Retirement Security: Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets
Released: 2017-01-09T00:00:00

Letter

Background

In passing the Employee Retirement Income Security Act of 1974 (ERISA), Congress sought to encourage individuals to save for retirement in tax-favored retirement arrangements. Traditionally, account owners participating in these arrangements defer taxes on contributions to these accounts up to certain statutory limits, and in general, contributions and investment earnings on those contributions are not taxed as income until the account owner withdraws them from the account. In addition, account owners typically direct their investments and make decisions regarding the purchase, sale, reinvestment, and withdrawal of investments. Individuals saving for retirement in the United States typically save through IRAs or an employer-sponsored plan, like a 401(k) plan.

What Is a Solo 401(K) Plan? While employer-sponsored plans generally have multiple employees participating in their plans, a solo 401(k) plan—also called an individual 401(k), a one-participant plan, self- employed 401(k), or self-directed 401(k) plan—are qualified retirement plans designed for the self-employed or a small business owner with no employees (beyond themselves and their spouse). The Economic Growth and Tax Relief Reconciliation Act of 2001 included reforms that generally provided small business owners with no employees and the self-employed the same advantages of a conventional 401(k) plan, such as employee deferrals, loan features, and Roth contributions. Solo 401(k) sponsors select plan investment options and may contribute to the plan both as plan sponsor and plan participant up to a combined $54,000 per account (or $60,000 if age 50 or older) in tax year 2017. In addition, plan sponsors may elect to maintain exclusive authority and discretion to manage and control plan assets without involving a third-party. to qualify for preferential tax treatment. The most common IRA types are: (1) traditional IRAs (which allow eligible individuals to make tax-deductible contributions and accumulate tax-deferred investment earnings); and (2) Roth IRAs, (which allow eligible individuals to make after-tax contributions and accumulate investment earnings tax-free).

401(k) plans have become the most common employer-sponsored retirement savings vehicle in the United States. Created by the Revenue Act of 1978, 401(k) plans typically allow participants to specify the size of their contributions and direct those contributions, as well as any made by their employer, to one or more investments among the options that the employer has preselected as offering effective diversification across broad asset classes. Investment options generally include mutual funds, company stock, and money market funds. DOL’s Employee Benefits Security Administration (EBSA) is responsible for, among other things, administering and enforcing the fiduciary, reporting, and disclosure provisions of Title I of ERISA. Self-employed individuals or owners of small businesses with no employees may sponsor a 401(k) plan, known as a solo 401(k) plan. To set up a solo 401(k) plan, individuals must adopt a written plan document, arrange a trust for the plan’s assets, develop a recordkeeping system, and provide plan information to employees eligible to participate. Solo 401(k) plan account owners can select the plan’s investment options as plan sponsor and invest in these options as the plan participant. (See sidebar for further description of solo 401(k) plans, the 401(k) plans we focus on in this report.)

The owner of a tax-deferred account cannot keep retirement funds in their accounts indefinitely. When IRA owners or 401(k) plan participants reach age 70½, they generally have to start taking annual payments—known as required minimum distributions (RMD)—from their plan savings based on their account balance and life expectancy. The distribution for the year in which a participant turns 70½ must be made no later than April 1 of the following calendar year and no later than December 31 for any other subsequent year.

Investments

Account owners have wide latitude in the types of assets in which they can invest and custodians can choose to limit which type of assets they will allow. While some custodians generally limit investments to publicly traded assets, other custodians allow investments in a range of unconventional assets. (See table 1.)

Roles and Responsibilities

Under Title I of ERISA, fiduciaries of ERISA-covered plans, such as conventional 401(k) plans, must carry out their responsibilities prudently and solely in the interest of the account participants and beneficiaries. For ERISA-covered plans, a fiduciary includes a person who has discretionary control or authority over the management of an account, including management over the account’s assets, or anyone who, for a fee or other compensation, renders investment advice with respect to an account. Among other duties, fiduciaries have a responsibility to select and monitor investment options and service providers; report account information to the federal government and to participants; and ensure that the services provided to their account are necessary and that the cost of those services is reasonable. Many actions needed to operate a qualified retirement account involve fiduciary decisions, whether an individual or plan hires someone to manage the plan or manages the account themselves. However, unlike conventional 401(k) plans, solo 401(k) plans are generally not covered under Title I of ERISA, including the fiduciary standards in Part 4, or subject to DOL oversight because they are sponsored by employers that have no employees.

The IRC generally requires plans (including certain IRAs and 401(k) plans) to hold plan assets in a trust fund maintained for the exclusive benefit of employees and their beneficiaries. The IRC establishes the requirements that a trust must satisfy in order to “qualify” for favorable tax treatment. In some cases, both the employer and employee may contribute to the trust. The assets are held in trust until distributed to the employees or their beneficiaries according to the plan’s provisions.

Individuals who own a business or are self-employed can establish a 401(k) plan that allows unconventional assets, a solo 401(k) plan, either on their own or by consulting a professional or financial institution—such as a bank, mutual fund provider, or insurance company—to help them establish and maintain the plan. Because solo 401(k) plans generally do not have to comply with ERISA Title I, Part 4 fiduciary requirements, the individual, as plan sponsor, may also serve as the plan fiduciary and trustee.

Individuals can establish an IRA with a bank or qualified firm that acts as a trustee or custodian of investments contributed by the individual or purchased with funds contributed by the individual. A traditional IRA is established after a custodial agreement (IRS Form 5305) is fully executed by both the grantor (account owner) and the trustee (custodian). IRS developed a model Form 5305 and permits custodians who use the form to incorporate additional provisions as long as the provisions are agreed to by the account owner and custodian, and comply with federal and state requirements. These additional provisions typically outline the parties’ roles and responsibilities. Custodians are not required to use the model form, and are instructed not to file it with IRS. .

