Your investment may be disallowed under Internal Revenue Code Section 408 or result in a “Prohibited Transaction” under Internal Revenue Code Section 4975 and could result in the immediate disqualification of your IRA.
Although IRAs are generally not ERISA plans, the Department of Labor has jurisdiction over these plans for purposes of the prohibited transaction rules, including individual requests for exemptions from those rules. There are two different consequences for incurring a prohibited transaction under the Code:
- For the IRA owner, the IRA is deemed immediately disqualified as of January 1 of the year in which the prohibited transaction occurred (an extremely severe tax consequence), resulting in current income tax treatment of a traditional IRA and possible excise tax penalty for a premature withdrawal from an IRA. If this deemed “distribution” occurs, it will be subject to ordinary income tax and, if you were under the age of 59 1/2 at that time, a ten (10%) percent excise tax on premature distributions may also be assessed.
- For the Disqualified Person involved in the transaction, the initial tax on a prohibited transaction is 15 percent of the amount involved for every year (or portion thereof) in the “taxable period,” which is the period beginning when the transaction occurs and ending on the date of the earliest of (1) the mailing of a notice of deficiency for the tax, (2) assessment of the tax, or (3) correction of the transaction. The 15% excise tax is followed by an additional tax of 100% if the disqualified person is recalcitrant.
The prohibited transaction rules are extremely broad. Thus, the IRA owner self directing his investments must be especially cautious in engaging in transactions that could compromise his best judgment or result in indirectly benefiting him.