Should You Consider a Self-Directed IRA?

Paul Winkler: Welcome, this is “The Investor Coaching Show.” I am Paul Winkler, talking about money and investing—and today, retirement planning because there is going to be a day when you are dependent upon your money. You work for money, then money works for you if you get it right.

Investing Isn’t as Easy as You Think

So that’s why I come at this from an educational standpoint because if you look at the returns of investors versus markets historically, the average investor significantly underperforms markets. And there are good reasons for it.

You may think, “Ah, this is easy. This is simple. I just saw this little ad and now I’m going to read up on some articles on investing.” It seems like everybody’s telling you to do something different, and then you just kind of shake your head and go, “I didn’t even know what to do because it’s all confusing. Everybody seems to be contradicting each other.”

The average investor significantly underperforms markets.

You go through market upturns, when markets are looking good. Let’s say that you’re investing in U.S. stocks that are raging hot and doing very, very well. Everybody’s writing about how great the economy is, how wonderful the market is, how wonderful the president is.

The president is always taking credit for the market going up. I mean, I don’t care which party you’re talking about. If the stock market is going up, they say, “Hey, look at the stock market. Look how great it’s doing.” They will point to that as evidence of their good leadership.

And if it’s Congress, they’re going to point to it and say, “Hey, look how great we’re doing.” Now, if it’s going poorly, you have to blame the other side, right?

That’s how it works. You can’t take any of the blame; you get to take all the credit. That’s how politics works. After markets go down, you will hear doom and gloom and how terrible things are going to be.

And inflation is going to get worse and earnings are going to get worse. And the economy is going to go bad. And you’re going to hear from some person that predicted the market was going to go down and that person will be saying, “See, I told you that this was going to happen.”

You’ll see all kinds of analysis on how bad the economy is going to be going forward and how you need to actually switch your investment strategy to something else. You’ll hear: “Get into gold. You need to get into silver. You need to get into self-directed IRAs. You need to buy real estate.”

Self-Directed IRAs

Well, that’s the very first thing that I want to talk about, because it was a topic that came up this week.

Somebody asked about self-directed IRAs. In fact, there was an article about the topic titled “6 Reasons to Avoid a Self-Directed IRA.” Now, if you’ve never heard of this, you can take matters into your own hands when it comes to investing all day long.

The investment industry will let you do that. And when I say take it into your own hands, that’s literally what a self-directed IRA is. It allows people to do things that you can’t do in an ordinary IRA—which, more specifically, is to invest in alternative assets.

Now, this is something that the investment industry does too. Don’t leave it to the investment industry not to screw things up just as well. That’s exactly what they did in 2008. They started moving toward alternative assets. Think commodities like gold, silver, lumber, and diamonds. You could invest in trees if you want to.

You could invest in real estate. You could invest in individual stocks. Now, you wouldn’t need a self-directed IRA to do individual stocks, you can shoot yourself in the foot with a regular IRA with that one.

But that is what these self-directed IRAs are designed to do, to allow people to do things that they wouldn’t normally be able to do. And the article points that out by saying that self-directed IRAs are not for the average retiree or for the faint of heart. These specialized retirement accounts let investors do what they want. Now, I’d put investors in quotes there if I were writing the article, because it’s really gambling.

Self-directed IRAs are designed to allow people to do what they wouldn’t normally do.

You may not think of it as gambling. You just think that you’re prudent. Especially as we get older, what we tend to do is gain more confidence in our abilities.

There’s a psychological aspect to it that people tend to get a little bit more confident. And the reason they did get confident is because they feel like they’ve got so much experience.

And the problem is that when we get a lot of experience, we start to see false patterns. And we start to say, “Well, every time in my life that this happened, this was the next thing that happened.”

What Happens With False Patterns?

It’s just basically what happens. I saw this before, I read this book before, and I know how it ends.

What we don’t realize is that it doesn’t end the same way ever. And the reality is if it did end, let’s say it did end a certain way last time, you’re not the only person that noticed that it ended that way last time. Everybody else is taking action based on it ending the way it did last time.

