You will strive to achieve the highest possible returns to secure a comfortable retirement once you have established your Individual Retirement Account (IRA). Nevertheless, there are restrictions on your actions, and you must be cautious as certain transactions are forbidden.
Further detail will be provided in this review of the rules in order to assist IRA holders, as a lack of knowledge regarding these prohibited transactions can result in severe tax consequences, such as penalties and the forfeiture of advantageous tax treatment for your IRA. The Internal Revenue Service (IRS) has compiled a list of prohibited transactions that individuals saving for retirement should steer clear of.
Understanding Prohibited Transactions
Before investing, it is crucial for IRA owners to have a clear understanding of the regulations and guidelines governing IRAs, especially self-directed IRAs. Familiarity with these rules is necessary to prevent the disqualification of your IRA. The RITA organization and its members are dedicated to educating the public and their clients about these regulations through their proactive approach to providing educational resources and information. For instance, the following conversation will provide you with an overview of the general restrictions when engaging in transactions with your IRA.
To start delving into the dos and don’ts of self-directed IRA investing, it is crucial to have a clear understanding of what a self-directed IRA or pension plan (such as Solo 401(k)) entails. The term “self-directed” does not possess a technical or legal definition but rather acts as a descriptive term regarding the management of the IRA. Essentially, it signifies that either the IRA owner or an individual appointed by the owner is responsible for making all investment choices and decisions for the IRA. A self-directed IRA can be held at a brokerage firm or with a specialized self-directed IRA custodian like those affiliated with the RITA Association. The key distinction between these two types of custodians lies in their investment limitations. While brokerage firms and traditional banks that offer self-directed IRA services primarily limit investments to publicly-traded assets like stocks and mutual funds, genuine self-directed custodians take into account all legally permissible investments as potential opportunities.
Self-directed IRAs have a crucial characteristic in that they are exclusively owned by an individual and are distinguished by their taxpayer ID. With the exception of certain employment-related IRAs, they are not subject to ERISA regulations, which govern fiduciaries of pension plans and encompass restrictions on prudence, diversification, and foreign investments. Instead, IRAs are governed by IRC section (408), while pension plans are regulated under IRC sections 401, 403, and 457.
At firms like those in RITA, IRA investments are not limited to traditional assets such as stocks and mutual funds, allowing for numerous investment options through self-directed IRAs. Nevertheless, there are certain investment types and transactions that are forbidden for all IRAs, including self-directed ones. It is crucial to be informed about these restrictions in order to protect the status of your IRA and avoid potential taxes and penalties. Therefore, we will now examine the fundamental tax regulations related to IRA investing and provide a broad overview of the legal framework behind these rules.
The Basics
It is possible to find a concise explanation of the fundamental do’s and don’ts on the IRS’s official website ( www.irs.gov ) in Publication 590. These guidelines can be easily and generally understood as encompassing:
- three asset types that you can’t invest in, and
- that neither you nor any other “disqualified person” may, under the tax laws, engage in self-dealing with your IRA.
Aside from explaining the details behind the last sentence, that’s essentially what you need to know. Self-dealing refers to the restriction that neither you nor any other “disqualified persons” can use your IRA for personal gain, except for what you naturally receive as your IRA grows. Individuals who are unaware of the rules or wish to gain more from transactions than the law permits are putting their retirement savings at risk by subjecting their retirement accounts to taxes and penalties as a consequence of engaging in a “prohibited transaction”. In simple terms, prohibited transactions involve any attempt to derive personal benefits from your IRA or pension plan’s transactions, which is also known as the “exclusive benefit” rule.
The creation of IRAs was a direct result of the ERISA Act in 1974, which aimed to strengthen and reform pension laws. This allowed individuals to have an alternative method of saving for retirement. As time passed, the government recognized the significance of IRAs in an individual’s overall retirement plan, leading to increased benefits such as higher contribution limits and improved flexibility in moving funds between different pension plans. The growing awareness, both of the importance of IRAs to their owners and the substantial size of the IRA market ($3.7 trillion in 2010), has sparked greater interest from the IRS and the Department of Labor (DOL) in protecting IRAs from disqualification. The DOL, specifically responsible for determining prohibited transactions, has played a role in safeguarding IRAs.
Who can hold your Self-directed IRA?
The IRS has authority over IRAs and the Internal Revenue Code, which sets the rules for IRAs and determines which institutions can hold them. Essentially, any bank, credit union, or state-chartered financial institution (such as a trust company) is automatically eligible to be an IRA custodian if they have been approved and accepted by a regulating body like a state banking commissioner or the FDIC. Any institution that does not fall into this category must seek approval from the IRS to become a custodian for IRAs. Currently, there are approximately 270 such institutions in the U.S., known as “non-bank custodians”, including broker/dealers and mutual fund companies. If your company does not belong to the “banking” category or have IRS approval, it cannot directly offer IRA custodial services. Placing your IRA with an unauthorized institution puts you at risk of invalidation, as well as potential taxes and penalties. Therefore, it is important to ensure that the institution you choose is duly chartered in one of the two alternative classes mentioned above and can provide evidence of its status upon request. It is worth noting that all RITA members are authorized and regulated to offer custodial services for IRAs.
