01 Jul Using a Self-Directed IRA for Investing in Crowdfunding Opportunities
Investing in crowdfunded equity, debt and real estate represents a fundamental shift in business and asset capitalization. It’s what’s been truly termed as “democratization of capital.” The opportunity for investing in these new asset classes will only proliferate when Title III is finally implemented. And, with trillions of dollars in retirement plans across the country, IRAs and 401(k)s may be yet another currently-invisible elephant in the room. But the risks may outweigh the promises of grandiose opportunity for most of the non-accredited folks. Unless you’re like the last GOP presidential hopeful Mitt Romney who reportedly has millions stashed in his retirement accounts, it’s not likely that crowdfund investing in risky startups is the best move. For those with a steel nerve and the ability to play the risk card a bit, investing in crowdfunding with the likes of one’s retirement kitty–especially with the right deal–could have enormous payouts. Just ask Mitt Romney.
How a Self-Directed IRA Works
Before we dive into the opportunities available to self-directed IRA holders, it will be helpful to discuss what a self-directed IRA is, how it works, how one is set up and what are the upfront and on-going costs of such an account. Like a typical IRA a self-directed IRA is structured in one of two ways: as a Roth with tax advantaged investing done with after-tax dollars and as a traditional IRA, with tax advantaged investing done pre-tax. In a traditional IRA the tax is incurred when the money is withdrawn and minimum percentage withdrawals begin to incur at the age of 70.5. Roth IRAs, on the other hand (and due to their post-tax nature), have no minimum withdrawals and are available to grow tax-free for infinity, with the exception of potential alternative minimum tax requirements.
A self-directed IRA is a uniquely structured version of one of the two accounts mentioned above. In a typical IRA, individuals are limited by the investments available through the custodian. A self-directed IRA is uniquely structured with the barrier of an an LLC where the individual is the sole managing member of said entity. As a result, the managing member can “direct” where investments are made. With the exception of a few rules that include self-dealing and family members, a self-directed IRA investor has the unique ability to invest in things like real estate, precious metals, private equity (including crowdfunding) and other securities deals. A great diagram of the structure is outlined below.
In a typical self-directed IRA, existing IRA or 401(k) funds are “rolled-over” into a new self-directed account fully-managed by the LLC whose sole managing member is the investor himself/herself.
Focusing on the Least Risky Investments
While the upside potential may be as huge as all the hype of crowdfunding would have you think, the risks of investing in crowdfunding with your self-directed IRA are likely too wide for most. The loss of principal in something as sacred as an IRA may be too much for most–especially the non-accredited folks–to be able to bear. It’s actually one of the reasons typical IRAs and 401(k)s were structured with custodians and geared toward equities and debt products in a seemingly diversified way. But if history can teach us anything it’s that even the indexed equity products aren’t fully devoid of systematic risk. A rising tide may float all boats, but in 2008 many boats were left on dry ground when the inverse occurred.
Overcoming the risk of investing in crowdfunding with a self-directed IRA is not easy and requires a keen eye on the deal–whether real estate, equity or debt. Sometimes the best opportunity is a diversified pool of equities, much like a mutual fund. I expect such a broad-sweeping product may become available in the crowdfunding arena, but we’re just not there yet.
My personal take is that certain cash-flowing equity deals (like MBOs or LBOs with immediate payouts), PIPEs (private investment in public equity) in an APO (alternative public offering) and some crowdfunded and cash flowing real estate deals may actually be well-suited for the self-directed IRA. What do you think? Do you think investing in crowdfunded deals with a self-directed IRA is a good idea? Is it worth the risk? Or, is it a matter of personal circumstance?