Reporting Requirements

IRA custodians have several reporting requirements with respect to IRA investments. IRA custodians are required to submit annually a Form 5498 IRA Contribution Information to IRS for each IRA account under custody. As part of this reporting, IRA custodians must ensure that all IRA assets (including those not publicly traded) are valued annually at their fair market value (FMV), and IRS requires custodians to report the year-end aggregate FMV of all investments in an IRA. Starting with tax year 2015, IRS required custodians to report the aggregate FMV of investments falling in specified categories of unconventional assets and to identify the category in which the assets belonged. Custodians are also required to submit Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., each year that an IRA withdrawal took place and detail the total distributions from the account during the calendar year. Form 1099-R also provides information about the IRA distributions, such as whether the distributions were taken before age 59½.

A 401(k) plan’s annual reporting requirements are generally satisfied through filing a Form 5500 Annual Return/Report of Employee Benefit Plan (Form 5500) and its accompanying schedules. The Form 5500 is the primary source of information collected by the federal government regarding the operation, funding, expenses, and investments of employee benefit plans. The Form 5500 reporting requirements vary depending on the size and type of plan: plan sponsors required to submit the long form must fill out multiple schedules and attachments that collect information on particular aspects of the plan, such as the value and types of plan assets; plans allowed to complete the short form have fewer reporting requirements.

Prohibited Transactions

IRA owners and 401(k) plans are not permitted to engage in certain prohibited transactions. Prohibited transactions generally fall into two categories: Involving disqualified persons. An IRA owner and 401(k) plan are prohibited from engaging in a transaction with a range of entities, including a fiduciary, a person providing services, or members of the IRA owner’s family, including a spouse, ancestor, or descendant.

Involving self-dealing. An IRA owner and 401(k) plan fiduciary are prohibited from engaging in a transaction where the account owner or the fiduciary benefits from the asset prior to retirement.

Unlike a 401(k) plan sponsor, who has an opportunity to voluntarily correct some prohibited transactions after they occur, IRA owners face adverse tax consequences when engaging in a prohibited transaction. Examples of a prohibited transaction in an IRA may include: (1) directing the IRA to purchase a vacation home as a rental property for personal use; (2) selling their own property to the IRA; and (3) taking a salary from an IRA-funded business. Specifically, if the IRA owner engages in a prohibited transaction, the IRA loses its tax-favored status as an IRA, and the account is treated as distributing all of its assets to the IRA owner at the FMV on the first day of the year in which the transaction occurred. The IRA owner may also be subject to a 10 percent additional tax on early distributions unless an exception applies.

Tax Liability in Retirement Accounts

Earnings and profits made in tax-favored savings vehicles are generally reinvested in the account with taxes deferred until distribution. However, two circumstances can generate current tax liability for retirement account owners:

Unrelated Business Taxable Income (UBTI): Unrelated business taxable income is gross income generated from an ongoing trade or business (less allowable deductions) that is not related to the exempt or tax-deferred entity, such as an IRA. An IRA or 401(k) plan that earns $1,000 or more of gross income from an unrelated business must file Form 990-T with IRS and pay related taxes.

Unrelated Debt-Financed Income (UDFI): Unrelated debt-financed income is a form of UBTI. If an asset purchased by an IRA is debt- financed (e.g., a mortgage on a rental property), income produced by that asset could be subject to taxes.

Regulatory Framework

Multiple federal, state, and independent entities provide regulatory oversight for retirement accounts invested in unconventional assets, although agency jurisdiction varies depending on the type of provider, the state in which it conducts business, and type of plan offered. Table 2 provides a summary of the regulatory activities of some of the major entities involved in overseeing these accounts.

Full Extent of Retirement Account Investment in Unconventional Assets Is Unknown, but Custodians Reported Nearly Half a Million Accounts Invested in Unconventional Assets in 2015

Federal Government Collects Limited Data on Unconventional Asset Holdings in Retirement Accounts

To date, federal data collection efforts capture limited information on the unconventional asset holdings in IRAs and solo 401(k) plans, making their overall prevalence unknown. Historically, IRS has not collected FMV data specific to unconventional asset holdings in IRAs. For tax year 2015, IRS began requiring IRA custodians to report selected information on unconventional asset holdings in IRAs. IRS did not fund electronic compilation for the 2015 data but plans to electronically compile data for tax year 2016 that will be filed in 2017. As of November 2016, IRS has not provided a date on when the new IRA asset type data will be available for further analysis. While estimates have been reported in recent years regarding the aggregate investment in IRAs that may hold unconventional assets, we could not determine the validity of these estimates based on the sources of data used to support them. In addition, DOL collects no data on unconventional asset holdings in solo 401(k) plans because sponsors of solo 401(k) plans are generally not required to report their investment holdings. As a result, federal data collection on unconventional assets is incomplete and unspecific with respect to the types of assets held in these accounts. (See table 3.)

Custodians Report Nearly Half a Million Retirement Accounts Are Invested in Unconventional Assets

Seventeen of the 26 custodians we identified who allow investment in unconventional assets reported holding an aggregate of more than 488,000 retirement accounts at the end of calendar year 2015. Custodians reported that owners of these retirement accounts invested in a range of unconventional asset types and identified real estate, private equity, and hedge funds as the most common asset types held in these accounts. In addition, they reported that account owners invested in Limited Liability Companies (LLC) and limited partnerships, precious metals, promissory notes, church bonds, and private placements. Custodians also reported that these accounts have an aggregate value of approximately $50 billion; however, we could not determine whether the accounts exclusively held unconventional assets or, if not, which portion was attributable to cash or publicly traded assets held in the accounts.

