IRAs were created to be a tax-advantaged way to save for retirement. As a self-directed IRA holder, you have the option to develop retirement savings by capitalizing on your knowledge and expertise for investment opportunities. Whether you invest in alternative or traditional investments (or a mixture of both), knowing the IRS rules associated with these accounts is beneficial. This article touches on two aspects of IRS rules that often affect self-directed IRA owners: prohibited transactions and disqualified individuals.
What are prohibited transactions and disqualified individuals?
Among the many facets of IRA structure and guidelines, IRS Publication 590-A discusses
prohibited transactions and disqualified individuals.
“Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.
Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).”
When it comes to an IRA or other retirement plan, Internal Revenue Code 4975
prohibits the following actions:
Sale or exchange, or leasing, of any property between a plan and a disqualified person;
Lending of money or other extension of credit between a plan and a disqualified person;
Furnishing of goods, services, or facilities between a plan and a disqualified person;
Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
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
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.
From IRS Publication 590
, the IRS also prohibits an IRA from investing in collectibles, such as:
Alcoholic beverages, and
Certain other tangible personal property.
According to IRS Publication 590
, there are some exceptions to the list of collectibles in the form of one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. Certain platinum coins and certain gold, silver, palladium, and platinum bullion may be permissible by the IRS.
What could happen to an IRA if there is a prohibited transaction or an action with a disqualified individual?
Staying within IRS guidelines is beneficial to the well-being of your IRA. According to IRS.gov
, prohibited transactions in an IRA could have the following effect:
“Generally, if an IRA owner or his or her beneficiaries engage in a prohibited transaction in connection with an IRA account at any time during the year, the account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.”
The IRS also describes some possible consequences of participating in a prohibited transaction in their Retirement Plan FAQ
“A disqualified person who takes part in a prohibited transaction must correct the transaction and must pay an excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.
The amount involved in a prohibited transaction is the greater of the following amounts:
the money and fair market value of any property given; and
the money and fair market value of any property received.
If services are performed, the amount involved is any excess compensation given or received.
The taxable period starts on the transaction date and ends on the earliest of the following days:
the day the IRS mails a notice of deficiency for the tax;
the day the IRS assesses the tax; and
the day the correction of the transaction is completed.”
It is important to remember the examples above only skim the surface of IRS regulations and nuances of tax code and law. Seeking the guidance of qualified tax, legal, and financial professional can be beneficial in evaluating investment opportunities and determining the soundness of the courses of action with your IRA.
One of the easiest ways to correct a prohibited transaction is to avoid making a prohibited transaction in the first place.
As the IRS states in their Retirement Topics – Tax on Prohibited Transactions
“A disqualified person who participated in a prohibited transaction can avoid the 100% tax by correcting the transaction as soon as possible. Correcting the transaction means undoing it as much as you can without putting the plan in a worse financial position than if you had acted under the highest fiduciary standards.”
If you have evidence or other reason to believe you have or may have conducted a prohibited transition, seeking the guidance or assistance of a qualified, disinterested third party can be in your best interest.
These references are no substitute for the guidance of qualified tax, finance, and legal professionals in investment and IRA related decisions. Instead, they can be viewed as a starting point for your research and a building block in increasing your knowledge of self-directed IRAs.
The IRS makes its forms and publications
readily available. You can view them online through interactive files as well as request a hardcopy mailed to you.
The Cornell University Law School’s Legal Information Institute
is a publicly available resource housing a legal encyclopedia, lawyer directories, and legal collections. For example, section (e) of 26 U.S. Code §4975
, which deals with the tax on prohibited transactions, is one of many items available in their legal collection on US tax code.