Individual retirement accounts are required to be held at an institution that meets the requirements of being a Trustee or Custodian under IRC Section 408. The difference between a Trustee and a Custodian can be confusing, especially when dealing in the world of IRAs. A trustee is an institution that has fiduciary control over the IRA and a custodian is an institution that holds assets for the benefit of the IRA participants. Section 408(h) defines the custodian of a custodial account as the trustee for the IRA and the same rules and regulations apply, so there is effectively no difference at all. A Self Directed IRA is always housed in a custodial account because having a trustee, or someone other than you, manage your “self directed” IRA is an oxymoronic statement.
Although all IRAs fall under the same guidelines, different institutions have different rules, and there are many strategies and structures that can be used depending on an individual’s personal retirement goals.
History of IRAs
IRAs first came into existence on Labor Day 1974, and back then individuals were only allowed to contribute $1,500 into their account. Outside of Wall Street investments and CDs, there is not much one can invest in with this small amount of money, so it made perfect sense for individuals to make their contributions at a local bank or brokerage firm that acted as an IRA custodian and offered CDs or securities. Over the years these popular IRA custodians created IRA departments and trained their employees on how to follow their rules for Individual Retirement Accounts. These employees naturally work hand in hand with outside companies and their ERISA attorneys – after all, this is where a large portion of their business comes from – company sponsored plans, rollovers, etc.
All the while there isn’t much incentive or need to educate anyone about how an IRA can leave their control and invest in alternative assets. Over the decades this left the general public with a common misconception or general understanding that IRAs are supposed to flow down a certain path and can only be invested through the more popular banks, brokerage firms and annuity companies. Keep in mind, every company is in business for its own reasons. So if you’re looking to put some money aside and don’t want to deal with the headache of investing it on your own, a financial advisor or banker can help you meet your goals, but if you are an investor who wants to be in the driver’s seat it is imperative to know who has an incentive to teach you how to drive, and who wants to take your keys.
Types of Custodians
Below is a list of some of the different financial institutions (Trustees/Custodians) that can act as an IRA Custodian and an overview of what they are in business for. Understanding the role of your custodian and their business model can be very important and save you time when researching who should be custodian of your IRA.
Banks are in business to hold your deposit and give you a small yet safe return on your money. They make a profit by taking your deposit and realizing gains off of interest on loans, buying and selling debt or other securities or investing in safe non-security assets that can be acquired undervalued, such as notes, structured settlements, tax liens and deeds. Banks are usually not interested in allowing their IRA participants to make their own investments unless they have a substantial amount of money and are willing to leave the lion’s share at the bank.
Credit Unions are similar to banks but are co-operatives and owned by their participants. Most Credit Unions have tax advantages and are nonprofit organizations, therefore they can loan money at a lower rate and give their investors a better return than a bank can. Credit Unions are usually started by a community organization like a Church or University for example and their focus is to better the local community. Ironically, most Credit Unions follow suit with banks and will not allow their IRA participants to make their own investments in the local community, but instead are limited to the Credit Union’s money market accounts, CDs or other restricted investments.
Brokerage Firms are in business to broker securities instruments. Securities are investments on steroids. Below is a basic comparison of a simple investment and a securities investment:
An investor loans money to an individual and secures the investment with property or credit in the event of a default on the loan payments. An agreement or promissory note states that the investor is owed interest and principal over a specific period of time. The individual makes monthly payments according to the terms of the promissory note.
(Process 1) Company A is in business to loan other people’s money to thousands of individuals and sell off the promissory notes to a bank (Company B). Company B buys up multiple “Company A” type businesses through a sub company (Company C) and sells the sub company through an investment bank (Company D). Company D changes the legal structure of Company C and evaluates its net worth. Company C is ready to be sold off to the general public in tiny chunks. Algorithmic equations based on market fluctuation constantly changes the value of Company C. A Brokerage Firm (Company E) buys large discounted chunks of Company C through Company D. This process is repeated with futures contracts i.e. corn, steel (Process 2) and equities i.e. Coca Cola, Google (Process3). Company E partners Process 1,2 and 3 type companies and calls it a fund. A Stock Broker assists an investor in purchasing shares in Company C or a fund where Company C makes up a portion of the fund.
Securities investments can be extremely complex for the average investor to perform adequate due diligence on. In our example it would be literally impossible for one investor to know if the loan (root investment) were being paid on time or at all and what fees or profits were collected through all these companies. Securities investments are performed through global and highly regulated markets. A securities instrument cannot be bought directly from the investor, it has to be a regulated transaction that is brokered by a licensed professional and housed in a specific manner.
Brokerage Firms are in the securities business, and there are many ways a brokerage firm can make a profit in this business. Brokerage Firms are not interested in helping their IRA Participants make a loan or get into their own “simple investment”.
Trust Companies are typically setup to act as a conduit or fiduciary for a trust, estate or similar entity. The range of services they provide can vary, but their role as Custodian to an IRA is primarily to make sure the IRA is staying within the allowable parameters, investments and assets are registered properly, keeping accurate records and reporting to the IRS on behalf of the IRA. Although Trust Companies are regulated by state banking regulations, it’s common for Trust Companies to be non-depository entities that are either owned by a bank or use an outside bank to hold funds for the benefit of their clients. A Trust Company that acts as custodian for IRAs can allow its IRA participants to make any investment that is not life insurance, a collectible, or a prohibited transaction under IRC Section 4975. However, a Trust Company does reserve the right to reject an investment that is not administratively feasible or one that they just don’t want to hold. Trust Companies make their profit by charging fees for every transaction they make so it’s typical for an IRA to be forced to go through the Trust Company for literally every movement. A Trust Company can even reject a common investment like a stock or they may require you go through a specific broker that they have a relationship with. Trust Companies are also restricted in certain abilities, for example, because they are a fiduciary to your IRA, soliciting investments is a conflict of interest and could be prohibited. That’s why a Trust Company who acts as custodian for your IRA will most likely be nothing other than an entity that keeps all the paperwork in line so that your IRA stays an IRA.
Independently ApprovedIRA companies have applied for and received approval to act as custodian for your Self-Directed IRA but this is a general overview of the qualified companies. If you were to look at all the Banks, Credit Unions, Brokerage Firms and Trust Companies in America (or qualified overseas) you would find thousands of them. When researching who should act as custodian for your Self Directed IRA it is most important to know what type of investments you will be making and which type of company will be more familiar and comfortable with that type of investment; for example, If you want to buy real estate in an IRA, you should go to a company that is familiar and comfortable with holding real estate; if you want to buy stocks, you should go to a company that is familiar and comfortable with holding stocks. Companies may vary within their niche industry as well; for example, some brokerage firms will manage your account where other brokers (discount brokers) just execute your trade.
New Standard IRA LLC
The new standard of IRA investing is growing in a more lucrative environment that is closer to home and simple to understand. Private parties can make private agreements freely without going through costly administrative burdens and red tape. This is typically handled under an IRA LLC (New Standard IRA). Under the IRA LLC Structure you can move freely between investments and various financial institutions because instead of being held up by a custodian, you are moving through just another financial institution you can choose to do business with under your IRA LLC.
Need help facilitating your IRA LLC?
Give us a call and an IRA LLC Specialist can assist helping you move down the path to true financial freedom over your IRA.