IRAs made up the vast majority of accounts and assets reported, and solo 401(k) plans constitute less than 1 percent of reported accounts and assets. (See table 4.)

The aggregate data that custodians provided help establish a baseline of retirement account investment in unconventional assets, but these data are not comprehensive in that they exclude several other potential sources of such investment. For example, industry representatives stated that other banks, trust companies, and financial service providers may accommodate investments in unconventional assets, such as commercial real estate, for their high net worth clients. Additionally, some individuals with 401(k) plans who invest in unconventional assets serve as plan trustee and would not need to retain the services of a custodian to process account transactions. Therefore, it is likely that the total number of accounts invested in unconventional assets would be higher.

Retirement Account Owners Investing in Unconventional Assets Are Responsible for Account Management and Compliance

Transferring existing retirement savings to a new account or plan that allows investment in unconventional assets expands the roles and responsibilities of account owners for managing aspects of their accounts. Many individuals seeking to set up a new account may be accustomed to tax-favored status for their IRA or 401(k) plan, but their decision to invest in unconventional assets is accompanied by a range of responsibilities that may be new and unfamiliar. For example, all 20 custodial agreements we reviewed required individuals to agree to be responsible for directing their investments; and oversee the selection, management, monitoring, and retention of all investments in the account. In addition, while account owners may seek the assistance of knowledgeable third parties, such as attorneys, accountants, tax advisors, and financial planners, the account owners bear the consequences of any mistakes made in managing their accounts. According to DOL, IRA and 401(k) plan investors often lack investment expertise and must rely on experts, but are unqualified to assess the quality of the expert’s advice or guard against its conflicts of interest. Moreover, DOL notes that many of these experts often receive fees (or other forms of compensation) that may introduce conflicts of interest between them and the plan officials, plan participants, and the IRA investors they advise.

Selecting an Appropriate Account Type. Individuals seeking to save for retirement by investing in unconventional assets must first determine which type of retirement savings vehicle and investment aligns with their savings goals. Nine of 17 custodians reported that clients want to invest in unconventional assets for a variety of reasons, including avoiding the stock market, diversifying retirement portfolios, investing in a tangible or familiar asset, or investing in a company not yet publicly traded. One custodian said that most individuals seeking investment in unconventional assets did not own their own businesses, and that it was more common for these individuals to establish an IRA with a custodian that allowed this kind of investment. Self-employed individuals or owners of small businesses who employ no other full-time employees may qualify to sponsor a solo 401(k) plan. Two service providers who advise their clients on creating solo 401(k) plans to invest in unconventional assets said that their clients preferred the 401(k) plan for its higher annual contribution limits and the ability to take participant loans.

Establishing and Funding an Account. An individual must take several steps to establish and fund an account that allows investment in unconventional assets. First, individuals opening an IRA must find a custodian willing to administer the asset. Eighteen of the 21 service providers reported that in their experience most individuals wanting to set up an account had a specific investment or asset type in mind before making initial contact with them. Twelve of the 17 custodians reported that they placed some restriction on the types of unconventional assets that they would allow. For example, they reported that they did not allow investment in certain assets, including foreign-based assets, precious metals, person-to-person promissory notes, or single-member LLCs. One custodian noted that such restrictions were necessary because some assets were administratively infeasible for its business plan. For example, a custodian who does not specialize in foreign-based assets may not accept custody of these types of assets. Second, prospective IRA owners must sign a custodial agreement that outlines the respective roles and responsibilities of the account owner and custodian over the lifecycle of an account. Our analysis of agreements available on 20 custodians’ websites found that 18 custodians used IRS’s model custodial agreement to help IRAs conform to IRS requirements. The model agreement includes several articles that IRS has approved regarding contribution limits, prohibited assets, RMDs, and the treatment of beneficiaries, among other things. The agreement also provides custodians with an opportunity to amend the form with additional provisions as long as these provisions comply with applicable requirements of federal and state law. Third, the individual must authorize the custodian to fund the new account either through a new contribution, or through a transfer or rollover of funds from another qualified retirement account.

Purchasing Assets. The choice to purchase unconventional assets rather than publicly traded stocks and bonds in a retirement account marks a significant shift in the balance in account management responsibilities toward the account owner. On the one hand, solo 401(k) account owners sponsor the plan and can serve as its trustee, allowing them to purchase any asset permissible in the plan documents and deposit the asset in their designated trustee account. On the other hand, IRA owners investing in unconventional assets must locate an asset, determine its suitability for their retirement goals, and conduct due diligence on the investment and the investment sponsor. In addition, to finalize the purchase, these IRA owners must collect, review, and prepare all purchase documents and provide them to the custodian to execute the purchase on behalf of the IRA. IRA owners and custodians must complete this sequence of tasks each time an asset is placed in the account. (See table 5.)

The amount and type of documentation that account owners must provide to custodians before an asset can be purchased can vary considerably depending on the type of asset being purchased. Our analysis of custodian documentation found that assets like promissory notes or precious metals require minimal documentation from the account owner, while other assets, such as real estate or private equity, can require the account owner to provide considerable documentation before a purchase can be made. Depending on the asset type selected, an account owner may have to expend considerable time and effort to finalize an asset purchase. (See table 6.)

Some IRA owners may choose to exercise greater control and limit a custodian’s direct involvement in the purchase of unconventional assets by adding a checkbook control feature to their IRA. In order to obtain checkbook control, the account owner must first establish an LLC that is owned by the IRA. Once this new LLC is established, a business checking account linked to IRA funds is set up, and account owners are named manager of the LLC with control of the checkbook. Using the checkbook owned by the IRA’s LLC, the account owner can take advantage of time-sensitive offers and purchase assets directly from investment sponsors without having to wait for a custodian to execute a purchase or sale.

