Prohibited Transactions & Disqualified Persons
- Prohibited Holdings
- Prohibited Transactions and Disqualified Persons
- Consequences for Prohibited Transactions
IRS Rules for Self-Directed IRAs: Investment Restrictions, Disqualified Persons and Prohibited Transactions
Self-directed IRAs and other plans provide a great deal of freedom, flexibility, and choice of alternative investments. They are also governed by a set of rules that self-directed investors must be aware of and follow.
There are two types of limitations in regards to IRA investments: restrictions on the types of investments that can be held in an IRA, and certain transactions that are prohibited.
Fortunately, these restrictions are minimal. The Internal Revenue Code Section 4975 permits you to invest your IRA into any type of asset other than life insurance and collectibles, such as art work, antiques, stamps, etc. Prohibited transactions governed by IRC 4975 include any transaction between your IRA and yourself or other disqualified persons, or any disqualified person receiving a current benefit from the assets in your IRA.
Most people have been conditioned to equating saving for retirement with investing in the stock market. This is a result of most IRA custodians (banks, brokerage firms) limiting investment options to these traditional stock market-based investments. Fortunately, the IRS rules are much less restrictive and allow many alternative investments.
Instead of creating a long list of every possible investment, the IRS made a short list of prohibited holdings. Your self-directed IRA may NOT invest in collectibles or life insurance contracts. Any other type of alternative investment, including real estate, mortgage loans, private placements, and LLC’s are permitted, as long as your IRA custodian allows these types of investments.
Prohibited Transactions and Disqualified Persons
Along with the great tax benefits, IRAs come with some restrictions designed to prevent the inappropriate use of retirement funds prior to retirement. You are not permitted to receive any current personal benefit from the assets in your IRA. So, if your IRA owns a rental condo on the beach, you are NOT permitted to use or stay in that property. You are also not permitted to conduct any transactions between yourself and your IRA. For example, if you own a piece of real estate personally, you are NOT permitted to sell that property to your IRA or to personally buy a property from your IRA. These same restrictions apply to certain family members and others defined as “Disqualified Persons.” It is critical to understand who these people are.
- The IRA holder and his or her spouse
- The IRA holder’s lineal descendants (children, grandparents, etc.) & their spouses
- The IRA holders lineal ascendants (parents, grandparents, etc.)
- Investment advisers, managers and fiduciaries
- Any corporation, partnership, trust, or estate in which disqualified persons have a 50 percent or greater interest
- Anyone providing services to the IRA
Your retirement plan is intended to benefit you when you retire and not before. Therefore, transactions that provide immediate financial gain or current personal benefit to the account holder or other disqualified persons are not allowed.
- Sale, 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
- Income or assets of a plan being transferred to, used by, or used for the benefit of 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 interests or for his own account
- Receipt by any disqualified person who is a fiduciary of any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the income or the assets of the plan
Consequences for Prohibited Transactions
In order to dissuade people from prohibited holdings and prohibited investments, the IRS has severe consequences for the owner of the plan and for the persons who participate in a prohibited transaction.
For example, some consequences include:
- Investment is treated as a distribution, which may be a taxable event
- A 10 percent penalty for early distribution if you are not at retirement age
- Additional penalties can accrue for under-reporting if the IRS does not catch it for several years
- Participant may have to pay a 15 percent excise tax on the amount involved for each year
IRC 4975 also governs the consequences if an IRA owns a prohibited holding or conducts a prohibited transaction. For details regarding these consequences click here: IRC 4975 – Prohibited Transactions & Disqualified Persons