So in other words, everyone else sabotages it for you and it doesn’t work out the same way. And the problem is you won’t get that lesson until you’ve lost, until you have really lost in the game.

Too often, investors don’t learn the right lessons until they’ve lost the game.

That’s the problem. It is too late when you finally learned the lesson with real money. Maybe you sort of learned a lesson when you didn’t have real money, maybe you didn’t have a whole lot, but you’re going to learn the hard way one way or another.

David Rodeck is the writer of this article. I hardly agree that it is something that people just don’t recognize how bad it actually can be. You talk about the faint of heart. You’ve got to really be willing to just lose it.

Having worked an entire life and losing everything you’ve got because you thought you knew what you were doing. Now, the article talks about investing directly in alternative assets—cryptocurrencies, real estate, and private businesses are some of the things you can do.

Cryptocurrencies, we saw what happened there. There are a lot of people that lost their life savings right there, and thought they really knew what was going on.

It has happened before with real estate. I was talking to somebody this week, and he said, “Do you remember the 1980s? Do you remember what happened in real estate?”

I said, “Oh, yeah. I remember.” I remember how much bravado people had at that point in time, thinking that they had it all down. And the wealthy were investing in real estate at that time too.

It was the most sophisticated thing you could do at that time. It was the thing that seemed like it was the most sensible. The tax laws were phenomenal. It all worked until it didn’t. It all worked until Congress came in and changed the rules.

You Cannot Predict, but You Can Notice

Then once they changed the rules, bam, you were done. The game was up, and it wasn’t going to work anymore.

You could do private business. And with real estate, you could get into these self-directed IRAs. You make one wrong step and bam, you receive a tax bill like you would not believe because you have a disqualified IRA.

Now, some of the points in this article, I want to make some points because there’s some really good things even if you weren’t thinking of doing a self-directed IRA. I think some of the points he makes in this article are worth hearing for anybody that has any type of IRA.

I actually saw an article in The Wall Street Journal today. When I look at how things work in the investing world, things just make sense to me and how things actually play out. It just makes sense. I mean, you can look at things—not to predict the future, not to predict where markets are going, but you can see how certain investment vehicles are made popular and then blow up.

You can see what can happen to make them blow up. The article in The Wall Street Journal was just one of those examples, and I’ll talk about that in a second.

As an investor, you want to be well-diversified.

Like ordinary IRAs, assets grow tax-free inside of a self-directed account and these are marketed by big investment firms. He says, “Now, there’s several problems with this.” The first one he brings up is you’re not as diversified as you think.

That is very, very true. He says, “Alternative assets can be used as a way to diversify your portfolio because they don’t move in lockstep with stocks and bonds.” And they don’t.

Back in 2008, alternative assets actually went up in value and people said, “Hey, wow, this is really, really cool. This is a great diversifier.” The problem was that you could go in an entire 30-year period with no return or a return that is basically inflation and that’s it.

Now, you may not get movement that is in concert with stocks or bonds, but one of the things that you want to make sure you’ve got going for you when it comes to investing is getting a return above inflation. And the problem with the commodities is you’re not producing anything.

Commodities

When I own a commodity like gold, I’m not producing a product. I don’t have a cost of capital. Nobody’s paying to use my money. So it doesn’t work really well. And that’s exactly what he says here, basically you’re buying something and it may take a big chunk of your savings to do it.

The problem is you can end up with an asset that is just a single asset. Like buy a piece of real estate with your IRA and you’ve got one piece of real estate. I’m sorry, but that’s not diversified.

When I own $30,000 worth of stocks, I’ve got lots of real estate, but I don’t have it in one area only, I’ve got it all around the world. So I’ve got a way, way larger degree of diversification when I do that.

He says, “To diversify using alternative assets like real estate or commodities, you want to make sure that you’re sticking with mutual funds.” Now, that’s one area I would disagree.

