Chances are, you either have an IRA, or a 401(k) you plan to convert at some point to an IRA. And chances are, you’re less than confident in how your dollars are invested. What are the BEST investments for your IRA?
In this article, we’ll look at some rules of thumb and pros and cons for choosing assets in your IRA. First, let’s look at an overview of retirement accounts and where your money might be now.
Over 43 million American households have individual retirement accounts, or IRAs. According to Rothira.com, 35 percent of households contribute to a traditional IRA, 36 percent contribute to a Roth IRA, and 9 percent contribute to a SEP or SIMPLE IRA. One in five investors has more than one type.
IRAs had an average balance of $103,500 at the end of the second quarter 2017—just slightly higher than the average 401(k) balance of $99,900, according to Investopedia.com. Total IRA assets topped $9 trillion dollars for the first time the end of 2017, reported the Investment Company Institute.
So where is all that money invested? According to financial journalist Wendy Connett, the most common assets held in IRAs—in order—are:
- mutual funds
- individual stocks
- money market funds
- and bonds.
Obviously, those are the most “traditional” options, but there are many more. Self-directed IRAs allow you to invest in almost any asset. However, just because you CAN put something in your IRA doesn’t mean you SHOULD—even if it might be a good investment outside of an IRA.
Where your IRA fits into your personal economy
Most investors need various assets that serve one of three main purposes:
#1: Savings. You need a good place to store and grow cash safely. This should be your liquidity; your savings for emergencies and opportunities.
#2: Growth. You need assets that will grow investment dollars long-term, ideally faster than cash alternatives yet without unnecessary risk to principle.
#3: Income. You need assets to generate income or cash flow, especially as you near retirement.
(You might notice that the order above is somewhat sequential. You should SAVE before you invest. Most people will choose to GROW their assets while young and gradually transition to CASH-FLOWING assets that will eventually supplement or replace their earned income, although we recommend practicing generating income with your assets long before you have to rely on it.)
Now let’s look at those three categories again with IRAs in mind:
Is your IRA the best place for your savings? No, it’s not! Your savings should be available for you to use for curveballs, emergencies, investments and opportunities. In contrast, your retirement account is designed to tie money up for decades! Unless you are 59-1/2, your IRA is a terrible substitute for savings. You will have to pay a penalty and (depending on type) income tax, too.
Plus, you don’t save the same way you invest. Your savings should be safe, liquid, guaranteed to grow and completely free of any foreseeable risk or volatility. In contrast, investments aim for higher rates of return and may tie your money up for years at a time, for instance, in a private equity fund. This is where we recommend you save.
Is your IRA a good place for long-term growth investments? Yes! Your IRA is designed for long-term growth, so that should be your focus when choosing assets for your retirement account. And when you have ample savings and liquidity outside of a retirement account it allows you to focus your IRA properly on long-term gains.
Examples of growth assets include:
Stocks and mutual funds. Since equities will “roller coaster ride” and are subject to systemic risk, never rely on stocks as your only (or even your primary) investment! However, in a well-diversified portfolio, equities can have their place.
Whether you choose individual stocks, index funds and ETFs, managed funds or other types of mutual funds, aim for broad diversity and low fees. Avoid “target date funds” which seek to adjust risk for you with an ever-changing stocks vs. bonds plus other (sometimes complex and risky) assets. Instead, diversify your own holdings with other assets and—unless you enjoy picking your own stocks—opt for no-frills funds that follow the S & P 500, the Russell 2000 or other indexes that track a wide swath of the market. In general, it’s difficult for managed funds to beat the returns of the market as a whole, as any advantage is often erased by higher fund costs.
Pros: ease of investing, plus long-term returns can do well if you choose wisely and don’t lose too much to overzealous or hidden fees.
Cons: volatility, risk of loss, frayed nerves.
Although stocks and mutual funds are the most common asset to hold in an IRA, there are a myriad of other options. The rest of the assets mentioned below are available through self-directed IRAs, which give you a much broader range of choices.
