Investing in alts through a self-directed IRA? Read this first

Self-directed individual retirement accounts come with tax advantages and access to alternative investments — along with major technical caveats and the risk of costly mistakes.

That's why it's important for investors tapping into alternative vehicles not allowed in traditional IRAs to not only pick the right service providers but also understand the complex rules for prohibited securities transactions, according to Todd Kesterson, a certified public accountant and principal of family office services with accounting and advisory firm Kaufman Rossin. Investors who turn to financial advisors to build their wealth via the strategy, which reportedly helped make Peter Thiel a billionaire, could wind up liable for taxes and excise penalties if they run afoul of the guidelines for self-directed IRAs.

"Then they liquidate the IRA. It's done, and they dissolve it, and everything is distributed out and it's a taxable transaction as well as an excise tax," Kesterson said. "It hurts everyone."

Self-directed IRAs cannot hold life insurance; collectibles; real estate properties used by the client households; investments into loans to the investor, family members or other related parties; or any asset acting as collateral, Kesterson wrote last month in Crain Currency, citing IRS Code Section 4975 and IRS Publication 590.

Regulators have frequently warned about the fraud risks involved with so-called self-directed IRA custodians — a third party between the investor and the fund or other product company that services the account.

"Self-directed IRA custodians: DO NOT sell investment products or provide investment advice; DO NOT evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters; and DO NOT verify the accuracy of any financial information that is provided for an investment in the account," the North American Securities Administrators Association, a network of state regulators, said in a 2023 investor alert and bulletin. "Self-directed IRA custodians are only responsible for holding and administering the assets in the account. Furthermore, most custodial agreements between a self-directed IRA custodian and an investor explicitly state that the self-directed IRA custodian has no responsibility for investment performance."

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Choose wisely and hire a professional

Wealthy investors may be somewhat less likely to fall victim to bad actors, but they can still benefit from the advice of advisors and tax pros as they think through their investments. Clients' choices could be affected by legitimate custodians' areas of expertise, varying fees and stances on whether an investor is a so-called disqualified person engaging in what the IRS deems to be "self-dealing." In addition, the investors and their advisors must ensure that the custodians receive annual valuations of the assets from the fund company, Kesterson said.