I would never own commodities in an IRA because there’s no cost of capital. So I’m not going to agree with every single part of his article, but I think he makes a really good point about diversification.

Now, why is that important? Well, there’s something called the prudent investor rule.

Trusts, in order to actually fall within the dictates of the law have to follow something called the prudent investor rule.

Let’s say you’re managing money for a child that can’t manage their own money. You’re going to be held to prudence because they don’t want you to mess up this kid’s money.

Years and years ago, I used to actually write investment programs for the court. Basically what I did is I followed the dictates of the prudent investor rule. What is prudent?

One of the things it talks about is risk and the duty to diversify.

All economic events do not affect the value of all investments in the same way.

In other words, you may have a few really lousy years for real estate, but large U.S. stocks may just do just great.

You may have an absolutely abysmal few years for large U.S. stocks, but small U.S. companies may do great. You may have years where everything in stocks goes down in real estate, but cash is the only thing holding value.

A Problem With Self-Directed IRAs

You may have years where stocks do poorly but bonds do well, or bonds do poorly but stocks do well.

The idea here is to own things in every area, so that they don’t all move in the same way. That’s what it says. It says risk or volatility, which is often referred to in economic literature as standard deviation that tells you how much something can go up and down.

So I might have an expected return for large U.S. stocks. In every 30-year period it’s about 10. Historically, 10 has been the average annualized return from the 1920s until now. But how many years was the return in 10?

Pretty much never. You might be up 35%, down 15% and up 20% and down 10% for a year. You’re sitting there going, “Ugh.” You hate it when it goes down, but guess what? That’s the permission slip. If it weren’t for those negative returns, we wouldn’t see the higher returns that stocks give us versus fixed income.

So basically what they’re saying is that we measure risk in economic literature through standard deviation, which is in turn is a square root of the variance. Basically variance is how much it varies from the meaning.

One problem with self-directed IRAs is that you have no dissimilar price movement.

They’re basically moving together. In essence, if the things that you’ve invested in go down in value, they’re all going down together and your retirement goes to nothing all at one time.

Another thing that they had in the article is that you get no guidance. With self-directed IRAs, it’s self-directed. You’re the one directing the ship.

But you get no guidance when you’re trying to do this on your own and you may be smart, but the reality of it is you probably don’t know what you don’t know.

That’s what it gets down to. Now, another thing he talks about is fraud. He says, “And here’s potential for fraud. Not only can you get investments that are opaque, but the Securities Exchange Commission warns that criminals prey on those with self-directed IRAs.”

They prey on people that do this stuff. Why? Because they think they know more than they really know.

Investing With False Confidence

There was a study that was done and it was actually looking at how people’s confidence level can be blown out of the water through getting just a little bit of information. The study found that when people got a little information, they started taking actions as if they really knew more than they did.

It was just a funny thing because people that really did know their stuff were fooled by these people because of their level of confidence. But it was false confidence. What happens is that people with criminal intent will actually go after people that are using self-directed IRAs and get them to do things that they probably shouldn’t do.

When people receive information, they quickly fall into the practice of taking actions based on false confidence.

Our fluid intelligence actually stops growing at age 45. Like it or not, we don’t have growth in that particular area.

Now, crystallized intelligence can grow forever. That’s where you’re talking about experience.

But guess what? Fluid intelligence doesn’t. Yet, our confidence level doesn’t seem to wane as we get older. So that’s why it’s really good to not go down this direction.

Now, there are three more things that I’m going to talk about regarding this that have a big impact on whether this ends up being a successful way of doing things or not.

The third point talks about paying hefty fees. Self-directed IRAs aren’t cheap. Along with transaction fees, the IRA custodian can charge an account set up fee, an annual fee, a per asset held in your account fee.

Fees can be quite high for these things. But I think even more than that, the problem that you run into is you may be paying fees but not necessarily getting advice, and then you could end up with tax bills on your hand that dwarf any kind of fees you might end up paying.

RMDs still apply with these, required minimum distributions. Now, this can get really tricky because you have to figure out the asset value every single year to determine how much money has to come out.

