In general, the penalty under Internal Revenue Code Section 4975 generally starts out at 15% for most type of retirement plans; however, the penalty is harsher for self-directed IRAs.
IRA Holder or IRA Beneficiary Engages in a Prohibited Transaction Under IRC 4975
When a self-directed IRA or Roth IRA holder (owner) or beneficiary is involved in a transaction that is deemed prohibited pursuant to Internal Revenue Code Section 4975, pursuant to Internal Revenue Code Section 408(e), the IRA loses its tax-exempt status and the IRA holder (or beneficiary) is treated for tax purposes to have received a distribution on the first day of the tax year in which the prohibited transaction occurred. The distribution amount that the IRA holder is deemed to have received is equal to the fair market value of the IRA as of the first day of such tax year, and is required to be included in the IRA holder’s income for the year. In addition, unless the IRA holder qualified for an exception to the early distribution penalty (i.e. over the age of 591/2, disabled, etc.), the 10% early distribution penalty would also apply.
Therefore, if the IRA holder or IRA beneficiary engages in a transaction that violates the prohibited transaction rules set forth under Internal Revenue Code Section 4975, the individual’s IRA would lose its tax exempt status and the entire fair market value of the IRA would be treated as taxable distribution, subject to ordinary income tax. In addition, the IRA holder or beneficiary would be subject to a 15% penalty as well as a 10% early distribution penalty if the IRA holder or beneficiary is under the age of 591.2.
Non-IRA Holder or Non-IRA Beneficiary Engages in a Prohibited Transaction Under IRC 4975
In the case where someone other than the IRA holder or IRA beneficiary (for example, another disqualified person) engages in a prohibited transaction, that disqualified person may be liable for certain penalties. In general, a 15% penalty is imposed on the amount of the prohibited transaction and a 100) additional penalty could be imposed if the transaction is not corrected. Note – fiduciaries to an IRA or plan are not subject to the 15% or 100% additional penalty.
Penalties for Engaging in a Prohibited Transaction Under Internal Revenue Code Section 408
The penalty for engaging in an Internal Revenue Code Section 408 prohibited transaction differs from the Internal Revenue Code Section 4975 penalty. If an IRA assets are invested in collectibles or life insurance, only the assets used to purchase the investment are considered distributed, not the entire IRA.
In addition, pledging an IRA as a security for a loan is a prohibited transaction under Internal Revenue Code Section 408(e)(4). Under this section, if an IRA holder pledges a portion of his or her as security for a loan, only the amount pledged is deemed distributed – not the entire IRA.
The prohibited transaction rules are extremely broad and the penalties extremely harsh (immediate disqualification of entire IRA plus penalty). Thus, the IRA owner self directing his or her investments must be especially cautious in engaging in transactions that could compromise his or her best judgment or result in a direct or indirect personal benefit. Accordingly, it is crucial that any retirement investor looking to make an investment involving retirement funds work directly with a retirement tax professional or qualified tax adviser to make sure that the proposed transaction would not violate any of the IRS prohibited transaction rules.
To learn more about the IRS prohibited transaction rules for self-directed IRA LLC investments, please contact a tax adviser at 800-472-0646.