In a divorce, one spouse may receive retirement assets from the other via a qualified domestic relations order (QDRO). The advisor and the client need to think carefully about where to place those funds.
Obviously, the easiest thing would be to roll them straight into a mutual fund or similar vehicle. The procedure is simple, reliable and not paperwork intensive. However, not all clients prefer the “easy” route, and that’s especially true when it comes to retirement investing.
Popular in some areas is the move to self-direction. A self-directed IRA or 401(k) allows the investor to place retirement funds in assets other than market products. Here’s a quick rundown of what you need to know when a client decides to go self-directed and how you can keep a hand in managing those assets.
What drives a client to a self-directed IRA?
The answer to this question can be found in the most popular non-market asset: real estate. Usually, the average self-directed investor purchases a small property (think vacation home or multi-family) and then rents it out. The equity in the property plus the monthly rental income provides the return on the investment. From this perspective, a conservative rental provides a steadier and often more profitable income than a mutual fund. That can sound especially appealing after coming out of a divorce.
How does a self-directed retirement account work?
Currently, there are three popular options for self-direction. The first is the custodian model. In this model, the custodian acts as the middleman for the IRA and handles all investments and transactions. Whenever the account holder wants to purchase, manage, renovate or sell the property, she fills out paperwork and the custodian executes the transaction. This model is ideal for third-party placements, i.e., when the investor just provides the funds and somebody else takes care of the work.
In more typical situations, where the investor will be managing the property personally, custodian is not the way to go. The constant transactions, payments and management of a property can lead to a ton of custodial paperwork, which is expensive and frustrating. In those cases, the checkbook model is preferable.
Checkbook control works by setting up the IRA with a dedicated limited liability corporation, and then opening a bank account for the LLC. This setup allows the investor to invest the IRA funds directly with the new account’s checkbook. Any purchases made with that checkbook automatically become IRA assets. As with any IRA, the account itself is still held by a custodian, but the custodian is not used to execute any transactions. Everything is done straight just by writing a check. This model can cost a little more to set up, but for assets like real estate it saves significantly in transaction fees and ease of use.
The third option is for those who can claim some self-employed income and is known as the self directed Solo 401(k). This plan also has checkbook control, but instead of using a LLC, it works with a Trust. The plan holder opens a checking account at the bank of her choice in the name of the Trust, and then invests the retirement funds using the checkbook. The Solo 401(k) comes with a number of advantages not found in its IRA counterpart, including much higher contribution levels and the possibility of a significant personal loan. Additionally it doesn’t pay unrelated business income tax (UBIT) on real estate investments. What role does a financial advisor play with a self-directed IRA?
The versatility of self-directed platforms allow advisors to interact with them in whichever way they feel most comfortable. One standard approach is to use self-direction as a means of diversification. In this approach, the advisor can guide the client into splitting the retirement funds with some going into more traditional investments, while the rest are self directed. By maintaining the core of the funds in more traditional accounts, the advisor can better insure their security, as well as keep them in a standard AUM arrangement.
Another option (which works well for more experienced advisors) is for the advisor to be named as the manager of the IRA’s LLC. This gives the advisor complete control of asset acquisition and management, and provides for peace of mind in the investment process. In the case where a client wishes to go fully self-directed, an appropriate setup would see the advisor functioning in a fully advisory role (perhaps with a time-based fee schedule), and leaving the actual execution to the client herself.
Self-directed IRAs are a new area for many financial professionals, and it pays to get educated on their unique requirements. The most common questions that clients ask are those dealing with prohibited transactions. A knowledge of these rules is especially important as a retirement account can lose its tax-privileged status, as well as pay a hefty fee, if these rules are violated.
Although the basic rule is easy — you or any of your linear relatives may not give or receive direct benefit from the account — the details can get a little complicated and are worth knowing well. There are plenty of good resources on the web or in print that give a solid overview of Prohibited Transactions. Additionally, the company that your client chooses to open the self-directed IRA should itself have a solid knowledge base from which to draw.