Beware of The IRA Prohibited Transaction Rules
Avoid These 3 Things Or Your Self Directed IRA Is Doomed!
Today, I wanted to talk about something terrifying, and to me, there’s nothing more frightening than an IRS audit. Just ask anyone who has ever experienced an IRS audit, and they can tell you just how intense and humorless the IRS can be when it comes to the tax code.
The quickest way to get yourself into trouble with your self directed retirement account is to engage in an IRA prohibited transaction.
1. Avoid Prohibited IRA Investments
“Prohibited transactions are certain transactions between a retirement plan and a disqualified person. If you are a disqualified person who takes part in a prohibited transaction, you must pay a tax.” Source: www.irs.gov.
When investing your self directed IRA, the last thing you would ever want to do is something that would jeopardize your IRA retirement account by making an IRA prohibited transaction, but it can happen if you are careless or don’t bother to learn or follow the self directed IRA rules.
The IRS allows you to invest your retirement account in pretty much anything you chose. However, there are three investments they strictly prohibit.
- The first are collectibles. Some examples of collectibles include artwork, antiques, vintage cars, wine, baseball cards, jewelry, etc…
- Secondly, the IRS strictly prohibits you from investing in through your IRA is life insurance or life settlements. You cannot purchase a life insurance policy for yourself or anyone else through your self directed IRA.
- Third, the IRS prohibits investments into S-Corporations.
2. Avoid Disqualified Parties
In IRC section 4975 the IRS defines disqualified parties to your IRA as yourself, your spouse and any lineal family members.
It also includes any entity that has a combined ownership greater than 50% by a combination of disqualified parties, 10% owner, officer, director or highly compensated employee of such an entity and any fiduciary of the IRA or person providing services to the IRA.
Don’t Break The Rules or Engage With a Disqualified Person
A disqualified person is the IRA person, the spouse of the participant, ascendants of the participant (mother/father), descendants of the participant (daughter/son), spouses of the participant’s descendants (son/daughter’s spouse) and fiduciaries of the plan (custodian/trustee, IRA LLC Manager).
What does this all mean in layperson terms? A disqualified person is not allowed to:
- Personally, purchase an asset from or sell an asset to your IRA.
- Extend credit to your IRA or take an extension of credit from the IRA (loan to the plan, borrow from the plan or use it as collateral).
- Extend goods, facilities, services or sweat equity to the IRA or use the assets of the IRA for personal benefit, which is also known as self-dealing.
To further avoid circumventing the IRS rules, read our related article related to self-dealing prohibited step transactions.
IRA Prohibited Transactions Listed in IRC Section 4975
Prohibited transactions are any direct or indirect:
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) 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.
A fiduciary (one who controls 10% or more of the IRA) cannot deal with the IRA for their own benefit or have a receipt for consideration where they were involved in a transaction with the plan.
So What Are The Penalties for Such Actions?
IRAs have much stiffer penalties than most other types of qualified retirement accounts.
The penalty for engaging in a transaction forbidden by Internal Revenue Code (IRC) Sec. 408 differs from the penalty of IRC Sec. 4975.
If IRA assets are invested in collectibles or life insurance, only the assets used to purchase the investment are considered distributed, not the entire IRA.
Similarly, if an IRA account is pledged or assigned as security for a debt, the pledged portion is considered distributed.
How Severe Are The IRS Penalties?
Click on the links to the full tax code:
The penalties are pretty severe for IRAs and IRS penalties assessed to your IRA can quickly erode your investing efforts.
“Although the penalty for engaging in a prohibited transaction generally starts out at 15% for most types of retirement plans, the penalty is harsher for IRAs.
IRC Sec. 408(e) stipulates that when an IRA is involved in a transaction which is prohibited under IRC Sec. 4975, the plan loses its tax-exempt status and the IRA holder is deemed to have received a distribution on the first day of the tax year in which the prohibited transaction occurred. The distribution amount which the IRA holder is considered to have received is equal to the fair market value of the IRA as of the first day of such tax year.”
Source: BISYS Retirement Services IRA Training & Reference Manual States
A Note From The Pros
“…If you buy life insurance, collectibles or pledge your account as security, the only portion that will be taxed is the specific asset/value in question. Violating the prohibited transactions in 4975 would result in a full distribution of the account so it could spike your tax bracket.
On top of that let’s say you didn’t report the distribution for three years, and then got audited. You could be facing a penalty every year for non-reporting, and therefore, taxes could add up quickly if you make a prohibited transaction.
That said, I have faced an audit, and I have seen audits where clients did enter into the gray area (and some, in my opinion, violated 4975). It’s not as scary as you would think if you know what you are doing and have competent legal representation. In many cases, the IRS will allow you reverse the transaction to avoid the penalties, but again don’t bet on it. In the 11 years, I have been assisting people in self directing their IRAs. I have never seen a client get taxed and penalized for a 4975 violation. Fortunately, it is a rare occurrence.” self directed IRA advisor.
3. Don’t Neglect Proper Due Diligence
It is extremely important for clients to do their due diligence when choosing an investment. You must first determine whether or not your investment is going to be a prohibited transaction and make sure that no disqualified parties are involved.
Next, it’s important to do research on the company or individual that you are investing with to make sure that the investment is legitimate and that you’re not going to lose the money you’ve invested due to fraud.
When Making an IRA Investment Avoid The “Gray Areas”
The next time you think about making an alternative IRA investment, which lies in a “Gray Area,” make sure to think twice and seriously about the consequences of an IRA prohibited transaction and decide whether it’s worth the risk. Either way, if you have to reverse a transaction or pay the tax for violating the IRS code as the result of an audit, it is costly!
We’ve discussed prohibited transactions in previous articles. If you have specific questions about a particular investment, you should speak with your consulting team, whether it’s your CPA or a tax attorney before committing any retirement funds to a self directed Ira investment.
Remain vigilant and stay clear of the not-so-friendly IRS by avoiding IRA prohibited transactions.