the IRS as follows:
“…must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.”
IRA custodians are held to strict IRS requirements and are also subject to regulatory audits. Custodians that meet these conditions can hold title to:
- Issue funds
Not all custodians deal in alternative assets. Some only deal in traditional assets, like publicly traded stocks, others specialize in alternative assets, and some custodians do both. The term “alternative assets” encompasses a variety of financial products, including private equity, special purpose vehicles (such as the funds offered on the MicroVentures platform), real estate, collectibles, venture capital, derivatives, certain insurance products, and in some instances, digital assets such as cryptocurrencies.
As a side note, liquidating distributions from special purpose vehicles such as the MV funds may be made in cash, publicly traded shares, or a combination of both. You may want to ask if and how a potential custodian would accommodate these types of transactions.
Something to note here is the difference between an IRA custodian and an IRA administrator. An administrator essentially acts as a middleman between the retirement account owner and the custodian. For a fee, they can help establish and maintain the retirement account, handle paperwork, and in some instances, help facilitate the calculation of fair market value. An administrator works with, not in lieu of, a custodian.
What Custodians Do
An IRA custodian essentially holds (custodies) your investments and helps facilitate compliance with IRS reporting and regulations. A custodian tracks all of your IRA’s activities and reports all transactions to the IRS. An IRA custodian does not offer investment advice as a financial advisor would, or tax or legal advice. They also do not determine the market value of investments in alternative asset classes.
Choosing an IRA Custodian
Choosing the right custodian is important, and it’s imperative that you do your due diligence before committing. Here are some things to consider:
When choosing a custodian, it is important to first outline your investment strategy. Custodial accounts include fees, you can mitigate the impact of those fees by selecting a reputable company that can custody all or most of the alternative asset classes in which you intend to invest. Self-directed IRA custodians typically have a limited duty to investigate assets, but some incorporate a due diligence process to determine what they will and will not allow on their platform.
All custodians charge fees, and they vary between providers. Be wary of any custodian that is hesitant to discuss fees, as how they are scheduled and structured will impact your returns. A potential custodian should clearly describe what, when, and how you’ll be charged for their services. The most well-known custodial fee is the annual fee, but some firms may also incorporate transaction fees, services fees, a set-up fee, research fees, and closeout fees. Annual custodial fees may be a flat fee, a percentage of the total asset value of your IRA (noting again that alternative assets are illiquid and difficult to value), or charged on a per-asset basis.
Depending on your investment strategy, you may choose to make few transactions, or you may choose to make multiple transactions a week. If you plan to make frequent transactions, your custodian must be aware of your needs and be able to handle these transactions quickly.
Knowledge and industry experience are key. Do your homework on the business – find out how long it’s been around, if it’s been recognized, read reviews, look into the executive team. While a custodian may not offer investment advice, they should be knowledgeable on self-directed IRAs and willing to educate clients.
To get the most out of this relationship, you should know what to expect going in. Feel free to ask your potential custodian how accounts are generally managed, how investments are processed, timelines, and how quality is managed internally. You’re paying for a service; you don’t want one that is inconsistent or low quality.
Working with an IRA Custodian
The process of making investments through your IRA will vary from one custodian to another. One thing to note across the board is that in order to avoid a tax-reportable distribution, any transactions made through your IRA and any documents pertaining to them must be titled in the name of your IRA, not to you yourself. Likewise, all profits made from investments your IRA owns or proceeds from the sale of those assets must be returned to the IRA.
Self-directed IRAs are certainly not for everyone. That said, if you do want to invest in special purpose vehicles and/or private equity through your IRA, its vital that you select a reputable custodian that not only is able to hold alternative assets, but understands your needs and expectations. Consider reviewing your options with an unbiased investment professional, tax professional, or attorney. Know what you want, do your homework, and ask the right questions.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.