Self-Directed IRAs and Fraud? A Timely Warning

BawldGuy Here: Sadly, the onset of investment scams aimed at Self-Directed qualified retirement plans was inevitable. When nearly $100 Billion is sitting in these plans, the unscrupulous, unfortunately, sees opportunity. This is why, whenever I’ve headed group investments, a third party, completely detached has been installed as both auditor, bookkeeper, and accountant. It’s the only way to fly. My thanks to John for this well timed post.

With doing blogs on the BawldGuy site, it is nice that the website owner is a person who, like many of us, cringes when stories come out related to scams and frauds. Besides the obvious pain that it causes to those who have been negatively affected by such schemes, it also makes no sense. True, many of these schemes tend to be Ponzi schemes (NOTE: if none of you are familiar with how term term “Ponzi Scheme” came to be….it is an interesting story that everyone should read) whereby investment dollars always need to come in to pay those individuals who are due money. But, what is really sad, is that there are so many good, solid investment options out there, a fraudulent promoter need not try to prey and take advantage of others.

In fact, for anyone who is reading this and who has also spoken to me, you know that one of my mantras in working with clients in establishing self-directed IRAs and 401Ks is that I do not give tax, legal, financial or investment advice, and painstakingly refrain from the conversation. As I tell many, “my job is to establish your plan so that you can self-direct….but, I will never sell you anything.”

So, with the 2008 crash and an ever-evidenced weak if not abysmal market, it is only more prevalent that self-directed plans are gaining more and more popularity. In fact, they would be even more popular except for the fact that, statistically speaking, very few people are aware they can even self-direct their retirement assets.

Well . . .

With all the good that a self-directed plan can provide to the owner/trustee of their retirement plan, a few bad apples out there have found a way to prey on individuals. Recently, the SEC Office of Investor Education and Advocacy (www.investor.gov) sent out an Investor Alert related to recent fraud cases whereby the funding for the investment made by the investor came from self-directed plans. They noted a recent increase in reports or complaints of fraudulent investment schemes that utilized a self-directed IRA as its main feature. Why? Well, simple. Especially in these uncertain economic times where people have lost jobs, etc., many people have retirement plans that they can use for investment purposes. It is a relatively attractive platform by which these people can secure investment funds vs. writing out a check from their local bank account.

The SEC continued by stating, “While self-directed IRAs can be a safe way to invest retirement funds, investors should be mindful of potential fraudulent schemes”. You see, self-directed plans carry the responsibility that individuals be responsible for their funds and invest them wisely but also within IRS regulations. This gets back to a blog I did before and the contents of which the SEC echoed…..IRA custodians do not, generally, review your potential investment for either its perceived success, its compliance with IRS regulations OR that one is not being defrauded. Thus, the warning.

Unfortunately, and the SEC has cited many in a recent report, there are unsavory folks out there who defrauded individuals. In many cases, these unsavory folks specifically “pitched” the self-directed IRA as the vehicle of choice to make the investment. Besides the ease of “pitching” self-directed plans because of their relative ease in establishing, etc., illicit promoters know that a “boatload” (that’s my official term) of accessible funds are tied up in retirement plans. As evidence, the SEC has noted that as of 2011, it is estimated that US investors held approximately 4.7 trillion in IRAs…..and, folks, this is not counting other retirement plans (e.g., 401Ks, 403Bs). And, by the way, it is further estimated that investors only hold approximately 2% of this money, or 94 billion, in self-directed IRAs.

Not surprisingly, fraud promoters who engage in fraudulent and Ponzi-based schemes want to exploit such plans as the plans allow individuals to hold within their IRA any permissible asset class investment, which includes unregistered securities. This coupled with the fact that IRA custodians rarely, if ever, are responsible for investigating such investments on behalf of the IRA owner….remember, it IS self-directed. And, remember, such a wide array of investment options is totally permissible as the IRS only restricts investments in life insurance contracts and collectibles as non-permitted asset investments using such plans.

