When choosing a financial professional to work with, it’s important to find someone who’s reputable and trustworthy. One thing to consider when vetting financial advisors or other professionals is whether they’ve ever been engaged in self-dealing. Self-dealing is a term you might be familiar with if you own a self-directed IRA. In that scenario, the IRS prohibits you from using a self-directed IRA in a way that generates some personal gain to you prior to drawing on those funds for retirement. But it’s also important to understand what self-dealing means in a financial advisory setting and how to spot it.
In simple terms, self-dealing can happen when a financial advisor or other financial professional acts in his own best interest rather than in the best interests of their clients. This can take different forms but the intended result is generally the same: to create some benefit, either direct or indirect, for the advisor.
Self-dealing can happen in fiduciary relationships. A fiduciary is someone who acts on another person’s behalf to manage financial and/or legal affairs. That can mean the trustee of an estate, the executor of a will, an attorney or a financial advisor.
Fiduciaries are held to certain ethical and legal standards that obligate them to act in the best interests of the clients they serve. Self-dealing is considered a breach of fiduciary duty. Specifically, it’s a violation of the duty of loyalty, which says that fiduciaries must act without creating financial conflicts of interest.
Self-dealing can happen in different ways, and it isn’t always easy to recognize. Here are some examples of what self-dealing can look like in different financial relationships.
Self-dealing in trusts
A trust is a legal entity that allows you to transfer ownership of assets to a trustee, who is a fiduciary. Trusts can be useful in estate planning for creating a legacy of wealth while minimizing estate and gift taxes for your heirs.
Your trustee is obligated to administer the trust according to the terms you set. But self-dealing can happen in a trust if the trustee:
- Makes inappropriate investments using trust assets
- Lends a trust’s assets to friends or family members or leverages trust assets to obtain a loan
- Engages in investment churning to generate higher broker fees in order to receive a kickback from the broker
- Buying property or other assets that are held inside the trust
- Distributing assets from the trust to themselves, their friends or family members
Any of these things could be considered self-dealing because they benefit the trustee, not you or your beneficiaries.
Self-dealing with a financial advisor
There are some great reasons to work with a financial advisor. An advisor can offer professional insight to help you shape a comprehensive financial plan. They can also help with decision-making so you can reach your financial goals.
In a financial advisor relationship, self-dealing can happen when an advisor:
- Encourages you to buy certain investment products to generate a larger commission for themselves
- Uses funds from your investment account to invest on their own behalf
- Offers investment advice that would generate some kind of indirect benefit for themselves
- Makes inaccurate statements to influence your investment decisions to their benefit
When a financial advisory has fiduciary status, they’re required to avoid doing anything that would conflict with or compromise your best interests. For example, they’re not allowed to offer misleading information about an investment and they’re supposed to disclose any potential conflicts of interest to you.
These fiduciary standards are designed to protect you and ensure that you’re getting reliable advice from your financial advisor. Self-dealing can happen when an advisor behaves in a way that goes against those standards.
Self-dealing in an IRA
Self-directed IRAs can allow you to add alternative investments, such as real estate, to your retirement portfolio. But the IRS has some specific rules that prohibit self-dealing activities, including:
- Making any improvements or repairs to an investment property owned inside the IRA yourself
- Paying yourself for any work done on an investment property
- Using self-directed IRA funds to invest in a company you own or control
- Using self-directed IRA funds to pay debts related to a business you own
- Living in an investment property part-time or using it for a vacation home
- Commingling personal and IRA funds
Any of these things could be viewed as self-dealing by the IRS. If the IRS thinks you’re self-dealing, you could lose any tax benefits associated with having a self-directed IRA.
How to Avoid Self-Dealing in Financial Relationships
When working with a financial advisor, trustee, executor or any other financial professional, self-dealing is something that’s best avoided. Finding someone reliable to work with starts with asking the right questions and researching the fiduciary’s background.
For example, if you’re looking for a financial advisor it’s helpful to use tools like FINRA’s Broker Check to look into their background. This can give you insight into their professional background and history. It can also let you see at a glance any ethical or legal complaints or violations listed against them.
Using a trusted source to find an advisor can also be helpful. SmartAsset’s financial advisor matching tool, for instance, allows you to get personalized recommendations for advisors in your local area. Advisors are professionally vetted for you, which can save time in the search process.
What to Do If a Breach of Fiduciary Duty Occurs
If you’ve been working with a financial advisor and you believe they’ve been engaging in self-dealing with your assets, there are things you can do about it. Specifically, you can file a breach of fiduciary duty claim for damages.
A successful claim requires that you be able to prove to a civil court judge that:
- A fiduciary relationship existed between you and the person you’re filing the claim against
- That a breach of fiduciary duty within that relationship occurred
- And that the breach of fiduciary duty caused you financial damage that the court could remedy with a civil judgment
If you think you may need to file a claim for self-dealing as a breach of fiduciary duty, talking to an attorney can be helpful. An attorney can help you establish whether you have the grounds for a claim and walk you through the process of filing one.
The Bottom Line
Self-dealing can take various forms but it’s especially important to watch out for in financial advisor relationships. An advisor who self-deals could cost you wealth and keep you from reaching your financial goals. That makes it vitally important to do your research carefully when choosing an advisor to work with. And if you have a self-directed IRA, it’s also important to make sure you’re investing according to the guidelines set down by the IRS to avoid negative tax consequences.
Tips for Investing
- Consider talking to a financial professional about whether he or she is a fiduciary and what that means to you. For example, an advisor who’s registered with the Securities and Exchange Commission is held to a fiduciary standard but a broker-dealer is held to a suitability standard only. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free financial advisor tool can match you in minutes with advisors in your local area. If you’re ready, get started now.
- If you’re setting up a trust or drafting a will, consider who you’d like to act as trustee and executor. You could name a person to act as a trustee, but a corporate trustee, such as a bank, may be more appropriate if you don’t have someone you can count on to carry out your wishes.
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