In the daily course of business, a question that comes up rather often is “Why do I need a custodian?” The first thought I have is the sound of my mother’s voice saying, “because I said so.” Only in this case, it is Congress via the IRS instead of my mother issuing the edict.
Usually people want a bit more than that in their answers. So, here are the things you should know about custodians and why you need them. They can be quite different from each other even though they operate by the same set of government regulations.
Every single qualified account is required by law to have a custodian to administer it. Below is a comprehensive list of account types requiring a custodian in addition to the traditional Individual Retirement Arrangement (IRA), with which most people are familiar.
- Archer Medical Savings Account (MSA)
- Health Savings Account
- Qualified Retirement Plan Custodial Account
- 403(b)(7) Custodial Account
- Roth IRA
- Deferred Compensation Plan of State and Local Government and Tax Exempt Organizations Custodial Accounts
- Coverdell Education Savings Account
The why is simple. Congress passed IRA legislation so that people would have an incentive to save for their retirement. They did this by giving various tax advantages. Those tax advantages come with a set of rules that need to be obeyed. You can read more about some of those rules in IRS publication 590.
The government created the role of the custodian to assist them in the administration of those rules. Custodians are fiduciaries but do not give investment or legal advice. They do make distributions and assist in the purchase of assets for the IRA holders. They also provide recordkeeping and reporting to the IRS for all those accounts as required by law. The custodian is often a licensed financial institution. Individuals may not act as an IRA custodian.
Now you know a bit about custodians but do they all provide the same service to their IRA clients? Just because there is one set of rules for custodians does not mean they all do things the same way. When all is said and done, being a custodian is a business. All businesses make choices on how they would like to service their clients.
They do so in basically two ways that are termed self-directed and non-self-directed. Most people would be hard-pressed to name a self-directed IRA custodian. The custodians that they are familiar with are not known for being custodians but instead as broker dealers. These are big name companies people turn to in order to purchase publicly traded investments like mutual funds and ETFs. The fact that they also will be your IRA custodian when you purchase these assets in your IRA is not even an afterthought most of the time.
Many investors are learning that real estate and other alternative assets can be owned in their retirement portfolio. This gives greater diversification to the assets held in your IRA. If you turn to one of those big names and ask how real estate can be held in the account you have with them, the likely answer is “You cannot.”
Why not? Real estate is an acceptable investment according to the regulations. The simple answer is there is no way for that big name broker dealer to make money on the transaction. That is why the self-directed retirement custodian exists. This type of custodian services the segment of clients that want the full spectrum of investments available for their retirement accounts. Unlike the big name broker dealers, they cannot make money selling their clients’ investments. Thus, they charge a fee to provide that government-mandated custodial service. All custodians play by one set of rules but now you know why they do not all hold the same type of assets.