Exclusive Benefit Rule
The first thing to note is the fundamental rule that applies to all IRA investments, which is the exclusive benefit rule. This rule states that only the IRA can benefit from any transaction. This rule makes sense when considering the main purpose of an IRA or Individual Retirement Arrangement (the legal term for an IRA). The government introduced IRAs alongside the Employee Retirement Income Security Act (ERISA) to regulate employer-sponsored pension plans and prevent fiduciaries from misusing or stealing pension funds. The creation of IRAs was meant to allow individuals to save for retirement independently from their employers’ plans and protect future retirees. Unfortunately, 30 years later, the government had to intervene again with the Pension Protection Act of 2006 to prevent new abuses and safeguard the retirement accounts of employees, as seen in the cases of Enron and WorldCom.
However, how would we define the exclusive benefit rule in practical terms?
- Basically, neither the IRA owner nor any other “disqualified person” may receive a personal benefit as a result of a transaction by his or her IRA.
It would be almost straightforward if not for the plan asset rule and other elements of IRC 4975, which we will discuss later. For instance, you are not allowed to borrow from your IRA or lend money to yourself or any close relative (known as a “disqualified person”), despite the fact that there is a Department of Labor (DOL) Prohibited Transaction Exemption (PTE) called 80-26, which allows limited circumstances for lending money to your own IRA. Another example of violating the exclusive benefit rule would be buying a vacation home for personal use. You cannot use your IRA-owned vacation home for vacation purposes, even for a short period of time. Additionally, you cannot use the property even if you pay rent, as the government views this as a personal benefit. You are also not allowed to purchase raw land for hunting with friends. In simple terms, engaging in a prohibited transaction as an IRA owner or beneficiary has severe consequences. Your IRA loses its tax-exempt status starting from the first day of the year the prohibited transaction occurred. This results in a taxable distribution of your entire IRA balance (excluding Roth IRAs, where only the earnings up to the deemed distribution are taxed), along with a 10% penalty if you are under the age of 59 1/2, as well as additional penalties and interest if the taxes were not paid on time.
What Is a Prohibited Transaction?
An improper usage of IRA assets by the owner, beneficiary, or any “disqualified person” constitutes a prohibited transaction. Such disqualified individuals encompass:
- Any family member such as a spouse, ancestor, lineal descendant or their spouse
- A fiduciary for the IRA
- Any person who has discretionary authority or control over your IRA assets
- Any person who provides fee-based investment advice for your IRA
- Any person who has discretionary authority or responsibility for administering your IRA
Your assets may be subject to penalties, excise taxes, and loss of IRA status if you engage in prohibited IRA transactions.
How to determine if you are creating a prohibited transaction?
How can you determine if you are participating in a prohibited transaction? One of the first steps is to identify all individuals involved in the IRA transaction. This includes your IRA, which will provide funds for the investment, and yourself, the IRA owner, who is considered a disqualified person. Are there any other disqualified persons connected to this investment? Are you personally benefiting from your IRA’s transaction? To illustrate, let’s say you work as a real estate broker and often use your IRAs to buy properties due to your expertise and interest. You come across a property you’d like to include in your IRA. However, as the seller’s broker, you are entitled to a commission. Would collecting this commission be considered a prohibited transaction? What do you think? Yes, you’re correct. Taking a commission in this scenario would be considered a prohibited transaction because it involves personal benefit from your IRA’s activities. Now, suppose you are selling a property that your IRA owns. Can you charge your IRA a commission? No, you cannot, for the same reasons stated in the previous example. Let’s continue with this same situation: imagine your son is also a broker at your firm. Could he sell the property to your IRA and receive a commission? No, he cannot, as he is a disqualified person in relation to both you and your IRA because he is your descendant.
Can you handle the sale without taking a commission? Is that acceptable? (Stronger position and not just maybe) Possibly. As long as you only perform basic paperwork tasks and don’t provide professional services that would normally be paid for, it should be fine. However, it is advisable to involve another unrelated broker to handle the sale and receive a commission instead. Could you reach an agreement with that broker, where they sell a property to their IRA and you earn a commission? You should already know the answer to that. Yes, you are right in assuming that such an arrangement would be considered a “step transaction”. Any such similar agreements created beforehand to avoid prohibited transactions will not pass an examination by the IRS or DOL.
