By Patrick Hagen
The past year was marked by historic volatility as the market collapsed in March before finally recovering and ending the year strong. But even with this impressive recovery, significant issues remain with the U.S. economy due to the impact of the coronavirus. As a result, many investors are looking to take advantage of the market rally and build diversified retirement portfolios.
One option for investors here is to take advantage self-administered individual retirement accounts (SDIRA), which are experiencing a resurgence in popularity. Their main feature is to allow investors to diversify out of the market and into alternative options, such as private equity and private debt, while providing tax advantages.
One of the attractive aspects of SDIRAs is the role they can play in tax-efficient investing. Tax-smart investing is a primary consideration right now, not only due to the general uncertainty surrounding financial markets, but also the ever-increasing national debt. That bill will have to be paid at some point, and it could take the form of tax increases for US citizens.
As a type of ARI, SDIRA has integrated tax benefits related to capital gains and income tax. With this in mind, proper planning for investors involves determining what types of investments are best suited within an IRA. A standard private equity offering, convertible debt investment, venture capital fund, or real estate are all assets that might make sense for a long-term IRA implantation. The tax burden is deferred in traditional IRAs and eliminated in Roth IRAs, allowing individuals to keep that money invested and grow it throughout their lives, which could translate into a larger nest egg to be drawn when they are reaching retirement age.
Overview of Private Equity
When you invest in private equity, venture capital (VC), and other start-ups, the opportunity comes with the high risk and high reward aspect. Every publicly traded company started out as a private company at some point, and anyone who invested at the ground level was probably very successful, as these stocks got exposed to the general markets and became much more valuable.
Whether you invest in a start-up bank, private venture capital fund, or hedge fund, the potential returns are usually higher than those of common stocks, mutual funds, or ETFs. Is there more downside risk in some cases? Absoutely. But investors here are betting on the upside.
Private debt details
When it comes to private debt, there are two types to consider. One is convertible debt, which is often used in raising capital at an early stage for start-ups until they are able to raise larger capital as part of a bid. ‘actions.
For example, let’s say someone invests $ 50,000 in a start-up business. Rather than receiving shares, they would get a promissory note that could be converted into shares, usually at a price lower than the price of the next round of equity financing. Some people like to invest in convertible notes because it allows them to acquire more shares due to compound interest and conversion discount than if they were waiting for a share offer.
The other type of debt is secured real estate, where an IRA lends money to a business or individual secured by a trust deed or mortgage, and the IRA receives an agreed interest rate on that. investment. This can be an attractive alternative diversification strategy, as the investor essentially becomes a lender like a bank in exchange for a fixed, pre-planned return in their IRA.
This is a unique opportunity because of the gap that exists between what small community banks are willing to lend on certain transactions and what large banks typically lend on large transactions. The result is a middle market where investors can deploy funds. If an IRA makes this investment in private notes, the return can be very solid and the collateral backing provides relative security.
Truly diversified pension plans
In some cases, investors can be relatively diversified in terms of personal financial statements and assets. For example, they may own real estate, private debt investments, or even startups or private equity stakes. But these assets are rarely held in their retirement portfolio, which often makes up the majority of their net worth.
For those who work with a brokerage firm on their retirement account, that firm’s restrictions inherently limit their ability to invest in certain assets. It is likely that they will only have exposure to bonds, stocks and ETFs, and will not be able to invest in something alternative and uncorrelated. Therefore, investors may want to consider how diversified their retirement portfolio really is and whether they could benefit from setting up an SDIRA, especially for first-time access to alternative investments through their retirement account.
A major impact on the SDIRA space was born from the Jumpstart Law Our Business Startups (JOBS) in 2012, which legally allowed non-institutional investors to invest in alternatives. Previous legal language was very restrictive as to what an accredited investor could be, so there were plenty of investment opportunities to choose from, but a very small number of people could actually invest in them.
The JOBS Act has made this type of investment more accessible, and awareness is gradually growing among non-approved investors as well as approved investors. Additionally, the fundraisers realized they needed to refine their message. So instead of targeting only family offices and institutional investors, they have broadened their scope to include accredited high net worth investors and non-accredited investors who meet certain guidelines. As a result, it is easier for them to raise capital, and many people who want to invest in start-ups and private companies find that they now have this ability.
However, there is still significant room for growth when it comes to investing in alternative assets through SDIRAs. In fact, “The Retirement Industry Trust Association (RITA), a self-directed trade group in the IRA industry, estimates that the assets of these types of retirement accounts represent 3 to 5% of the total assets held in IRAs. With widespread skepticism about public markets persisting among investors and the growing appetite for alternative options, alternative assets held in SDIRAs could increase dramatically in 2021.
About the author: Patrick Hagen
Patrick Hagen is National Director of Business Development at STRATA Trust Company. He has over 15 years of professional experience with SDIRA. Through his work, he contributes to the training of investors and financial advisers, by making them aware of SDIRA and alternative investments.
The information provided in this article is educational content and not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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