Between the time you contribute to and distribute from your IRA, you will be working to ensure that your assets provide the best possible return. However, there are some limitations on what you can do. When investing your IRA assets or implementing certain transactions, you must exercise caution. Lack of knowledge about the rules can lead to serious tax consequences, including the disqualification of your IRA assets. To assist IRA holders in protecting the qualified status of their IRAs, the department of labor provides a list of transactions that IRA holders should avoid, which are referred to as "prohibited transactions". Here we review the common prohibited transactions for IRAs, SEP and SIMPLE IRAs.
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What Is a Prohibited Transaction?
A broad definition of a prohibited transaction is the improper use of your IRA assets by you - the IRA owner - your beneficiary, or certain other parties who are referred to as "disqualified persons". Disqualified persons include:
- Members of your family, such as your spouse, ancestor, lineal descendant and any spouse of a lineal descendant.
- Any party that exercises discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets.
- Any party that charges to provide investment advice with respect to your IRA or has any authority or responsibility to do so.
- Any party that has any discretionary authority or discretionary responsibility in administering your IRA.
- Your IRA custodian/trustee.
- Any entity in which you own at least a 50% share.
Examples of a Prohibited Transaction
The following are examples of improper uses of IRA assets that result in prohibited transactions:
1. Borrowing Money From Your Plan
Many qualified plans offer loans to participants, but these participants are allowed a certain period within which they must repay the loan with interest. IRAs, on the other hand, are prohibited from making loans to any party, including IRA owners and any disqualified person. Borrowing is not to be confused with legitimate and allowable investments, such as private placements. Nevertheless, caution must be exercised to ensure that funds are not invested with a disqualified person. For instance, if your wife is starting a property rental business, she may need investors to provide start-up capital. While you may be able to use your regular savings to invest in the business, you cannot use your IRA assets because your wife is a disqualified person. The investment would be allowed if the business owner were not a disqualified person. (For more insight, see Borrowing From Your Retirement Plan.)
2. Selling Property to Your Plan
If you sell property to your IRA, the sale is a prohibited transaction.
3. Paying Unreasonable Compensation for Management of Your Plan
The compensation the asset manager receives for managing IRA assets should be comparable to the compensation for managing assets of similar balances for all the managers other customers.
4. Using the IRA as a Security for a Loan
Unlike your regular savings account, you are not allowed to use your IRA as collateral for a loan as the amount you pledge as security will be deemed a distribution by the IRS.
5. Buying Property for Personal Use
Using IRA assets to buy property for your personal use is considered an improper use of IRA assets and could result in disqualification of the IRA.
Effect of a Prohibited Transaction
Generally, the IRA assets involved in a prohibited transaction are treated as though they were distributed on the first day of the year in which the transaction occurred. This means that the assets must be added into the income of the IRA owner, and if the IRA owner is under age 59.5, early-distribution rules will apply. For prohibited transactions involving pledging the IRA balance as security on a loan, only the amount pledged is considered disqualified and treated as a distribution.
Investment in Collectibles
The type of IRA product you purchase usually determines your IRA investment options. For instance, a bank may offer certificates of deposit as IRA investments; a mutual fund company will offer a variety of mutual funds from which to choose for investing your IRA; a brokerage firm, on the other hand, may offer you a self-directed IRA.
In a self-directed IRA, your investment options are many and varied. The only restriction is that you may not invest your IRA in collectibles. Should you invest an IRA in collectibles, the amount is considered distributed to you in the year you invested it, and if you are under age 59.5, you may have to pay the 10% early-distribution penalty. Collectibles include the following:
- Alcoholic beverages
- Certain other tangible personal property
Because your IRA assets could be vulnerable if you use them to complete certain transactions, you should know what these prohibited transactions are and their consequences. Your IRA disclosure statement, which must be provided to you when you establish your IRA, should include information about transactions that are considered prohibited, as well as any exceptions. When in doubt, be sure to check with your IRA custodian/trustee.