It's possible to invest funds from an individual retirement account in a hedge fund, but this transaction isn't for the faint of heart. Investing in a hedge fund may require a special type of IRA. It may also cause the investor to have tax liability for what happens with the hedge fund, even though the money is in an IRA that usually enjoys tax-deferred status. It could even cause problems for the hedge fund manager.
Hedge Fund Basics
Hedge funds are investment funds that usually use complicated strategies and investments to achieve their returns. Most are only open to accredited investors, meaning that anyone buying them needs to have a high net worth or income to qualify. Hedge funds frequently have high fees but can also offer returns that justify those fees. Many are also highly leveraged, which can increase the magnitude of both gains and losses in the market.
IRAs and Hedge Funds
Regular IRAs and Roth IRAs generally aren't set up to allow investors to buy hedge funds. IRA custodians usually limit the available choices to traditional investments, such as publicly traded stocks, bonds and funds, while also allowing the purchase of some annuities or savings account products. To invest in a hedge fund, investors usually need to open a self-directed IRA account. Self-directed IRAs can be set up to give their owners the latitude to buy the full range of investments allowed by the Internal Revenue Service, including hedge funds.
Two IRS prohibitions may come into play for investors hoping to use IRAs to invest in hedge funds. The first is that self-dealing, which is the practice of an investor personally benefiting from the money in his IRA, is banned. This means investors can't buy an interest in a hedge fund that he or a direct family member is involved in managing. The second is that IRA money can't be used to invest in life insurance. Given that hedge funds can invest in creative vehicles, like buying life insurance settlements, it's possible that a hedge fund investment could violate this requirement.
Unrelated Business Taxable Income
The tax-advantaged nature of IRAs and Roth IRAs isn't absolute. Certain types of income are considered "unrelated business taxable income," or UBTI, and are subject to tax even when they're inside the IRA. One form of income that qualifies as taxable UBTI is money that is earned as a result of leverage. Because hedge funds are frequently heavily leveraged, much of their income could end up being subject to income tax, negating some of the benefit of holding them in an IRA in the first place.
Benefit Plan Regulations
While IRAs are not workplace benefit plans, the IRS treats them as such for the purpose of regulating hedge funds. If 25 percent or more of the money in a hedge fund comes from a benefit plan covered by the Employee Retirement Income Security Act of 1974, that fund has to follow ERISA's rules. ERISA plans include, for this purpose, IRAs and 401(k)s. When a fund has to follow ERISA rules, it needs to be registered with federal or state regulators and post a special bond, and it may also be subject to a wide range of other regulations. While these considerations affect hedge fund managers and not investors, they could lead to a hedge fund manager refusing an IRA investment.
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