Account Management and Compliance. Account owners who invest in unconventional assets typically agree to become responsible for the day- to-day management of their accounts and ensuring that the account remains compliant with laws and regulations, according to our review of selected custodial agreements. As an IRA custodian can only act on the direction of the account owner, an account owner generally must inform the custodian of the many tasks needed to maintain assets in their account—such as purchases, sales, earned income, payments due, requested distributions, and changes in the account’s value—and provide sufficient documentation to the custodian to facilitate each account transaction on their behalf. (See table 7.)

The extent of custodian involvement in the ongoing management of an account can depend on the types of unconventional assets held in the account. For example, one custodian mentioned that promissory notes that promised a balloon payment of principal and interest at the end of a specified term generally required less recordkeeping from the custodian. The same custodian and another described the management of a real estate holding in an IRA as being a labor-intensive, manual process. In this case, a custodian would coordinate with the account owner to pay all expenses from IRA funds, such as maintenance, improvements, property taxes, condominium association fees, general bills, and insurance, and return any related income to the IRA.

Account owners need to be mindful of fees and expenses associated with plan investments and services to determine whether they continue to be reasonable in light of the services provided. Given that retirement accounts must be held in trust, IRA custodians generally charge a range of administrative and transactional fees for the services they provide throughout the lifecycle of an IRA. While some transactions like precious metal storage lend themselves to a flat fee, other transactions like real estate purchases can involve multiple transactions requiring greater involvement by a custodian, leading to a higher incidence of fees that must be paid out of the account. In reviewing fee disclosures from custodians who made them publicly available on their websites, we found that custodians generally charged fees for similar services—account establishment, account maintenance, transactional fees, and account termination—but the type of fee structure used and amounts of fees charged varied among custodians. Custodians’ fee structures generally included a (1) flat fee; (2) a per-asset fee in an account; or (3) a fee based on a percentage of an account’s value. Some fee structures consisted of multiple categories, such as a flat fee plus a per-asset fee. The fee structure used can affect annual account costs, as shown in table 8.

Finally, one fee disclosure we reviewed reminded account owners of their responsibility to monitor their accounts, noting that unfunded accounts and accounts with zero value would continue to incur fees until the account owner provided written instruction to close the account.

IRA owners with checkbook control can perform some tasks associated with maintaining the account without a custodian’s assistance and thus avoid some of the custodian’s administrative and transaction fees related to these services. For example, an IRA owner, as manager of the LLC owned by the IRA, can manage several administrative services associated with rental real estate in an IRA, such as paying property taxes, insurance premiums, and utility bills, and writing checks from the LLC bank account to cover property repairs and maintenance. However, whether using a custodian or not, the account owner, in signing a custodial agreement, agrees to be responsible for ensuring that transactions do not run afoul of the prohibited transaction rules and for determining whether transactions constitute contributions to or distributions from the IRA.

Closing an Account and Distributing Assets. As with purchasing assets and maintaining an account on an ongoing basis, account owners investing in unconventional assets are responsible for overseeing the distribution of assets from their accounts, such as determining the amount of any RMD and directing custodians to release the funds. Whether seeking to liquidate the assets in an account, take physical possession of the assets, or transfer assets to another custodian, account owners must direct the custodian to facilitate the removal or transfer of assets from the IRA.

Distribution of assets. Either the account owner or the custodian can initiate a distribution of account assets. Account owners can submit a distribution request to the custodian. The custodian follows the account owner’s directions to distribute account assets to the account owner either in cash or other in-kind distribution. In the case of an in- kind distribution of assets, the custodian may ask the account owner to provide an updated FMV for the assets before completing the distribution. A custodian can also initiate a distribution of account assets for a variety of reasons, including engaging in a prohibited transaction or nonpayment of fees, The custodian must report distributions to IRS and the account owner on Form 1099-R.

Custodian-to-custodian transfer. The account owner can establish a new account with another custodian and authorize a transfer of assets from the old account to the new account. The new custodian works with the account owner to re-title illiquid assets in the name of the new account and forwards the transfer request to the current custodian for execution. The original custodian confirms that all fees and expenses have been paid and illiquid assets are properly re-titled; and transfers the assets to the new custodian. Custodians are generally not required to report such transfers between IRAs to IRS or to account owners on Form 1099-R.

Some custodial agreements contain provisions that a custodian may initiate a distribution of unconventional assets to the account owner (or transfer assets to another custodian) without an account owner’s consent. When this occurs, the custodian notifies an account owner of the custodian’s intent to resign and terminate an account, and generally gives the account owner 30 days to exercise their right either to request a lump sum distribution or to name a new custodian to initiate an in-kind transfer. If the account owner does not name a new custodian, the custodian can transfer the assets in-kind to another custodian of their choosing or distribute the account’s assets to the account owner. If distributed to the account owner, the custodian must report the distribution to IRS and provide a Form 1099-R to the account owner.

IRA Owners with Unconventional Assets Can Face Challenges with Tax Liability, Valuation, and Distribution, and IRS Provides Limited Guidance to Assist Them

Certain IRA Transactions Can Trigger Loss of Tax- Favored Status or Generate Immediate Tax Liability

Loss of Tax-Favored Status

IRA owners who invest in unconventional assets take on a heightened risk of engaging in a prohibited transaction and losing tax-favored status for their retirement savings. IRS officials stated that prohibited transactions are the most prominent compliance risk associated with investing IRA savings in unconventional assets. Prohibited transactions are more likely to arise with investments in promissory notes, private equity, and real estate because—unlike publicly traded stocks, bonds, and mutual funds—these investments can involve disqualified family members or other disqualified persons. Similarly, IRA investments in rental real estate, with its many transactions, for example, can leave IRA owners susceptible to a number of prohibited transactions, any one of which would result in the loss of the IRA’s tax-favored status, as shown in figure 1.

