After setting up your Individual Retirement Account (IRA), you will be working to achieve the best possible returns to ensure a comfortable retirement. However, there are limitations on what you can do. Certain transactions are prohibited and you must exercise caution.
Lack of knowledge about these prohibited transactions can lead to serious tax consequences, including penalties and the loss of favorable tax treatment for your IRA. To assist IRA holders, the Internal Revenue Service (IRS) provides a list of prohibited transactions that retirement savers should avoid. Here we review the rules in further detail.
- A prohibited transaction is the improper use of IRA assets by the IRA owner, their beneficiary or "disqualified person" such as a fiduciary.
- Borrowing from an IRA or pledging IRA assets as loan collateral are both prohibited.
- IRAs are restricted from buying life insurance or collectibles.
- Your IRA trustee or custodian is obligated to make disclosures regarding prohibited transactions.
What Is a Prohibited Transaction?
A prohibited transaction is the improper use of IRA assets by you the IRA owner, your beneficiary or any "disqualified person." A disqualified person includes:
- 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
Engaging in prohibited IRA transactions can result in penalties, excise taxes and the loss of IRA status for your assets.
Prohibited Transaction Examples
The following are examples of prohibited IRA 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 example, if your spouse is starting a property rental business, they 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 spouse is a disqualified person. The investment would be allowed if the business owner were not a disqualified person.
2. Selling Property to Your Plan
If you sell the property to your IRA, the sale is a prohibited transaction.
3. Using the IRA as a Security for a Loan
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.
4. Buying Property for Personal Use
Using IRA assets to buy property for your personal use is considered improper use of IRA assets and could result in disqualification of the IRA.
Prohibited Transaction Result
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 to the income of the IRA owner, and if the IRA owner is under age 59½, 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.
Changes Due to COVID-19
Under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), individuals impacted by the coronavirus pandemic may take up to $100,000 from retirement accounts such as a 401(k), 403(b) or IRA without having to pay the 10% early-withdrawal penalty.
Distributions must be taken in 2020. Taxpayers must report the distributions as income. However, to minimize their tax burden, they have the option of breaking their withdrawal into equal parts reported over 2020, 2021 and 2022. For example, a $90,000 distribution would be reported as $30,000 in income in each of those years. Taxpayers can also avoid the tax hit by redepositing the money into their retirement accounts by 2022 (versus the standard repayment requirement of 60 days).
Investment in Collectibles
Generally speaking, the IRS places few exceptions on the types of assets an IRA may hold. Most investors will buy stocks or bonds, while those closer to retirement may seek the safety of a bank certificate of deposit. Because of the administrative burden, many IRA custodians do not offer real estate as an investment, though there is no law preventing them from doing so. If you find a trustee that handles self-directed IRA accounts, real estate and other investments become possible.
However, the law restricts IRAs from investing in two types of assets: life insurance and collectibles. Collectibles include the following:
- Metals (with the exception of certain bullion)
- Coins (with some exceptions)
- Alcoholic beverages
- Certain other tangible personal property
If you use IRA funds to invest in collectibles, the amount is considered distributed to you in the year of investment. If you are under the age 59½, the 10% early-distribution penalty would apply.
The Bottom Line
Prohibited transactions can have a dire impact on your retirement portfolio. You should know what constitutes a prohibited transaction and the steps to avoid their consequences. When you establish an IRA, your trustee should provide a disclosure statement, which will include information about prohibited transactions as well as any exceptions. When in doubt, be sure to check with your IRA custodian or trustee.