What he said in the article is that self-directed IRAs are retirement plans. You’ll still need to take required minimum distributions once you’ve turned 72. That can be tricky to do if you’re investing in assets that aren’t easily cashed in.

The Rules for Self-Directed IRAs Can Be Harsh

Now, let’s say you have illiquid assets. You don’t go and cash in and sell the roof of a house. Then there’s a Roth IRA version, like ordinary Roth IRAs, a self-directed version is funded with post tax dollars. But you can end up with some problems and you lose key advantages with real estate.

There are quite a few investing downsides with self-directed IRAs.

One of the benefits with real estate that he points out, which I have pointed out many times on this show, is that you have the ability to depreciate real estate. Well, with self-directed IRAs, you lose that ability.

Many of the benefits associated with investing in property go away. Now, I’m not a big fan of property. I don’t invest in property. I have some properties, but a very, very small amount of my assets are in property simply because I just don’t like the idea of having to constantly keep up with it.

So the IRS has rules on self-directed IRAs and one of them is that you cannot use or manage the assets personally.

If you buy a beach house as an investment, you or your friends can’t stay there for free. If the wind blows off the storm gutter, you can’t fix it yourself, but need to hire a professional using cash from your IRA balance.

If you get caught breaking those rules, the IRS could void your entire IRA forcing you to take out the balance, not just the problem asset which could mean a sizable tax bill and the loss of future tax benefits of these investments. Besides that, it’s great.

Well, that is not exciting in my mind. You also miss out on the tax breaks for owning investments outright. It’s the IRA that holds title to the property, not you personally, and your IRA doesn’t pay taxes each year.

That’s a problem for real estate owners and investors, as they won’t be allowed to claim annual deductions for repairs, mortgage, interest, depreciation, property taxes, losses against personal income. That is a lot of downsides right there.

A Quick Note on Investing in Gold

Now, I promised I’d say something because a lot of times I see gold used as this. I talked about this, back in 2008 because it was everywhere you looked. They’re still out there.

I don’t even know why they’re still out there. The return on gold has been so abysmal that it just amazes me that there are still commercials out there about investing your IRA in gold and silver.

Depending on which one is doing okay at a particular point in time, they switch as to what they actually go and advertise on TV. But gold was everywhere in 2008.

So you look at that period of time at what stocks had done. It’s just ridiculous that gold has gone nowhere.

I was doing workshops on the subject and somebody asked, “So why gold now, Paul?”

And I said, “Look, it has its own function for its own demise. Think about it. If gold goes up to the price that they keep saying it’s going to go up to, then people will mine for it everywhere.”

I kid you not, a couple years later there were TV shows that came out talking about mining for gold. And they were following these people looking for gold, right?

I said, “People will go to the bottom of the sea to mine for gold if the price goes high enough, because the cost of getting mining equipment under the sea would be worth it.” No joke. In The Wall Street Journalthis week, there was an article discussing how deep sea mining is close to being a reality.

Now, this is the funny part, because deep sea mining will not be for gold but for metals that can be used to make electronic vehicles. Now, you know what they’re mining for is not gold because gold prices are not high enough to justify going and mining at the bottom of the ocean for it.

The point is that when you have something that goes high in price and is a commodity and is high in value, it does so why? It does so because it is scarce. The value is high because it’s scarce.

What will people do if the price gets high enough? They will get rid of the scarcity. They will increase the supply and that will reduce the price. It will have the function for its own demise, which is what I said 14 years ago.

To me, it makes sense. It’s logical. I don’t think it was a big mental jump to say that would happen. But I just think it’s interesting just to see that it is looking like it’s going to happen, but it’s not even for gold because gold never went up that high in price. It’s car batteries.

So the bottom line with self-directed IRAs is to watch out for false confidence.

False confidence is a killer when it comes to investing.

Thinking that you know things that you don’t know can cause you to do a lot of things that you will come to regret, but you might be suffering through your regret with a lot less money.

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