$100 billion retirement risk: SEC issues new warning about IRA fraud and cryptocurrencies 

  • As more individuals, especially baby boomers, move to self-directed individual retirement accounts to help them build a better nest egg, they could be putting themselves at risk for fraud.
  • These unregistered IRAs, which now represent a $100 billion market, allow people to invest far outside core stock market and bond market holdings.
  • These secondary retirement funds often include real estate, private mortgages, precious metals and private company stock. But the increasing level of investment in cryptocurrencies, from bitcoin to tokens and initial coin offerings, led the SEC to issue a new warning this month about potential IRA fraud.

It's not uncommon for those nearing retirement to become nervous about their nest egg, concerned it won't be sufficient. This has led some savers to pursue self-directed IRAs, an individual retirement account that you control with investments of your own choosing. These IRAs are often invested in real estate, private mortgages, precious metals and private company stock. But with the increasing appearance of bitcoin and other cryptocurrencies in these retirement accounts, the Securities and Exchange Commission has issued a new warning.

In its August 8 Investor Alert, the SEC warned that assets in traditional IRAs — stocks, bonds and mutual funds — generally fall under the agency's oversight, but that is not the case with self-directed IRAs, which lack transparency.

Although the IRS requires that a self-directed IRA be set up by an authorized custodian, they don't validate the legitimacy of the investment, so there's a potential to be scammed. Here, a cryptocurrency investor looks at a World Coin Index on a smartphone.
Nhac Ngueyn | AFP | Getty Images
Although the IRS requires that a self-directed IRA be set up by an authorized custodian, they don't validate the legitimacy of the investment, so there's a potential to be scammed. Here, a cryptocurrency investor looks at a World Coin Index on a smartphone.

The SEC said there wasn't a single event that led the agency to issue the new warning, but Lori Schock, director of the SEC's Office of Investor Education and Advocacy, told CNBC, "Now that some self-directed IRAs include digital assets — cryptocurrencies, coins and tokens, such as those offered in so-called initial coin offerings — we think it is important to alert investors about the potential risks and fraud involved with these kinds of investments that may not be registered."

The SEC joins the Association of International Certified Professional Accountants, which also warned about this type of fraud in its recent report, Eye on Fraud, indicating that the types of investments permitted in a self-directed IRA can be ripe for elder abuse. A self-directed IRA's unique risks "include lack of disclosure and liquidity, as well the risk of fraud," according to the report.

A $100 billion market and 'a growing potential pool' for fraudsters

Though the IRS requires that a self-directed IRA be set up by an authorized custodian, the custodians only hold and administer the assets. They don't validate the legitimacy of the investment, so there's a potential to be scammed. This situation is becoming more of an issue as boomers with significant wealth — much of it in retirement accounts — move into retirement, said Randal Wolverton, lead author of the report and a member of the AICPA's Forensic & Litigation Services Fraud Task Force. That "becomes a growing potential pool for fraudsters," he said. Scammers look for soft targets, such as those who are wealthy and incentivized to invest or exhibit signs of loneliness or diminished cognitive ability.

Mary Mohr, executive director of the Retirement Industry Trust Association — the trade association for banks and trust companies that administer self-directed IRAs — said her organization has been working with the North American Securities Administrators Association on antifraud initiatives since 2011. She said the total number of assets in organizations that are members of her trade group just crossed the $100 billion mark. "We're a fast-growing segment of the marketplace," she said.

Self-directed IRAs aren't new; they were created through the 1974 Employee Retirement Income Security Act. Mohr said these types of investment accounts hold appeal because some people are looking to diversify away from securities and mutual funds and use the full spectrum of what is allowable by the IRS. "They want to invest in what they know and what they feel they have control over." She said problems may arise because some IRA owners are under the illusion that the custodian conducts due diligence on investments, when self-directed IRAs are a do-it-yourself affair.

Mohr said to watch out when a promoter says an investment is IRS-approved, since the IRS doesn't approve any assets, nor do custodians. She said unsecured promissory notes are an area in which the most fraud occurs. If someone is promoting a promissory note that will pay 12 percent to 15 percent, it's possibly a scam, she said.

