Pay Dirt: A novel way to invest

After Tom Fafinski lost money in tech stocks, he began searching for alternative places to invest. Fafinski, 44, of Farmington, discovered self-directed IRAs and used money earmarked for his retirement and his kids' college to buy an Eagan townhouse as an investment property.

Sick of being stuck with a dozen mutual funds in his workplace retirement plan, Tim Olson rolled over his 401(k) to a self-directed IRA and is building townhouses in Wells, Minn. A self-described "hands-on" kind of guy, Olson likes to keep his IRA money in town, using local contractors and investing in CDs from a local bank. A self-directed IRA lets him do that. "The biggest appeal is the options; I'm not limited to mutual funds."

Both Fafinski and Olson are part of a growing number of investors turning to self-directed IRAs. "The worse the stock market does, the more business I get," said Todd Grill, principal of Entrust Midwest, a company that administers self-directed IRAs.

Investors with self-directed IRAs go out and find the asset to invest in rather than relying on the universe of mutual funds and other investments available through companies such as Charles Schwab or T. Rowe Price.

Like traditional individual retirement accounts, self-directed IRAs have the same contribution limits and rules for withdrawing money. The difference is what's inside these accounts -- real estate, gold or shares of a privately held business, to name some examples. Grill tells clients they can be like Buffett. "Warren Buffett invests in private companies. Warren Buffett invests in real estate. Warren Buffett invests in precious metals. Warren Buffett does foreign currency trading. Now you can do exactly that same thing, but on a smaller scale."

In a nutshell, here's how a self-directed IRA works. You open an IRA through a company such as Entrust, Equity Trust, Guidant Financial or Pensco Trust. The company then acts as the trustee of your account and facilitates investments on your behalf. But you find the investment opportunity and do the due diligence.

Grill has clients invested in ethanol, wind energy, real estate in Mexico, even movies. Clients can also use money to finance a business start-up, which Grill thinks could be a popular option for laid-off workers.

Grill's average client is 50 years old and financially sophisticated with assets available to put to work. Many are buying foreclosed properties in north Minneapolis, using IRA money to make improvements, and selling the properties for a profit. The profit goes back into the IRA to be taxed as ordinary income once the client makes distributions in retirement.

But these IRAs aren't for everyone. You need expertise as well as money.

Todd Terhorst, a certified financial planner with Diversified Wealth Management in St. Louis Park, suggests clients have around $50,000 to dedicate to self-directed investments and to keep the rest in more traditional, stocks, bonds and cash. But what's most important is a willingness to be hands-on and do the research. Otherwise, there are other options for diversification.

"Nowadays, at smaller dollar values, we can get exposure to very unique asset classes, whether it's precious metals or real estate or managed futures or currency ... in more traded vehicles," he said. These assets are a lot easier to sell than are physical assets such as gold or property.

You also need to think about why you're making an investment. Clients needing more cash flow today would not want an asset locked up in a retirement plan for years -- or decades. Then there are taxes. Terhorst says, for instance, that owning a rental property within an IRA can change the tax treatment of current rental income and future profits from selling the property. On the other hand, you're using pretax money to make the investment and tapping what may be the only funds you have to make the purchase.

If you don't have enough money in your IRA, you can pool funds from different IRAs. For example, Fafinski bought the townhouse using money in his IRA and Education IRAs for his kids. You can also take out a loan to buy property, but that's a complicated technique that needs professional hand-holding.

Then there are the restrictions for what you can buy inside an IRA. No life insurance, S corporations or collectibles. For a full list of what is and isn't allowed, check out IRS publications 590 and IRC 4975.

As for fees, companies such as Entrust can be paid based on the value of an asset, or based on how many assets you own inside a portfolio. Grill said it costs $50 to open an account and his average client pays a $250 to $300 annual fee. Then there are small charges for investment transactions, check writing and wire fees. Terhorst, whose fee for assets under management goes down each time a client moves money to a self-directed IRA, often charges a retainer fee for advice.

Like any investment, assets owned in your self-directed IRA can go down. Jokes Fafinski: "I suffered from the dot-com bomb and became committed to diversification. Today I get to enjoy having all of my asset classes diminish in value."