With its tax benefits and the potential for higher gains compared to investments from the stock market, a private equity investment can be one of the more rewarding investments in a self-directed IRA. Here’s a guide to help anyone interested in this investment type.
In this article:
- Overview of Private Equity Investments
- Self-Directed IRA Guidelines
- Considerations and Recommendations for Investing in Private Equity Investments
- Which Investors Might Not be a Good Fit for Private Equity Investments?
- Comparing the Costs to Any Potential Upside of Investing in Private Equity
Private Equity Investment | What It Is And How It Works
Overview of Private Equity Investments
For some, saving for retirement means investing in more typical investments, like stocks, bonds, and mutual funds. However, investing in a Self-Directed Individual Retirement Account (IRA) opens up numerous other investment opportunities.
A self-directed IRA allows for alternative investments, such as:
Private equity investing can be lucrative from a financial and investment perspective. In fact, the Private Equity Growth Capital Council reports that private equity outperformed the Standard & Poor’s 500 index by 5.2 percent during the 10-year period ending in 2015.
A private equity investment, similar to all investments, comes with complexities. Sometimes, it may not necessarily be the most appropriate investment strategy for every investor.
Fractal Profile Wealth Management President and American Society of Fiduciary Education Founder and CEO Hunter Unschuld cautions that a private equity investment is the epitome of “all or nothing.” He states that to invest in private equity is only either a home run or a strikeout.
- If one hits a home run, then the gains are greater than those one may receive in the stock market. Additionally, those earnings grow in the account tax-free.
- On the other hand, one of the biggest disadvantages of a private equity investment is if one strikes out. Unlike losses in a regular investment, one can’t write off losses taken in a private equity investment on their taxes.
The following are some of the best practices for investors to observe should they decide to invest in private equity through a self-directed IRA.
Self-Directed IRA Guidelines
Similar to a Traditional IRA and a Roth IRA, self-directed IRAs also have certain tax advantages. However, the Internal Revenue Service (IRS) imposes certain self-directed IRA rules and regulations when it comes to their management and use.
According to the CEO and founder of Socotra Capital Adham Sbeih, investors often tend to overlook the significance of these rules. One rule that most people tend to break is the fact that they can’t personally benefit from their IRA.
What is this rule all about? The IRS prohibits investors of self-directed IRAs from conducting transactions that produce an indirect benefit to them.
- The IRS doesn’t allow investors to lend themselves money from the IRA.
- They also can’t use those funds to purchase a vacation home.
- The IRS considers these activities to be under the umbrella of self-dealing, which is prohibited.
Equity Institutional Senior Vice President and COO Jeffrey Kelley also states that investors should be aware that transactions involving certain individuals are not allowed. These include transactions between an IRA and disqualified persons.
Should the investment activity go beyond what the IRS allows, the end result may prove to be damaging.
The worst that can happen is for the IRA to lose its tax-advantaged status and incur penalties and taxes on the prohibited transactions. This can essentially erase any gains that one made by investing through the IRA in the first place.
Disqualified Persons Definition: These are often certain family members and fiduciaries. They can also be a business or businesses that either the investor who owns the IRA or another disqualified person controls.
Considerations and Recommendations for Investing in Private Equity Investments
Private equity can diversify an investment portfolio. However, it’s equally important to understand where and how it fits in terms of one’s risk tolerance.
According to Unschuld, investing in private equity through a self-directed IRA raises the risk profile of an investor. To offset the higher risk this gives, the investor should take a more conservative approach in the other investments in their portfolio.
Wells Fargo Private Bank Chief Investment Officer Erik Davidson says that investors should approach private equity investments through a self-directed IRA with a holistic view. He further adds that investors should look at these investments with the entire portfolio in mind.
Davidson’s Recommendations for Investing in Private Equity
- Creating a balance between investments — Investors should focus on balancing between investments that have greater liquidity and a different risk-and-return profile on the one hand and private equity on the other.
- Plan for the long-term — He also urges investors to consider their broader timeline until retirement.
- Perform due diligence — According to Davidson, this is a must for investors planning to invest in private equity.
- Diversify within private equity investments — Davidson recommends this to avoid significant deal-specific exposure. Another supporter of diversifying is Sbeih, who believes that investors should consider diversifying into investments that counterbalance the weaknesses a private equity investment may carry. They need to have a tight grasp of how the investment winds down, which includes the timeline and process involved to make an exit.
Which Investors Might Not be a Good Fit for Private Equity Investments?
Davidson says that this investment strategy is not appropriate for investors who:
- Will soon need a certain level of liquidity
- Lack assets in their portfolio for diversification
Comparing the Costs to Any Potential Upside of Investing in Private Equity
AG Assed Advisory Principal and Founder Anthony Glomski says that, for some investors, the cost of private equity in a self-directed IRA can be restrictive.
Glomski states that many private equity investments their firm advocates for require the investor to be a qualified purchaser (QP). A QP is an individual who has at least $5 million in investable assets.
He adds that, typically, investments that do not require the individual to be a QP have bigger fees and expenses. Additionally, their performance also has an increased risk of being compromised.
For those planning to invest in either a venture capital fund, private equity fund, or fund of funds, it is necessary to carefully scrutinize the fee schedule.
This gives them a realistic picture of how much the investment will cost annually. This helps investors compare the performance of the fund and decide whether it is worth any gains they anticipate in the long term.
Tax implications is another factor that the investor should consider. Kelley states that depending on the account type, returns from a self-directed IRA can either be tax-deferred or tax-free.
Certain investments made with the use of self-directed IRAs may also generate unrelated business taxable income. Such is the case in:
- Limited partnerships
- Limited liability companies
- Other similar entities
In a self-directed IRA, it is the responsibility of the investor to be aware of tax liabilities.
- The investor invests in private equity in a business or businesses that generate income.
- The income is not paid out as a dividend.
- The investor has to pay tax on that income or face a penalty.
In this particular scenario, even if the money is inside the IRA, it’s still subject to tax in the year it was distributed. It is a great advantage to understand beforehand how private equity may reshape one’s tax outlook.
To determine if private equity investments are the right fit, and to make the most of it, it’s necessary to have a firm grasp of the basic concepts. Before making an investment decision, it’s best to gain an understanding of that investment and see if it aligns with one’s personal investment goals and philosophy.
Do you have other questions about private equity investment? Ask us in the comments section below!
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