Some individuals argue that it is acceptable for their IRA to engage with a disqualified person, as long as the transaction does not provide any advantage beyond what two unrelated parties would receive in a similar scenario. In other words, the transaction must be carried out at a genuine fair market value. These individuals contend that their IRA would financially benefit from such an arrangement. However, it is important to note that this argument can only effectively prevent a prohibited transaction if you formally request and obtain a prohibited transaction exemption (PTE) from the Department of Labor prior to engaging in the transaction. Seeking exemption after the fact will not be sufficient.
Reviewing IRC section 4975 can provide valuable insights into how the IRS or DOL might respond during an audit, as it is both a reason and a section of the Internal Revenue Code (IRC) that greatly influences free transactions with your IRA.
As mentioned before, merely executing a transaction at fair market value does not protect it from being deemed prohibited, primarily due to the rules stated in IRC 4975. Consequently, it is crucial for us to discuss the key aspects of this IRC section. To begin with, in a general sense as defined earlier, any transaction between an IRA and a disqualified person (such as the owner, the owner’s spouse, lineal ancestors and descendants, and spouses of lineal descendants) is considered a prohibited transaction, with the exception of siblings. In particular, the IRC forbids any:
- sale or exchange between an IRA and a disqualified person;
- loan or other extension of credit between an IRA and a disqualified person
- furnishing of goods, services, or facilities between an IRA and a disqualified person
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Put simply, you are not allowed to use your IRA to purchase your father’s farm when he retires, give a loan to your son for the down-payment on his first house, or use your IRA-owned vacant lot for parking your car.
So, what is the significance of all this? Initially, three components are required to establish a prohibited transaction:
- A plan (pension) or an IRA;
- A “disqualified person”; and
- A transaction between 1 and 2 above.
In addition to the previously defined list of “disqualified persons” in relation to IRAs, IRC 4975 further classifies the following as disqualified persons.
- Any entity that is 50% or more controlled or 50% or more beneficially- owned (including attribution from family members, partners and through other entities) by the IRA’s owner;
- Any officer, director, 10% shareholder, partner, or individual earning 10% or more of the annual wages of an entity identified in 1); or
- Any IRA trustee or custodian and/or service provider and individuals and entities related to them.
According to the IRS, if you have a stake of 50% or more in an entity, including any indirect interest through specified relatives, your IRA cannot engage in transactions with that entity because it would be considered a disqualified person. However, if you and your spouse together own 49% of the entity while unrelated partners or entities own the remaining 51%, it would be possible for your or your wife’s IRA to acquire the shares of the other partners and become 100% owner of the entity if desired. It is crucial to note that, at the time of executing the transaction, one cannot have an interest of 50% or more. Failure to adhere to this rule leads to the creation of a prohibited transaction.
Regarding the second point, if the entity meets the criteria outlined in item 1 and is considered a disqualified person, your IRA is prohibited from engaging in transactions with individuals whose circumstances mirror or surpass those mentioned in point 2. The same restriction applies to dealings with the entities listed in point 3. For instance, you are not allowed to co-invest with the custodian of your IRA. The Pension Protection Act of 2006 introduced a new exemption that permits specific sales and loans with non-fiduciary service providers, but only if specific conditions are satisfied.
Prohibited Transaction Examples
Here are some instances that are considered prohibited transactions within an IRA:
1. Borrowing Money From Your Plan
Although participants in numerous qualified plans have the opportunity to take out loans, they are required to repay the loan with interest within a specific timeframe. On the contrary, IRAs are not permitted to lend money to any individual, including the owners of IRAs and disqualified individuals.
Borrowing should not be mixed up with valid and permissible investments like private placements. However, it is crucial to exercise caution in order to prevent funds from being invested with someone who is disqualified. For instance, if your spouse is initiating a property rental venture, they might require investors to contribute capital for its launch. While you can invest in the business using your personal savings, it is not permissible to use your IRA assets due to your spouse being considered a disqualified individual. The investment would be permissible if the business owner were not disqualified.
2. Selling Property to Your Plan
If you perform a sale of the property to your IRA, it will be considered a prohibited transaction.
3. Using the IRA as a Security for a Loan
The IRS considers any amount pledged as security for a loan using your IRA as collateral as a distribution, which prohibits its usage.
4. Buying Property for Personal Use
If you use assets from your IRA to purchase property for personal use, it is viewed as inappropriate utilization of IRA assets, which could lead to the disqualification of your IRA.
Consequences of Creating a Prohibited Transaction
If you happen to make a mistake and engage in a prohibited transaction, what are the consequences? In most cases, if it was an administrative error by your custodian or administrator, you can rectify it within 14 days without facing any penalties. However, if not, your IRA will be treated as if it had been distributed to you at the fair market value as of the beginning of the year when the prohibited transaction took place. If your IRA holds assets instead of cash, those assets will be considered your personal ownership rather than belonging to your IRA. You will be required to pay taxes on the value of those assets and/or cash in the tax year when the prohibited transaction occurred, in addition to any applicable taxes, penalties, and interest for not paying them on time.