Some custodians can serve as gatekeepers for obvious prohibited transactions, such as an IRA owner purchasing his own property for the IRA, though account owners must navigate the IRA tax laws and can face additional taxes for noncompliance. Account owners who invest in an LLC inside an IRA with a checkbook control feature, which limits custodial involvement in transactions, also take on a heightened risk of engaging in a prohibited transaction and losing their IRA’s tax-favored status. Checkbook control may offer IRA owners additional conveniences and reduce transaction fees charged by custodians, but these IRA owners must closely monitor each action for prohibited transactions. For example, IRA owners with checkbook control may pay IRA expenses directly without submitting requests through a custodian; however they must avoid paying IRA expenses with personal funds, such as writing a check from a personal account rather than from their IRA checkbook, or making payments to themselves or another disqualified person. Six of 17 custodians said that they did not offer IRAs with checkbook control due to the lack of custodian oversight for prohibited transactions, among other things.

Unforeseen Federal Tax Liability

Earnings and profits made in tax-deferred savings vehicles generally get reinvested in the account without generating current federal tax liability, but investments in certain unconventional assets can generate ongoing tax liability for IRA owners. Certain investments can generate current tax liability from UBTI or UDFI earned in retirement accounts. Examples include using an IRA to invest in an active business or using debt to finance a portion of an asset’s purchase. (See fig 2.)

IRA custodians need to monitor IRA investments for UBTI and pay any applicable taxes from the IRA, but we found custodians often delegated the responsibility for monitoring for tax liability to the account owner. IRS requires custodians of IRAs subject to these requirements to file a Form 990-T for any UBTI of $1,000 or more. Most custodial agreements we reviewed required account owners to agree to monitor their IRA for business income; however, two service providers told us IRA owners familiar with investing in more conventional assets that do not generate business taxable income may not realize that the responsibility to monitor continues as long as the asset remains in the IRA.

Having to pay taxes from the IRA can pose additional challenges for account owners who invest in illiquid assets that cannot easily be sold to pay applicable taxes. First, illiquid unconventional assets, such as real estate, private equity, and promissory notes, may require account owners to find another investor to purchase their interest in the asset. Second, the account owner cannot pay the taxes with personal funds (a prohibited transaction) and must arrange to have a custodian pay the taxes from their IRA. Third, two service providers stated that IRA owners may not realize that once a retirement investment generates UBTI or UDFI, taxes must be estimated and paid quarterly if the tax is expected to be $500 or more, necessitating a certain level of liquidity to be maintained in the account.

Difficulty Obtaining Fair Market Value for Hard-to- Value Assets Can Heighten the Risk of IRA Noncompliance and Fraud

IRA owners who invest in unconventional assets may face challenges meeting their responsibilities to provide updated FMV information to their custodian to meet IRS’s annual FMV reporting requirement because some unconventional assets are inherently hard to value. Some unconventional assets, such as precious metals, have a readily available FMV; other assets, such as undeveloped land and private equity, may require IRA owners to obtain a third-party appraisal or rely on investment sponsors to provide the information. Many of the custodial agreements we reviewed made IRA owners responsible for obtaining and providing a year-end FMV of unconventional assets in their accounts to the custodian each year. However, some custodians contact the investment sponsor directly to obtain an updated FMV, and if unsuccessful, may report the last-known FMV or the original purchase price. As a result, the FMV reported to IRS may not reflect a nonpublicly traded asset’s current value. IRA owners who fail to provide updated FMV to their custodian within a specified time limit run the risk of their custodian distributing their assets from the IRA, which could lead to a loss of the account’s tax-favored status if the owner cannot identify a successor custodian willing to hold the assets. (See fig. 3.)

Even though the last-known FMV that the custodian reports to IRS may not necessarily reflect the current estimated value of an asset, it can be treated as an asset’s true value and result in federal tax consequences for IRA owners. For example, the last-known FMV can be used to calculate federal tax liability for IRA owners: when calculating RMDs; when determining the distribution amount in the event the IRA engages in a prohibited transaction; and when reporting an in-kind distribution in the event a custodian resigns an account (e.g., IRA owner fails to pay custodial fees or to provide updated FMV).

Distributions of assets at their last-known FMV can be especially damaging if the asset distributed is found to be valueless and/or an updated FMV is unattainable. Once a distribution is made from an account, the value of that distribution—even if based on a last-known FMV—becomes the value used to determine the account owner’s federal tax liability. IRS identifies noncompliance with IRA distribution rules through automated matching of custodians’ Form 5498 and Form 1099-R returns with taxpayers’ income tax returns. According to an IRS official, if a Form 1099-R incorrectly reported a distribution of a worthless asset as a distribution of a valuable asset, the individual receiving the incorrect distribution would be responsible for proving that the asset was worthless. The official further noted that, to remain compliant, the taxpayer could pay the tax due and subsequently file a claim for a refund, or report the depreciation of the distributed asset’s value on an annual income tax filing. Our review of consumer complaints found several examples of a custodian’s decision to report the last-known FMV creating tax consequences for account owners, as shown in table 9.

