Adam Bergman

Founder, Tax Lawyer, Author

Alternative assets can add real diversification to a retirement account, but they come with risks that stocks and mutual funds mostly keep out of view. I’ve worked with Self-Directed IRA investors for more than 15 years, and the people who get hurt usually didn’t understand who was responsible for what. In a Self-Directed IRA you choose the investment, so you also carry the job of evaluating it. Below are the main risks of alternative assets in an IRA, both investment and compliance, and the steps that reduce them.

Investment Risks of Alternative Assets in an IRA

• No built-in review. In a joint alert, the SEC, NASAA, and FINRA warn that Self-Directed IRA custodians don’t evaluate the quality or legitimacy of any investment or its promoters, and typically don’t verify the financial information behind it. Due diligence sits with the account owner.
• Fraud. The same alert notes that fraudsters sometimes claim or imply that custodians investigate and validate investments. A custodian holding an asset isn’t an endorsement of it. Any pitch promising “guaranteed” returns or “zero risk” should end the conversation.
• Illiquidity. Real estate, private placements, and notes can’t be sold in a day. That becomes a real problem when required minimum distributions, property taxes, or other expenses come due and the account has no cash.
• Valuation. There’s no exchange price. Values come from appraisals, statements, or the investment sponsor, so errors and optimistic marks are possible.
• Concentration. One property or one private deal can grow into a large share of the account, with no diversification inside it.
• Limited information. Private investments usually provide far less financial reporting than public companies, and you may only hear from the sponsor once a year.

Compliance Risks

The investment risks are the same ones you’d face owning these assets in a taxable account. The compliance risks are unique to retirement accounts, and in my experience they’re the ones investors underestimate.

• Prohibited transactions. The IRS prohibited transaction rules bar dealings between your IRA and you or other disqualified persons, such as your spouse, parents, children, and entities you control. Common examples include buying a property for personal use, lending IRA money to a relative, or getting paid for work on an IRA-owned asset. If you engage in one, the IRA is treated as fully distributed as of January 1 of that year, which means income tax and possibly a 10% early withdrawal penalty on the entire balance.
• Prohibited assets. Life insurance and most collectibles can’t be held in an IRA. Certain gold, silver, platinum, and palladium bullion and coins are an exception.
• UBTI and UDFI. Income from a business operated through the IRA, or from debt-financed property, can be taxable even inside the account. Once that income exceeds $1,000 in a year, the IRA must file Form 990-T and pay the tax from IRA funds.
• Reporting. Your custodian reports the account’s year-end fair market value to the IRS on Form 5498, so you need current valuations for any asset that isn’t publicly priced.
• Expenses and paperwork. Costs tied to an IRA-owned asset must be paid from the IRA, and income must flow back into it. Mixing personal and IRA funds is one of the most common mistakes I see.

Two Cases That Show What’s at Stake

In Peek v. Commissioner, 140 T.C. 216 (2013), two investors used their IRAs to form a corporation that bought a business, then personally guaranteed the loan used to finance the purchase. The Tax Court held that the personal guarantee was an indirect extension of credit to the IRA, a prohibited transaction, and the investors lost the tax benefits on years of gains.

In Ellis v. Commissioner, T.C. Memo 2013-245, aff’d 787 F.3d 1213 (8th Cir. 2015), an investor used his IRA to fund an LLC that ran a used-car business and then had the LLC pay him a salary. The court found that paying himself from an IRA-owned company was a prohibited transaction, and his entire IRA was treated as distributed.

Neither investor was trying to cheat the system. They made decisions that would’ve been perfectly normal outside an IRA. I go through more of these rulings in my summary of landmark prohibited transaction cases.

How to Reduce the Risk

1. Research the sponsor. Verify registration and background using FINRA BrokerCheck and the SEC’s Investment Adviser Public Disclosure site where they apply, and check with your state securities regulator.
2. Read the documents. Review the offering memorandum, financial statements, fee schedule, and exit terms before funding.
3. Plan liquidity. Keep enough cash or liquid assets in the account for fees, taxes, and any required distributions.
4. Size the position. Decide in advance how much of the account any single alternative can represent.
5. Confirm eligibility. Check that the asset and every party to the deal are permitted under the prohibited transaction rules before you buy.
6. Keep clean records. Document valuations, expenses, and income so annual reporting goes smoothly.
7. Get advice. Talk with a tax or legal professional about anything complex, especially deals involving leverage, operating businesses, or family members.

This is a big part of why I built IRA Financial with in-house tax attorneys and ERISA specialists. Most compliance problems I’ve seen could have been avoided with one conversation before the money moved.

Final Thoughts

None of these risks is a reason to avoid alternative assets in an IRA. They’re the price of the control a Self-Directed account gives you. Some of the most successful retirement investors I’ve worked with built their wealth through real estate, private companies, and other assets Wall Street doesn’t sell. Every one of them understood the rules, did the homework on each deal, and treated the IRA’s money as the IRA’s money. If you do the same, you can capture the upside of alternatives without putting your account’s tax status at risk.

This content is for educational purposes only and does not constitute legal, tax, or investment advice. Consult a qualified professional before making any investment decisions.