by Thomas English
*** Special Note***
This article was originally posted several years ago. Some of the information is outdated and some updates are placed at the end of the article.
One of the most confusing aspects of the self directed investing industry is what the difference is between a custodian, administrator, and facilitator. After catching up with Tom Anderson (founder, President, & CEO of PENSCO Trust Company, a self-directed custodian – www.penscotrust.com) and Jeff Nabers (founder of IRA Association – www.iraaa.org) we rounded up some answers for you.
Understanding what these providers do and how they work is vital to keeping your investment strategies safe.
A custodian is a company who is either
- approved and regulated directly by the IRS, or
- affiliated with or owned by a bank or trust company and subject to regulation from their state Banking Commissioner and/or the Comptroller of Currency and FDIC
Custodians handle the formation and maintenance paperwork for your retirement account as well as handle the money for you. Because all custodians are regulated by banking officials or the IRS, trusting them to handle your money is generally safe.
Some custodians are referred to as “trust companies” because some retirement accounts are treated like trusts under the tax code. Tom Anderson recommends, “To find out whether a company is an actual custodian, ask them for their documentation from their regulators.”
An administrator is a company who handles the formation and maintenance paperwork required for your retirement account. Some administrators actually handle your money and accept deposits as well. In this regard, an administrator actually acts like a middle man between the retirement account owner and the bank where they deposits are eventually held, even keeping records, and providing statements, etc.
Allowing an administrator to handle your money can be problematic for three reasons:
- Your account’s assets are often pooled with other people’s accounts which could subject your funds to additional liability;
- Asset pooling can sometimes result in the administrator taking much longer to follow through with your transaction directions than it would take when dealing directly with a custodian (e.g., there can be confusion over who to talk to-administrator or custodian);
- There is no strict IRS, banking or other regulator overseeing administrators. Such regulators have the power to take over firms that they feel are not operating safely and soundly from the consumers’ perspective. They regularly audit the firms they supervise, and custodians have to respond to any resulting demands of their regulators or face being shut down. Administrators are not subject to these same demands. This can leave open opportunity for fraud. If you were to roll your funds over to an administrator and the company disappeared with your funds, you would have a difficult time recovering them, if at all. That kind of fraud is unlikely to happen with a company strictly overseen by banking or IRS regulators.
“Handing your money over to an administrator rather than directly to a custodian has no real benefits, although it does increase the potential for substantial risk of loss or liability,” Anderson mentions. Often times, administrators will mention that custodians are unable to give investment advice legally (e.g., as they are chartered as self-directed ‘passive” custodians) while some administrators do give investment advice. Jeff Nabers suggests, “If you value the advice of an administrator, consider retaining them to act as a third party consultant while leaving your retirement account assets to be handled directly by a custodian.”
A facilitator is normally a company that provides advice and consulting. In this category, we are talking about all companies who call themselves facilitators, advisors, or consultants. Many facilitators assist in structuring investment strategies, often involving LLCs. It is common for investors to want to have “checkbook control” of their retirement funds. For that reason, some advisors promote using a special purpose LLC that is specifically designed for use with retirement funds. When paying to have an LLC created, expect to pay a higher fee than you would for a general purpose LLC, but be wary of companies who want to charge more than $3000 or those who try to convince you that your strategy needs several LLCs which could add up to very large formation costs up front and more maintenance costs each year. Facilitators often serve as a “one stop shop” and will handle everything for you, including your funds rollover and any paperwork or filings required to enact your strategy. However, they are not custodians or trustees and you will still need to use a custodian or trustee to hold your assets and process transactions.
In fact, regulators such as the SEC and FDIC have recently become concerned with the LLC concept of “checkbook control” often promoted by facilitators for fear that investors will either act on inaccurate advice from facilitators or inadvertently enter into a prohibited transaction on their own; invalidating their IRA and resulting in taxes and possible penalties. While there is no guarantee that working with a trustee or custodian directly will eliminate the possibility of a prohibited transaction, experienced, reputable, knowledgeable and regulated firms will look for these as part of their service and inform you if they see something problematic.
Depending on their actual experience, facilitators, administrators, advisors, and consultants may be valuable in the field of advice and consulting. They are unregulated and normally do not give accounting or legal advice. Therefore, you may want to work with an attorney or CPA that you or your custodian is familiar with. However, if you are thinking of using their services, make sure they are experienced in the field. And when all is said and done, make sure that your deposits and assets go directly to a custodian and not into the hands of an unregulated middleman.
A clear understanding of the different types of self-directed service providers enables you to breeze through setting up your structure with more confidence so that you can move on to the fun part – selecting your investments.
*** 2009 Updates ***
This original article was posted before Self-Directed Solo 401(k) plans became available (which happened in late 2006). The launch of the Self-Directed Solo 401(k) changed the entire Self-Directed Investing industry. All 401(k) plans are considered to be “qualified plans” governed by an entirely different section of the Internal Revenue Code than the IRA. This section, 401, does not mandate the use of a custodian.
The proliferation of custodian corporations came about because of the legal requirement for a custodian to act as an intermediary or limited-duty trustee for IRA accounts. While intermediaries are sometimes desirable between two separate parties, they are generally undesirable otherwise. One of the reasons the Solo 401(k) is much more powerful than an IRA is the fact that they can be created and managed without the use of a custodian at all. Rather than name a trust company as trustee or custodian of a Solo 401(k) plan, the plan participant can simply name themselves to handle the transactions.
Some tout the value of a custodian to include avoidance of prohibited transactions. We have found this to be merely marketing propaganda. A thorough review of custodial account applications has shown us that the accountholder always legally relinquishes the custodian from any such responsibility, and the obligation of most tax law compliance rests solely on the shoulders of the accountholder. Furthermore, prohibited transactions avoidance is quite simple – many would argue much simpler than selecting and pursuing alternative investments in the first place.
The bottom line? For an IRA, a custodian is required, and you should seek arrangements where a registered and regulated trust company is solely acting as custodian. For a Solo 401(k), you need a plan document provider, and hiring a custodian introduces only unnecessary costs and transactional delays.