So, according to the SEC, what are some basic ways that fraud promoters misrepresent potential investors into investing into their offerings? Well, here are a few:

Misrepresentations Regarding Custodial Responsibilities – Boy, this is an easy one. A promoter says something to the effect of, “hey, your IRA custodian wouldn’t let you invest in this if it wasn’t on the up-and-up, right?” Or, “we totally understand your interest and concern that this investment is permissible under all IRS rules”….they proceed to advise that someone at their “company” has checked it out with all the national IRA custodians and received “clearance” that this type of investment is permissible. They even suggest that the custodians “believe” this is an outstanding investment opportunity. Another will be an outright lie where the promoter says that the client’s IRA is protected up to $250,000 by the FDIC. This, by the way, may very well be true on CASH assets HELD by the IRA custodian, but it certainly isn’t true if the investor invests in any other asset class investment….legitimate or not (e.g., Ponzi-based or other fraudulent scheme by the promoter)

Again, buyer beware.

Exploitation of Tax-Deferred Account Characteristics – Self-directed plans are, generally speaking, tax-deferred plans that carry significant penalties for prematurely withdrawing (not investing…withdrawing) monies and fraud promoters may know this and use it to their advantage and, possibly, your detriment. Want a couple of examples? Well, first, most people know that since the gains in the plan are tax-deferred and they will not be taking out distributions until, generally speaking, retirement years, that they can “wait.” Let’s break this down further…..let’s say you were 50 years of age and you invested into an investment that promised a higher return the longer your funds are in the investment. Well, you might be thinking that since you don’t need these monies….immediately….that you can wait and get a higher return. Some have done this and have found that their investments disappeared somewhere along the line by a fraudulent promoter. This is not to say that such investments (e.g., higher returns for long hold times) are fraud-based, you just need to do your full diligence as this is being used as an example.

A second example is what I call WISH….the individual fears that their investment may be in trouble for a variety of reasons….and the promoter of the investment tells them to be patient. The IRA account holder may fear…and they shouldn’t by the way….that if they contact the SEC, IRS, etc., that the call they make may also trigger an early withdrawal “tax” or audit of some type. As a result, they kind of bury their head in the sand and “wish” that things will get better.

Lack of Information for Alternative Assets – As has been evidenced over the last several years, it is fair to say that your investment funds are not necessarily “safe” by any means in the market. And, alternative assets can be a safe, sound, “sleep well at night” investment that YOU feel comfortable making. As an example, I recently did a hard money loan where the loan I was giving out was “secured” by a PAID OFF property that had no liens of any kind against it. The borrower put up their home as security. In my mind, that was extremely secure….and certainly much more secure than Wall Street.

But, that being said, it is true that such investments may not have significant and comprehensive information related to the investment in order for the investor to make a decision based on historical performance and conditions, etc. And, where GE stock has been around for a long time, the alternative asset may not have that kind of history or track record of performance. And, even if such information is available for the investment, one should ask whether the investment (or fund) has been audited by an independent party? Something to think about.

What to Do? – Pull in your professionals. Ask questions and lots of questions. And, then ask some more. As the SEC says, be mindful of “guaranteed” returns and avoid unsolicited investment offers from people who may not have your best interests at heart. If someone is telling you about a 16% return on your investment, you might want to ask “what’s in it for you?” Not only is that a legitimate question, you may also receive a very legitimate response….but, you should still ask the question.

The SEC cited some recent cases if you want to do some more reading. Check out:

SEC v. United American Ventures
SEC v. Stinson
SEC v. Durmaz
State v. Smith (24C02-1102-FB-00044) and State vs. Snelling (24C02-1102-FB-00046) (Indiana)
In re: Stephen Edward Gwin, et. al. (Missouri)
Texas v. Warr Investment Group, LLC, et. al (Texas)

For more information, go directly to the source. Please visit http://www.investor.gov/news-alerts/investor-alerts/investor-alert-self-directed-iras-risk-fraud for the alert from the SEC.

Related posts:

1. Self-Directed IRAs – A Few Answers For You
2. Self-Directed IRAs and 401Ks – Accounting For Contributions
3. A Timely Warning To Those In The Middle Of Current Tax Deferred Exchange (1031)
4. Self-Directed IRAs and 401Ks – Don’t Trip Over the Crack
5. Self-Directed IRAs/401(k)s – The Maze of Custodians, Administrators and Facilitators