Custodians provided information to account owners through custodial agreements and other forms on owner responsibilities for providing FMV information for unconventional assets and supporting documentation to the custodian. For example, thirteen of the 20 custodial agreements we reviewed included custodian-specific policies informing account owners of their responsibilities to comply with IRS’s annual FMV reporting requirements. We found a range of policies, varying by asset type and custodian, for the FMV information that would be reported to the IRS and for when account owners needed to obtain independent appraisals to substantiate an asset’s FMV. For example, some of these agreements and other custodian forms: required IRA owners to obtain independent property appraisals for real estate investments at least once every 3 years; required IRA owners to obtain an annual comparative market analysis for real estate investments; collected FMV information directly from investment sponsors and other third-parties for certain assets, such as limited liability companies, limited partnerships, and hedge funds; and reported the purchase price for other assets, such as promissory notes.

However, some custodians also stated that requiring independent appraisals in years without a taxable event, such as a distribution, could be costly for account owners and discourage investments in certain types of assets.

The difficulty with obtaining and verifying FMV of certain unconventional assets can expose account owners to fraud and allow losses in value to remain undetected in retirement accounts for some time, eroding IRA owners’ retirement savings. In 2011 SEC’s Office of Investor Education and Advocacy and the North American Security Administrators Association (NASAA) issued a joint investor alert warning investors that money held in accounts that allow investments in unconventional assets presented attractive targets for fraud promoters seeking to engage in fraudulent conduct. The alert included multiple examples of SEC and state enforcement cases that involved fraudulent schemes associated with IRAs that allow investments in unconventional assets. SEC officials said that even though the prevalence of accounts holding unconventional assets cannot be readily determined, the potential for fraud in these accounts remained high and that concrete examples of fraud involving these accounts have been, and continue to be, well documented. Three state securities administrators said complaints from account owners were often filed years after an account had lost value because these owners believed the periodic account statements sent by the custodian were correct. For example, if custodians, and in turn account owners, rely on the purchase price of a promissory note as an annual FMV, they may not realize when a borrower has filed for bankruptcy and thereby be unable to pay back the note. Similarly, according to the three state securities administrators, investment sponsors may report incorrect FMV information to custodians to perpetrate fraud. Finally, some account owners appeared to misunderstand the custodian’s responsibility to report annual FMV as a form of verification, leaving these account owners open to holding potentially fraudulent assets in their accounts. (See table 10.)

Some Unconventional Assets Are Difficult to Distribute as Retirement Income

Account owners may also face challenges when trying to liquidate certain unconventional assets to distribute as retirement income. Unlike publicly traded assets, which can be purchased and sold with relative ease in retirement accounts, account owners may experience difficulty finding a secondary market in which to sell certain unconventional assets. For example, account owners trying to liquidate a private equity investment must find other investors willing to purchase the asset. (See table 11.)

Account owners who have difficulty liquidating unconventional assets may instead be required to accept in-kind distributions rather than cash to comply with the minimum distribution requirements. For example, an account owner invested in real estate may need to request that a custodian distribute a percentage of the property equivalent to their calculated annual RMD. In such a case, that individual would own an illiquid portion of the property personally while the account would own the rest. The account owner in this scenario would not be able to receive a cash distribution to use as retirement income, yet would be responsible for paying applicable income taxes on the in-kind distribution.

IRS Provides Limited Guidance to Account Owners Who Invest Their Retirement Savings in Unconventional Assets

Current IRS guidance provides little information to help IRA owners understand their expanded responsibilities and potential challenges associated with investing in unconventional assets. For example, in our review of complaint data, some account owners appeared to misunderstand their responsibilities documented in the custodial agreements, and expected their custodian to provide due diligence, monitor investments, or compensate them for investment losses. (See table 12.)

Federal internal control standards require agencies to communicate effectively with external stakeholders to help achieve agency goals. IRS’s Taxpayer Bill of Rights states that taxpayers have the right to know what they need to do to comply with the tax laws, and are entitled to clear explanations of the laws and IRS procedures in all tax forms, instructions, publications, notices, and correspondence. In addition, IRS’s strategic plan states that IRS guidance should help taxpayers understand their tax responsibilities through targeted outreach, communications, and education. We previously recommended that IRS outreach and education explicitly target the risk of noncompliance for IRA owners investing in unconventional assets.

We found three areas, in particular, where IRS guidance lacks specific information for account owners investing in unconventional assets:

Prohibited transactions. IRS officials said that engaging in prohibited transactions is the most prominent compliance risk associated with investing IRA savings in unconventional assets, but IRS has not yet compiled data to help provide targeted outreach to IRA owners who invest in unconventional assets. In 2014, we recommended that IRS: (1) add an explicit caution in Publication 590 for taxpayers about the potential risk of engaging in a prohibited transaction when investing in unconventional assets; and (2) identify options to provide targeted outreach to taxpayers with unconventional IRA assets and their custodians to help them avoid losing their IRA tax-favored status by engaging in a prohibited transaction. In 2015, IRS added an explicit caution to IRA owners in Publications 590-A and 590-B about the heightened risk of engaging in a prohibited transaction, but has not compiled the data to help provide targeted outreach. IRS said it could refine its outreach to those taxpayers with nonpublic IRA assets using the new asset type data once compiled electronically. Unless IRS augments outreach based on reliable data about unconventional IRA investments, these taxpayers at greater risk may not be able to ensure compliance with rules on prohibited transactions. Four service providers told us that additional guidance would help IRA owners investing in unconventional assets understand the risks for prohibited transactions.

