Self-Directed SEP-IRA

It’s about time I address the issue of our SEP-IRA as it makes up 15% (and growing) of our net worth.  SEP stands for Simplified Employee Pension and is mostly used by small businesses to provide a tax-advantaged retirement plan for their employees without going to the trouble of putting together a complicated 401k plan.  Like other IRAs, there are annual contribution limits, but unlike most IRAs which cap limits at around $5,000, an employer can contribute up to 25% of an employee’s wages up to $49,000 to a SEP-IRA.

Also, a SEP-IRA need not be under the control of a financial services institution like Fidelity or Vanguard.  The owner has complete control over the account, so long as he/she doesn’t engage in so-called “Prohibited Transactions.”  These can get a little complicated but it basically means that the employee must make decisions for the IRA which are in the IRA’s best interest, and not anybody else’s interest.  For instance, you are allowed to buy real estate with the IRA and rent it out to someone at a reasonable rate.  However, you can’t rent it out to yourself for free or a family member for close to free: that’s prohibited.  Any rent you do collect (like interest, dividends and capital gains in most IRAs) is tax deferred!

They recently garnered a lot of media attention when it became clear that Mitt Romney has an IRA worth as much as $100 million.  How could he grow it so large if contribution amounts are limited?  Simple: he’s got complete control of it!  He  was able to use the funds to invest in his own company, Bain Capital Management, and Bain even allowed employees to directly invest in Bain-managed firms.  If the company made a really good bet (which is the whole point of private equity) then employees like Romney stood to win huge!

However, there are some issues with investing in anything which is debt-financed, like the companies private equity firms tend to manage.  Any income the IRA earns in a debt-financed operation is considered Unintended Business Income and subject to a special tax (UBIT) at 35%.  However, if you read the Romney article you’ll see that one can avoid this UBIT by opening an offshore “blocking” corporation and investing in it.  Then this corporation will, in turn, invest in the debt-financed operation… Too complicated for me.

So what are we doing with ours?  Not a lot right now.  I’ve got about $55,000 in it right now and the only investments I’ve made have been in CDs which, as I’m sure you’re aware, are not high performers these days.  I’m currently trying to open a brokerage account for the IRA, but I’ve been frustrated by the fact that some companies will not manage these types of account.  ScottTrade allowed me to open an account and fund it with a token $500 before kicking it back to me a week later after the “New Account” department determined they don’t actually support those types of accounts.  Now I’m trying again with Fidelity.  I like Fidelity because they offer a wide array of investment opportunities from stocks and bonds to mutual funds and even money market funds.  Hopefully they will be more eager for my business.

And, there’s a really exciting new development in this area: the JOBS Act (should it pass) will allow small investors like me to make investments in startup companies through mechanisms like Crowdsourcing.  This is supposed to be a boon for startups and small businesses in the US, but is also potentially an invitation for fraud.

Upside

• High annual contribution limits
• Freedom to invest in (just about) anything
• Tax-deferred growth

Downside

• You need your own (profitable) business to open one, or convince the owners of the small business you work for to make gigantic contributions for you.
• Freedom to invest in (just about) anything: if you sink your retirement into pig farming on the moon, you may find that you did not meet your retirement targets when you retire.
• Complicated structure and rules can lure unwitting investors into prohibited or taxable transactions.

IRS rules for SEPs, including what constitutes prohibited transactions are documented in IRS Publication 560.  UBIT is covered in IRS Publication 598.  Of course, you probably want to consult a financial advisor and probably a lawyer before trying to start your own.  We used Guidant Financial to set ours up in 2009–it was a little pricy, but worth it in the long run.  You can also set them up on your own and save yourself thousands, you just want to be very careful.

Update

President Obama signed the JOBS Act into law last week, opening the door for small-time investors like myself to take a gigantic risk on startup companies. Still waiting to see what sorts of avenues will open up, will it be Kickstarter-like websites? Will there be an exchange?  Time will tell…