Custodians are essential in any individual retirement account (IRA) arrangement to maintain a tax-deferred or tax-free status. Custodians, also called trustees, are different depending on the type of IRA. Marketable securities such as mutual funds or stocks do not require any effort in choosing a custodian, however, IRAs that hold alternative investments like private notes, precious metals, or real estate need a self-directed IRA custodian. An IRA custodian is a financial institution that holds an account’s investments for safekeeping and sees to it that all IRS and government regulations are adhered to at all times.
Custodians are not hard to find but to choose the best and right one, the owner must decide what type of investments will be made in the account. Here, we look at some of the most common IRA custodians out there.
There are two types of IRA accounts that can be set up by individual investors: a traditional IRA and Roth IRA. The traditional IRA allows money within to grow free of income tax. However, it reduces taxable income in the year that the income is created and defers tax payments until the account holder withdraws funds in the following years. In other words, traditional IRAs are tax-deferred accounts. With a Roth IRA, there is no tax break on the sums contributed, but no taxes are owed when withdrawing money out at retirement. In addition, there are no taxes owed on earnings in most cases.
Traditional IRAs allow account owners to contribute pre-tax income to their IRA where the investment’s growth tax is deferred until withdrawal at retirement. Upon retirement, withdrawals from the IRA are taxed at the owner’s income tax rate. However, capital gains or dividend taxes are not assessed. It is important to take into account that contribution limits exist. For account owners under the age of fifty the maximum contribution is $6,000, and for those over the age of 50 it’s $7,000. Minimum distributions are also required starting at age 72.
Roth IRAs are retirement accounts where the owner pays taxes on the money deposited into the account (post-tax contributions), and then all withdrawals are tax-free. Roth IRAs are generally best to have when the account owner might retire in a state where income taxes are higher, or if there is speculation that income taxes may increase in the future. Contributions to Roth IRAs are capped when your income is higher than $139,000 annually for single account owners, and at $206,000 for married couples. The contribution limit is the same as for traditional IRAs at $6,000 for account owners under fifty and $7,000 to those who are older.
Traditional IRAs and Roth IRAs can be managed by the investment firm that custodies the IRA or be self-directed. A self-directed IRA (SDIRA) is an IRA in which the account owner chooses the funding methods and investment instruments allowing expanded investment options. Since SDIRAs allow a variety of investment options, they can provide greater investment diversification than standard IRAs. Any IRA in which the account owner makes all the investment decisions is “self-directed”. However, in financial services, an SDIRA is simply an IRA in which custodians allow the account owner discretionary control to invest in other investment products outside traditional stocks, bonds, and mutual funds. SDIRAs usually include alternative investments such as real estate and commodities.
When choosing between traditional IRAs and SDIRAs, the account owner must be aware of the different financial institutions that are available to serve as custodians. It’s important to note that only custodians are authorized by the IRS to hold – or to “custody” – your IRA account assets.
These are the common custodians for traditional IRAs:
Banks are an option when account owners prefer to have FDIC-Insured securities such as certificates of deposits (CD) or money market mutual funds in the IRA. However, banks generally do not allow individuals to invest in anything other than marketable securities, making them less flexible when it comes to holding private investments in their IRA. Additionally, banks that offer brokerage services for IRAs usually charge higher fees than traditional brokerage firms.
The only advantage of using a mutual fund as a custodian for an IRA is that these companies allow the account owners to invest in mutual funds or ETFs.
Brokerage firms and Insurance companies
Generally, both brokerage firms and insurance companies can be a good choice as IRA custodians when the account owner wishes to actively invest in individual stocks, bonds, ETFs, annuities, and mutual funds.
Robo-Advisors are online investment platforms that provide automated, algorithmic portfolio management advice. Since these platforms do not involve human interaction, fees and other expenses that usually make the return of investments in IRAs lower are often non-existent.
Things are a little more complex when it comes to self-directed IRAs. As alternative investments are more cumbersome for custodians to custody, administrators and facilitators have emerged as a liaison between the IRA account holder and the custodian. The three types of SDIRA providers are as follows:
As mentioned previously, custodians are entities that have been authorized by the IRS to provide custodial services and hold assets on behalf of an IRA. However, they are not likely to allow alternative investments as they typically offer custodial services only for marketable securities. Custodians tend to avoid holding private investments in IRAs as it presents too much paperwork for them. Additionally, as most private investments are non-standardized paper contracts, they cannot be managed in a scalable way. Generally, the option to hold private investments at most custodians is only available to special high net worth clients.
Administrators and Facilitators
An administrator is a company or person that does the work that a custodian would typically do if the custodian were to offer the ability to hold private investments in IRAs.
Facilitators place themselves on the front end of an IRA owner’s new account process to help them navigate the rules and implementation. Most facilitators are individuals or very small companies that push the IRA owned LLC so they can charge a fee. They will then pass the IRA owner off to a custodian. Essentially, facilitators act as a liaison between IRA holders and the custodian or administrator.
Both administrators and facilitators can act as intermediaries between the IRA account owner and the partner custodian that holds the assets. Administrators do all the work for the custodians and the custodians have the responsibility of auditing them. These custodians are usually non-bank trust companies that are chartered by individual states. It’s important to note that some states do not allow administrators to manage IRA accounts on behalf of the custodian in this way.
SDIRAs can use any of the traditional IRA custodians. However, since other custodians can be used, it is far too easy to violate IRS rules and fiscal regulations, for which penalties are severe. Account holders should be careful to avoid the following:
It is also important to keep the following in mind:
A diversified investment portfolio with the proper selection of individual stocks, bonds, mutual funds, and ETFs can help reduce the risk in an IRA, or in any account. For SDIRA investors, adding alternative investment opportunities including real estate and private companies has the potential to increase returns since these are riskier assets.
Fees and commissions charged are key decision factors in who you chose as custodian for your IRA. The most important ones to take into consideration are annual account maintenance fees, loads (charged in mutual funds), and trade commissions. Custodians charge different fees. Maintenance fees are usually deal-breakers, and no-load mutual funds are typically preferred by account owners.
Unless the account owner prefers a robo-advisor, IRA specialists at most custodians are knowledgeable professionals available to account owners. Managing IRAs can be complex and frustrating, and there is nothing worse than dealing with poor customer service. Selecting a provider with the right technology and user experience can go a long way in improving how you go about saving for retirement
When opening an IRA, it’s important to ask several questions to the potential custodian about the types of IRAs that they can most effectively service and the investments they are comfortable with. Once the proper IRA and investments are chosen, the main factors that will distinguish a custodian from another are investment options, fees, and customer service.
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