Unrelated business taxable income. IRA owners unfamiliar with monitoring their investments for UBTI have limited guidance to assist them in identifying and calculating their tax liability. IRS Publications 590-A and 590-B, which together serve as a general IRA handbook for IRA owners, make no mention of UBTI or its tax consequences for IRAs. IRS Publication 598 -Tax on Unrelated Business Income of Exempt Organizations lists IRAs as one of many exempt entities subject to UBTI, and provides detailed examples of how to calculate UBTI and file tax forms. However, the publication does not provide specific examples of how IRA investments in unconventional assets can generate UBTI. An IRS official said that the IRAs subject to UBTI represented a small percentage of 990-T filers, and that neither the frequency nor consequences of noncompliance met the threshold for including specific IRA-related content in the IRA and UBTI guidance. However, without an explicit caution or guidance from IRS, account owners may inadvertently invest in assets that require additional monitoring and filing obligations; failure to meet these obligations may subject account owners to underpayment penalties.

Fair market value. Current IRS guidance includes no guidance or advice to custodians or IRA owners regarding how to determine the FMV for unconventional assets held in retirement plans. An IRS official stated that FMV is a commonly understood term and that many professional appraisal companies could provide an unbiased value for any IRA asset. However, 9 of the 17 custodians reported challenges obtaining FMV information, such as from nonresponsive account owners or investment sponsors, or in obtaining adequate supporting documentation. Further, securities administrators in one state said that guidance could be improved to indicate to custodians the type of information that they should rely on for substantiating FMV. In addition, three service providers said that account owners needed clearer guidance on FMV reporting, such as the types of information that would fulfill the requirements.

Custodial Agreements That Follow the Model Form May Be Confusing

The inclusion of language from the IRS model form that a custodial agreement has been “pre-approved by the IRS” and the ability for custodians to amend the IRS model form may mislead account owners into thinking that IRS has reviewed and approved the entirety of the document they sign. Fifteen of the 20 custodial agreements we reviewed retained language from the IRS model form stating that the agreement had been “pre-approved by the IRS,” but an IRS official said that the agency does not receive, review, or approve custodial agreements. In fact, the model form instructs IRA owners and custodians not to file the form with IRS. In addition, 16 of the agreements resembled an IRS form, which may further lead account owners to believe that the provisions contained within the form had been verified by IRS. For example, these agreements included the IRS form number, an IRC section reference, and the IRS 2002 revision date for the model form at the top of the first page. Lastly, we found that all 20 of the custodians amended the form to include multiple provisions designed to protect the custodian. For example, some of these added provisions include: performing no due diligence on the investment and the investment indemnifying the custodian of responsibility for sharing known information on troubled assets with account owners; reserving the right to liquidate IRA assets of the custodian’s choosing; and employing and paying agents, attorneys, and accountants with IRA funds for any purpose deemed necessary.

The amended form may cause confusion on the part of IRA owners. For example, IRA owners may not be able to differentiate between the model IRS language and terms and conditions added by custodians. IRA owners may also read the “pre-approved by the IRS” statement and assume that the IRS has vetted the provisions added by custodians.

Conclusions

With few restrictions on the types of assets that can be held in an IRA or a solo 401(k) plan, individuals can invest their retirement savings in an increasingly diverse range of unconventional assets—some of which may not have been imagined as retirement plan assets when the first IRAs or solo 401(k) plans came on the market. Unconventional assets, such as virtual currency and unsecured promissory notes, when placed in retirement accounts introduce different kinds of risk to account owners, and can have potential federal tax implications. These risks are particularly high for older workers nearing retirement who transfer savings accumulated over the course of their careers to establish new retirement accounts that allow investments in certain assets that they may not fully understand and may expand their responsibilities. IRS has published detailed guidance to assist account owners with directing their retirement investments, but this guidance has not kept pace with changes in investment options. As a result, account owners who take on responsibility for accounts invested in unconventional assets must rely on guidance better suited for investments in more conventional assets— publicly traded stocks, bonds, and mutual funds—which are often professionally managed. As account owners consider investing in unconventional assets, they should have a clear understanding of what is required to manage such investments in a retirement account, ensure proper valuation and tax reporting, and navigate a complex set of rules that govern tax-favored retirement investments. The consequences for account owners who make a mistake can be severe and jeopardize a lifetime of retirement savings.

Recommendations for Executive Action

To assist IRA owners in addressing challenges associated with investing their retirement savings in unconventional assets, we recommend that the Commissioner of Internal Revenue take the following three actions:

Provide guidance to IRA owners on the potential for IRA transactions involving certain unconventional assets to generate unrelated business taxable income subject to taxation in the current tax year and subsequent years. For example, IRS could consider adding an explicit caution in Publication 590 Individual Retirement Arrangements (IRAs) and include a link in Publication 590 to Publication 598 Tax on Unrelated Business Income of Exempt Organizations to provide examples demonstrating how certain unconventional assets in IRAs can generate unrelated business income tax for account owners.

Provide guidance to IRA owners and custodians on how to determine and document fair market value (FMV) for certain categories of hard- to-value unconventional assets. For example, IRS could consider updating Form 5498 instructions to custodians on how to document FMV for hard-to-value assets (e.g., last-known FMV based on independent appraisal, acquisition price) and provide guidance directed at account owners that provides examples of how to ascertain FMV for different types of unconventional assets.

Clarify the content of the model custodial agreement to distinguish what has been reviewed and approved by IRS and what has not. For example, IRS could consider: (1) restricting custodians from stating that the form has been “preapproved by the IRS” on the form; (2) adding language to specify which articles have been preapproved by the IRS and which have not; and (3) limiting custodians from adding provisions to the model form other than those preapproved by the IRS.

Agency Comments and Our Evaluation

We provided a draft of this report to the Commissioner of Internal Revenue, the Secretary of the Treasury, the Secretary of Labor, the Chairman of the Securities and Exchange Commission, and the Chairman of the Federal Deposit Insurance Corporation for comment. In its written comments, reproduced in appendix III, IRS generally concurred with our findings and recommendations. In addition, each agency provided technical comments, which we incorporated as appropriate.

