Choosing the Right Custodian

Financial institutions, trust companies and banks that offer traditional custodial accounts have an obligation, imposed by the Securities and Exchange Commission, or by the individual states in which they are registered, to offer you investments that are legitimate, vetted offerings so you don’t get defrauded, or invest in something they should have known wasn’t suitable for you. You are relying on their due diligence and expertise in selecting the investments for you. Consequently, they won’t agree to hold assets with which they are unfamiliar, or that haven’t gone through their vetting process.

That leaves a vast variety of otherwise legitimate investments you could invest in, but that are generally not available to you from your traditional retirement account custodian. What you need is a special type of custodian that accepts non-traditional investments and is not bound by the same rules as financial institutions that offer traditional investment options.

Who Can Be A Self-Directed Custodian?

In general, the Internal Revenue Code allows banks and other entities that are subject to state banking regulation and control to be retirement account custodians. Most SDRA custodians are banks or trust companies subject to state banking regulation. The Code also allows persons that IRS is satisfied can carry out the administrative and reporting responsibilities imposed by the Code relating to retirement accounts to act as custodians. These are usually investment brokerage houses and financial institutions.

There are also “Administrators” who administer SDRAs. These are companies that provide the client interface and administrative record keeping and reporting, but actually have a bank hold custody to the assets held in the account. You interface with the Administrator, the Administrator takes care of the IRS reporting, keeps track of your contributions and distributions, and provides you with account statements and online access to any necessary paperwork, such as beneficiary designations.

What’s Different About Self-Directed Custodians?

SDRA custodians and administrators do not undertake the same obligations to you as traditional retirement account custodians. They take on no fiduciary obligation to you, like a trustee would, and they do not advise you on the suitability of any investments they hold. They will review investments you direct to make sure that the investment doesn’t disqualify the account for some reason, but otherwise all they do is hold title to the investment for your benefit under the terms of the account agreement.

In fact, the basic terms of the agreement between you and any retirement account custodian are set forth in a form prescribed by the IRS, to which the custodians add based on the specifics of how they operate.

At our last count there are about 46 SDRA custodians and administrators in the US. Click here to see a list.

Evaluating Custodians

It’s important to look over a potential custodian or administrator’s websites and talk to someone about what it will be like to work with them. Custodians differ widely in:

• How they operate
• How they charge for their services
• How much they charge for their services
• Specialization (Some specialize in specific types of investment, some don’t)
• How easy they are to work with
• How much service they provide.

The choice can sometimes depend on how often you plan to have investment transactions. Some custodians and administrators charge on a “per transaction” basis, and some charge a percentage of the value of your account, usually on a sliding scale. Many charge based on a combination of those methods.

So, for example, if you plan to buy a single asset and hold it for a few years, a custodian that charges on a per transaction basis may be quite a bit less expensive than one that charges a percentage of the value. It’s important to include these projected costs when you evaluate your projected return on investment.

Importance of Investment Type

The choice can also depend on the type of investment your are choosing. Custodians often specialize.

For example, you may want to buy a rental property. When you do, be aware that all expenses have to be paid by the SDRA custodian, not you personally. And all rent receipts have to be paid to the SDRA custodian as well. That can be somewhat inconvenient. That’s why many SDRA owners investing real estate use a “checkbook LLC.” In that case, the SDRA custodian holds the interests in the LLC, and you are the manager of the LLC in control of the check book.

Checkbook LLCs and Compliance

The problem is that many custodians don’t allow checkbook LLCs, or if they do, they require you to have an independent manager (which can be expensive). Why? As you can imagine, IRS doesn’t like the “checkbook LLC” arrangement because of its potential for abuse.

• If you engage in a prohibited transaction with the entity you immediately disqualify your SDRA as a tax exempt entity, and you pay tax on any income that would be derived from distributing out the entire account to you
• If you distribute some of the money from the LLC to yourself, the custodian has no record of the distribution.
• If you add extra money from your personal funds, the custodian has no record of a contribution.

Because of that banking regulators check the custodian’s files to see whether the custodian is monitoring compliance with the prohibited transaction, distribution, contribution and other requirements in order to satisfy its obligations to report such things to IRS. That creates a big headache if they don’t know how to do that, or if they don’t receive enough in fees to cover the cost. (Competition is high, so they probably don’t.) It’s not a cost effective arrangement for the custodian in many cases.

So, if you think it makes sense to have a checkbook LLC for your SDRA, be sure that your potential custodian allows it, and make sure you understand the requirements it will impose on holding one in your SDRA.

Type of Account

Finally, be sure that the custodian or administrator you choose offers the type of retirement account you want to open.

The vast majority of accounts are traditional pre-tax IRAs or Roth IRAs created by transferring funds from an employer plan, such as a 401(k) of the account owner’s former employer. But traditional and Roth IRAs don’t fit every need.

For example, if you are self-employed and you need a retirement plan, you might consider a “Solo(k)” plan. That’s a 401(k) plan that allows you, as an employee, to make “elective deferrals” from your earned income, and also allows you to make “profit sharing” contributions as the employer. If the custodian doesn’t offer these types of plans, you’ll find yourself being disappointed.

Be sure to consider your objectives when choosing your custodian. The type of investment, the method you want to adopt for making the investment, the type of account that suits your need, and the custodian’s account charges, can have important impacts on your choices.