Prohibited Transaction Result
Typically, if an IRA engages in a prohibited transaction, the assets involved are considered as distributed at the beginning of the year in which the transaction took place. Consequently, these assets need to be included in the IRA owner’s income, and if the owner is below 59½ years old, they will be subject to early distribution rules.
Only the portion of the IRA balance that has been pledged as security on a loan is considered disqualified and treated as a distribution in transactions that are prohibited.
Changes Due to COVID-19
Individuals affected by the coronavirus pandemic are allowed to withdraw up to $100,000 from their retirement accounts, such as 401(k), 403(b), or IRA, under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), without incurring the usual 10% penalty for early withdrawal.
In order to meet the deadlines, individuals are required to receive their distributions within the year 2020 and declare them as taxable income. Nonetheless, to reduce the amount of taxes owed, they can choose to divide their withdrawal equally and report it as income over the course of 2020, 2021, and 2022. To illustrate, if an individual received a distribution of $90,000, it would be recognized as $30,000 in income for each of those years. Alternatively, taxpayers can avoid the tax liability altogether by returning the money to their retirement accounts by 2022, which is different from the usual repayment timeframe of 60 days.
Investment in Collectibles
In general, the IRS does not impose many restrictions on the assets that can be held in an IRA. Typically, investors opt for stocks or bonds, while individuals nearing retirement may prefer the secure option of a bank certificate of deposit. Due to the administrative challenges involved, several IRA custodians choose not to offer real estate as an investment; however, there is no legal prohibition preventing them from doing so. If you manage to find a trustee who handles self-directed IRA accounts, it opens up the possibility of investing in real estate and other assets.
However, life insurance and collectibles are not permitted as investments in IRAs. Collectibles comprise of the following assets:
- Artwork
- Rugs
- Antiques
- Metals (with the exception of certain bullion)
- Gems
- Stamps
- Coins (with some exceptions)
- Alcoholic beverages
- Certain other tangible personal property
If collectibles are purchased using IRA funds, the amount will be treated as a distribution in the year of investment. If you are younger than 59½ years old, you will be subject to the 10% penalty for early distribution.
Having prohibited transactions can severely affect your retirement portfolio. It is crucial to understand what qualifies as a prohibited transaction and how to prevent the negative outcomes they bring. Upon creating an IRA, your trustee must supply a disclosure statement that encompasses details regarding prohibited transactions and any possible exemptions.
Summary of what to do and not to do
Things you shouldn’t do:
- Don’t create a prohibited transaction by having your IRA transact with yourself
personally, your spouse, descendents, or ascendants (e.g. avoid self-dealing); - Don’t engage in a transaction with your IRA and a third party’s IRA on a “quid pro quo” or reciprocal basis in attempt to circumvent an otherwise prohibited transaction;
- Don’t deal with an entity that you or the some of your related disqualified persons own 50% or more of;
- Don’t personally guarantee a loan that your IRA obtains;
- Don’t make personal (including disqualified persons) use of any asset your IRA owns;
- Don’t provide more than ministerial services (e.g., decision-making) to your IRA or IRA owned entity (e.g., no “sweat equity”);
- Don’t take any personal compensation for any services provided to your IRA or as a result of a transaction that your IRA participates in;
- Don’t engage in any transaction that results in any personal gain (e.g., a guarantee of employment) for you or your disqualified persons (other than the benefit that the IRA receives;
- Don’t co-invest personally with your IRA in any asset that you use as a loan collateral;
- Don’t take constructive receipt of any income from assets owned by your IRA and do not pay (personally) the expenses of assets held by your IRA.
Here are the guidelines:
- Do consider including alternative assets in your retirement portfolio for diversification and risk protection;
- Do consult with a knowledgeable advisor when in doubt.
- Do educate yourself. Read all the free educational material on our website or on those
of our members;. - Do consider using an IRA when you, a relative or friend starts a new business.
- Do consider your Roth IRA for those investments with the greatest upside potential;
- Do consult a tax accountant if you are considering using leverage when investing;
- Do maximize your contributions to 401(k)s that are matched by your employer and contribute to Roth IRAs each year, if eligible;
- Do , if you are a professional consider learning more about self-directed IRAs as a means to stay at the forefront of the knowledge curve;
- Do tell your friends about the possibilities of self-directed IRAs – they’ll thank you;
- Do consider getting your children started on saving for retirement and education while they are young by establishing a Roth IRA or Coverdell Education Savings Account.
Leave a Reply