When using a Self-Directed IRA or Solo 401(k) plan to make alternative investments, you must pay attention to all the rules set forth by the IRS. Arguably, the most important of these rules are the prohibited transaction rules. While the IRS does not say what you are allowed to invest in with retirement funds, it does outline what you absolutely cannot invest in. These include life insurance, antiques, many collectibles and certain coins. In addition to these items, you also may not take part in a transaction involving a disqualified person. Disqualified persons include you, your spouse and all lineal ascendants and descendants and their spouses. Correcting a prohibited transaction is technical, but fairly easy to correct. You must do so in a timely matter however.
What is a Prohibited Transaction?
The Prohibited Transaction Rules can be found in Internal Revenue Code 4975. There are three types of prohibited transactions: Direct/Indirect, Self-Dealing and Conflict of Interest. These apply to both IRAs and 401(k) plans. They’re in place so you don’t get a personal advantage in addition to the tax benefits of the plan. Here’s quick summary of each one:
- Direct/Indirect – This is a transaction between a disqualified person and his or her retirement account. For example, using your Self-Directed IRA to purchase a house that you then lease to your daughter. Since your daughter is a lineal descendant, this is a prohibited transaction.
- Self-Dealing – You cannot personally gain by the investments made by your plan. Your retirement plan is already tax-advantaged, therefore you cannot also personally gain from it. An example is when you want to personally own a real estate property, but you use funds from your 401(k), in addition to personal funds, to make the purchase. Since this benefits you personally, it is prohibited. Here’s another example: You invest in your son’s business with your Self-Directed IRA. Since, your son is a disqualified person, this is not allowed.
- Conflict of Interest – This involves a disqualified person who is also a fiduciary and is connected to a transaction that involves the income or assets of the individual’s IRA. Here’s an example: You take a loan from your Solo 401(k) plan and invest it in a business you manage and also have an ownership stake in. Since you are the fiduciary, there is a conflict of interest in the investment.
These are just a few examples of the prohibited transaction rules.
Penalties for Engaging in a Prohibited Transaction
Failure to abide by these laws come with serious consequences for your retirement plan. Typically, the penalty starts out at 15% for most retirement plans. However, Self-Directed IRAs are treated more harshly.
If you or your beneficiary of the IRA engages in a prohibited transaction, the IRA will lose its tax-exempt status. The entire fair market value (FMV) of the IRA will then be treated as taxable distribution and be subject to ordinary income tax. Furthermore, the IRA holder (or beneficiary) is subject to a 15% penalty, plus the 10% early distribution penalty if the IRA holder (or beneficiary) is under the age of 59 1/2.
If you have a Solo 401(k) and engage in a prohibited transaction, the penalty is 15% of the amount involved. The IRS allows for some time to pay this tax and fix the transaction. Failure to do so will lead to an additional 100% penalty of the amount involved.
Correcting a Prohibited Transaction
Basically, to correct a prohibited transaction within a retirement account, you must undo it as soon as reasonably possible. A frequent one that occurs is when you sell an investment held by your Self-Directed IRA and the funds go directly to you (or to a different IRA and custodian). Since they didn’t first go to original custodian, this constitutes a prohibited transaction. To correct this, you (or the new custodian) would need to send the funds back to the investment. In turn, the investment would then send them to correct IRA and custodian. You may then choose what to do with the funds.
Correcting a prohibited transaction is not always that simple. The rules set forth by the IRS (found here) are quite complicated. For example, if real property was involved (say you sold a 401(k)-owned property to your father), you would first need to rescind the sale. If any income was earned using the property, it must also be returned to the plan.
Navigating the complicated IRS Prohibited Transaction rules is quite difficult, even for experts. Self-directed retirement plans allow for numerous types of investment that can be made with just about anyone. However, when family is involved, you must tread lightly.
The content laid out here is just a “Cliff notes” version of all the nuances associated with these rules. It’s best to deal with professionals, who know the law backwards and forwards, before engaging in a transaction that might not be allowed by the IRS. The last thing you want is to be hit with a huge penalty, on top of a huge tax bill if your Self-Directed IRA is deemed “distributed” because of a mistake. Correcting a prohibited transaction can be done, but help will generally be needed.