Life Settlements. Did you know seniors can sell their life insurance policies they no longer need and receive cash they can use as a living benefit? These policies are known as life settlements and can be package together in funds that represent the secondary market for life insurance policies.
Life settlements are one of our favorite investments, especially for self-directed IRAs. They provide much-needed diversification, bringing balance and stability to stock-heavy portfolios. Life settlements are based on actuarial math, not market trends and are completely non-correlated to the stock market.
Pros: not connected to stocks, bonds, real estate, and geo-political happenings. While not risk-free, well-managed life settlement funds have a history of healthy, reliable returns.
Cons: You must be an accredited investor to participate in some life settlement opportunities, and a time commitment of 7-10 years is common.
Other possibilities for a self-directed IRA:
Private lending vehicles. While many private lending vehicles are income-oriented, some are designed for growth. Investor funds are used to provide capital for growing and established businesses. Investment terms may be short, such as one year or less, but capital and growth can be rolled into additional terms.
Pros: Diversification away from stocks and real estate. Industry grew during the last recession.
Cons: Competition, lack of collateral and lack of regulation can make this a riskier environment.
Gold. Gold has an attraction as a precious metal, a currency, and a hedge against the U.S. dollar. While it doesn’t exactly fit our definition of an “investment” and we would never recommend holding a large percentage of your assets in gold, some people sleep better at night with this precious metal in their portfolio. If that describes you, by all means you can put some physical gold (bullion, Krugerrands, etc.) in your IRA (or gold-related stocks, if you prefer).
Pros: Gold has a long history and has been valued across the ages on multiple continents.
Cons: It doesn’t produce cash flow or dividends, it can be volatile, and it’s easier to find a seller than a buyer.
For more information, read “Should You Have Gold in Your Portfolio?”
Is your IRA a good place for assets that produce cash flow? Income assets are not our favorite for IRAs, but it does depend somewhat on your circumstances. If you are already taking disbursements, income investments can work well in a retirement account. However, there are some issues to be aware of that make income investments a less-than-ideal fit for IRAs.
Private lending and real estate. For instance, you can end up with cash flow that is difficult to reinvest, as good income assets such as bridge loans require lump sums. Additionally, you end up with Unrelated Business Taxable Income (UBTI) in your IRA, which is undesirable. (More about that in this podcast: “IRA Investing for Growth.”) And if you hold cash-flowing real estate investments in your IRA, you’ll have a lot of awkward rules and regulations to work around, in addition to the other issues.
That doesn’t necessarily mean you should definitely cross off “real estate” from your list of IRA possibilities. If you have a strong desire to own real estate and all of your assets are currently in retirement accounts, you may decide to make it work. But be aware of the rules. For instance, financing will be more complicated as the IRA must own the property, not you personally. And any personal use whatsoever of a property held in your IRA is strictly forbidden. So don’t start thinking you’re going to buy a vacation home to rent out and occasionally use yourself with your IRA!
Bridge loans. Another option for holding real-estate-related investments in your self-directed IRA would be bridge loans or fractional real estate investments (such as a share of cash flow and/or equity in an apartment complex). Well-vetted bridge loan investments can create steady income, generally at rates significantly higher than a bank CD or similar vehicle. Again, these cash flow vehicles work best when you are in the withdrawal phase.
Mineral rights leases. These energy investments can be attractive because of the healthy cash flow, proven business model and short-term commitment (as little as one year).
We suggest scheduling a consultation with us to discuss whether such options would be suitable for you, or whether there might be better choices.
IRA Rules of Thumb for Investing Success
Follow the rules below for best results:
- Focus your IRA on long-term growth investments.
- Don’t put all of your eggs in the stock market basket, as that will expose your whole portfolio to systemic market risk.
- Use self-directed IRAs to diversify investments and asset classes.
- Save elsewhere so that you do not have to disrupt your long-term growth investments when you have a need for cash.
- IF you are using your IRA for cash flow, consider purchasing income assets.
- If possible, hold your investment real estate outside of your IRA.
- Get professional advice on the pros and cons of various investment decisions in your IRA.
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