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Appendix I: Objectives, Scope, and Methodology

The objectives for this study were to determine: (1) what is known about the prevalence of retirement accounts that invest in unconventional assets; (2) how these accounts are managed, and; (3) what challenges, if any, are associated with the administration of these types of retirement accounts.

Overall Methodology

Each of the engagement’s three researchable objectives required us to identify various arrangements for investing individual retirement account (IRA) and 401(k) plan savings in unconventional assets. For all objectives, we reviewed pertinent federal laws, regulations, and guidance on the use of retirement account savings, as well as recent federal and state enforcement actions against entities involved with these types of retirement accounts. In addition, we searched for relevant scholarly and peer reviewed materials, trade and industry articles, government reports, conferences papers, research publications, and working papers. We also interviewed a range of federal and state regulators, industry stakeholders, and participant advocates.

To determine the prevalence of retirement accounts that invest in unconventional assets and better understand how these accounts are managed, we conducted multiple structured data collection efforts from custodians and service providers that allow investment in unconventional assets. To identify challenges associated with administering retirement accounts that invest in unconventional accounts, we analyzed investor complaint data from three federal agencies and two independent organizations. We also used the multiple structured data collection efforts from custodians and service providers to obtain their perspectives on potential challenges for account owners and providers. In addition, we reviewed publicly available custodian and service provider documentation, including application forms, fee disclosures, and custodial trust account agreements, which are used to establish a traditional IRA and specify account owners’ roles and responsibilities. All data collected through these methods are nongeneralizable and do not necessarily reflect the experience of the entire population of custodians and service providers that hold retirement accounts invested in unconventional assets, and account owners who invest in unconventional assets. However, we believe the insights gained through these methods produced valuable information to better understand the extent and form of retirement account investment in unconventional assets.

Structured Data Collection Efforts

To identify custodians and service providers of retirement accounts who allow retirement account owners to invest in unconventional assets, we conducted a literature search, reviewed industry websites, interviewed industry stakeholders, and reviewed the Internal Revenue Service’s (IRS) list of nonbank custodians. Through this process we identified 26 custodians and 48 service providers with experience working with account owners in establishing and managing such accounts. We determined that these data were sufficiently reliable for the purpose of this report.

Next, to learn about the approximate number and value as well as types of retirement accounts held under custody at the end of calendar year 2015, we conducted a survey data collection effort from the 26 custodians that we had identified from available sources. We obtained responses from 17 custodians who varied in terms of the number and value of accounts they held, and the types of unconventional assets they allowed. We focused our effort on custodians as they are responsible under the Internal Revenue Code (IRC) for reporting the fair market value of all IRAs under custody to IRS. This removed the potential for double counting accounts and assets reported by both a service provider and the custodian they use to house clients’ account assets. Through this effort, we also collected information on the types of unconventional assets account owners most commonly invest in. We confirmed the accuracy of account and asset data reported by 10 custodians who agreed to participate in a second structured data collection effort.

To examine how these retirement accounts are managed and get a sense of the challenges they present to account owners and providers, we conducted additional structured data collection efforts. We developed a follow-up set of questions for the same 17 custodians and received responses from 10 of them. We also developed a similar set of questions for the 48 service providers we identified who provide administrative support for IRAs and solo 401(k) plans, collecting information from 21 of them. Through these efforts, we collected information on the steps needed to establish a retirement account for the purpose of investing in unconventional assets, as well as the roles and responsibilities of various stakeholders in managing and administering accounts. We also collected providers’ perspectives on the reasons why some account owners choose to invest IRA and 401(k) plan savings in these types of assets and the challenges to account owners and providers may face in doing so. We determined that these data were sufficiently reliable for the purpose of this report.

Analysis of Investor Complaint Data

To augment our understanding of challenges associated with managing retirement accounts invested in unconventional assets, we analyzed 334 investor complaints obtained from three federal entities—the Department of Labor (DOL), the Office of the Comptroller of Currency (OCC), and the Securities and Exchange Commission (SEC)—and two independent organizations—the Financial Industry Regulatory Authority (FINRA) and the Better Business Bureau. Our list of custodians and service providers was used to query databases for relevant complaints. We analyzed the complaints to develop general categories of challenges. We then conducted a two-step review and arbitration process to ensure proper categorization of each of the 211 complaints that we determined were directly associated with retirement accounts invested in unconventional assets based on available information. We did not confirm the authenticity of these complaints or investigate any of the allegations made. In addition, we did not collect information about all of their resolutions. We determined that the data we collected were sufficiently reliable for the purposes of this report.

Review of Custodial Agreements

To assess the clarity of information new IRA owners receive about their roles and responsibilities from custodians who allow investment in unconventional assets, we collected and reviewed 20 publicly available custodians’ individual retirement custodial account agreements, which IRS requires custodians and account owners to complete to establish a traditional IRA. We analyzed the content of these agreements and compared their format with the format of the IRS model Form 5305-A.

Appendix II: Excerpts of Language Included in IRS Model Form 5305-A

Appendix III: Comments from the Internal Revenue Service

Appendix IV: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to the contacts named above Christopher Falcone, Emily Gruenwald, David Lehrer, Jonathan S. McMurray, Jessica Moscovitch, Thomas Moscovitch, and MaryLynn Sergent made key contributions to this report. James Bennett, Amy Bowser, Caitlin Croake, Sheila McCoy, Jean McSween, Jessica Orr, Walter Vance, Kathleen Van Gelder, and Adam Wendel also provided support.