Wolverton said third-party scammers tend to promise returns that beat the existing market and tap into the fear of many retirees who are concerned they won't have enough money to sustain their lifestyle and lifespan in retirement. They're eager to multiply their nest egg.

"That's the impetus that a lot of our scoundrels are looking for when encouraging risky investments," he said. He added that fast-moving changes in the investment world, with cryptocurrencies like bitcoin, pose new and emerging threats. These types of currencies have a history of significant price fluctuations. A scammer is not responsible for the volatility, but may encourage quick actions to time the market swings to the detriment of the investors, Wolverton said.

Lisa A. K. Kirchenbauer, president of Omega Wealth Management in Arlington, Virginia, said that there is a danger in being defrauded by "shady companies" with self-directed IRAs. She said that the old adage, "if it's too good to be true, it probably is," applies here. Understanding the potential pitfalls are key. "This is not for your unsophisticated investor."

In addition to fraud, those considering a self-directed IRA need to be careful to ensure they don't violate any federal laws governing retirement accounts. Scott Bishop, head of financial planning for STA Wealth Management in Houston, said to be aware of promoters who claim it's possible to own your own business or vacation home with self-directed IRAs. Being personally involved with an investment could be a prohibited transaction that could disqualify your IRA, causing immediate taxation and/or penalties by the IRS, he said. Avoiding this situation of self-dealing can often be difficult when it comes to real estate transactions, Kirchenbauer said.

Nevertheless, Bishop said it is important to point out that there is the potential for self-directed IRAs to bring significant profits. "If you bought Facebook pre-IPO in your IRA, you'd be in great shape now."

5 ways to protect your investment when considering a self-directed IRA

1. Find a good custodian. Major investment firms, like Fidelity Investments, won't allow alternative investments as an underlying asset in an IRA. But Wolverton says the vast majority of those in the self-directed IRA business are honest. You can find them by checking out Retirement Industry Trust Association members here. The owner of the self-directed retirement plan may choose to use a securities broker to help them select listed stocks, bonds and mutual funds as investments in the retirement plan.

Securities brokers are regulated by the Financial Industry Regulatory Authority, and their backgrounds can be checked here. Mohr said to do your research; not all custodians handle all types of assets, so it's important to understand their services as well as their fees. Bishop said it's important to find a custodian who is not being promoted by someone selling something. And "if you can't find a custodian who is willing to make the particular investment, view that investment as a red flag," he said.

2. Familiarize yourself with IRS rules and regulations. If considering a self-directed IRA, make sure to understand which types of investments are prohibited so you don't incur harmful tax consequences. Consulting with professional investment advisers can help head off this type of situation.

3. Do your homework on investments. Research the investment to make sure you fully understand it. The SEC's Schock said to be especially wary of unsolicited offers, especially when a promoter promises guaranteed returns, since there are no guaranteed returns in investing. She advises checking with state securities regulators to see if there have been complaints about the promoter.

Wolverton said that investors should be suspicious of unverifiable biographies of managers or promoters. Ask questions about references and experience and determine whether the promoters are registered with the SEC, FINRA or state regulators. Request to see an offering memorandum and prospectus. Look over the financials.

Tom Anderson, Retirement Industry Trust Association president, said simply Googling the name of the person offering the investment can provide key background information, including whether there's been an arrest.

4. Read all materials pertaining to the investment. Bishop said it's key to closely review disclosure agreements that are part of any investment transaction or to ensure a financial, legal or tax expert does so. This will help you to better understand the expectations of return, liquidity issues, possibilities of loss and environmental liability, as well as the risk of a loss of principal if the investment goes belly up.

5. Involve a trusted professional. Schock says it's key to consult an accountant, lawyer or financial planner to independently evaluate the investment. Kirchenbauer agrees: "It's worth investing in someone's time to make sure you're not setting yourself up for a real problem," she said.

Helpful links

If you suspect you're a victim of fraud, file a police report. It also helps to file a complaint with the FBI's Internet Crime Complaint Center. You can also contact the North American State Security Administrators to get information on your state enforcement contacts.

AICPA has a fraud resource center.

The Retirement Industry Trust Association's website also provides information on safeguarding investments.

The SEC provides investor education materials on two websites where you can also file complaints or tips: https://www.investor.gov/ and https://www.sec.gov/. It also provides investor alerts.