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Avoiding Prohibited Transactions In Your Retirement Plan
Understanding Prohibited Transactions
A self-directed retirement account allows you to invest in a wide variety of assets. Prohibited transactions can occur for many reasons. Some of those reasons include purchasing a prohibited asset, conducting a transaction that involves a disqualified person, or getting involved in a transaction that could qualify as self-dealing. Because of this, it is important to know what kinds of investments are prohibited, who is considered a disqualified person, and how to perform investments in your plan without being guilty of self-dealing.
The Internal Revenue code does not list the various types of investments that are permissible. Rather, it lists what you cannot do. The restrictions on the types of investments that you can make are usually dictated by the custodian’s account agreement. The difference between a self-directed account and a more traditional brokerage account is that the self-directed account allows the broadest possible spectrum of investments that are not expressly prohibited.
It’s a common misconception that the only investments allowed in a retirement account are stocks, bonds, CDs, and mutual funds. The truth is that you can invest into a much broader spectrum of assets, and this has been allowable since IRAs were first established.
You may ask : Why the confusion? Well, the confusion arises because the “big banks” in the retirement industry did a really good job of educating the public that having an IRA means limiting your investment choices by putting your retirement funds into the assets that they sell. Although having an account with one of these banks is right for some, others want more choice and flexibility when it comes to their retirement investments. Enter – IRA Express.
With a self-directed IRA from IRA Express you can invest into any allowable investment as defined by the IRS. The prohibited asset list is very small. Odds are that if you are not looking to purchase a prohibited asset type, you can own in your self-directed IRA the investment you are considering. Optional investment choices include:
Real estate of all types, including:
- Single family and multi-unit rental property
- Rehab property
- Offshore real estate
- Debt financed real estate
- Commercial property
- Unimproved land
Notes of all types, including:
- Secured by first or second liens on real estate
- Secured by mobile homes
- Secured by life settlement contracts
- Secured by other assets, such as equipment
- Unsecured notes
Private Placements including:
- Limited partnerships
- Limited liability companies (LLCs)
- C corporation stock
- Foreign corporations or partnerships
- Joint ventures
Other miscellaneous investments:
- Tax lien certificates
- U.S. minted gold, silver, and platinum coins
- Gold, silver, platinum, and palladium bullion
The laws regarding IRAs and other plans contain few restrictions on the types of investments that are permitted. The only prohibited investments contained in the Internal Revenue Code are life insurance contracts, antiques and collectibles. S-Corporation stock is also prohibited because of how the corporation passes through its income to the shareholders. Collectibles are defined to include any of the following:
- Rugs and antiques
- Metals and gems, except bullion and U.S.- or state-issued minted coins
- Stamps and coins
- Alcoholic beverages
Although Internal Revenue Code 4975 lists very few investment restrictions, certain transactions (as opposed to investments) are also prohibited.
It is extremely important to understand what constitutes a prohibited transaction. There could be severe consequences for you as the plan owner and for the persons who participate. The IRA may be dissolved, and the entire amount treated as a distribution for that year. If you are not yet 59½, you may also have a penalty for early distribution. Because the IRS often does not catch a prohibited transaction for several years, additional penalties can accrue for under reporting income during the years following the prohibited transaction.
Disqualified persons who participated in the prohibited transaction initially pay an excise tax of 15 percent of the amount involved for each year. If the transaction is not corrected within the taxable period, an additional tax equal to 100 percent of the amount involved will also be imposed. The general rule to remember is that a prohibited transaction involves:
- Selling, exchanging, or leasing any property to a disqualified person
- Using the income or assets for personal gain
The critical point in determining whether a transaction might be prohibited is gaining an understanding of who is considered to be a “disqualified person.” Remember to stay on track!
The definition of a “disqualified person” is designed to make sure that the transactions performed in a retirement plan are performed with an “arms-length” and are performed for investment purposes only. The following parties are considered disqualified persons:
- Fiduciary of the plan ~ For a self-directed IRA, any person who controls or manages its assets is considered a fiduciary, including the IRA owner.
- Anyone providing services to the plan ~ This can include attorneys, CPAs and your third-party administrator.
- Employer of employees that are covered by the plan.
- Employee organization whose members are covered by the plan.
- Direct or indirect owner of 50 percent or more interest in a corporation or partnership.
- Member of the family of any individuals listed above. Family members include your spouse, ascendants and lineal descendants, and any spouse of a lineal descendant.
- Corporation, partnership, trust or estate owned 50 percent or more, directly or indirectly, by a disqualified person.
- An officer, director, a ten percent or more shareholder, a highly compensated employee (earning ten percent or more of the yearly wages of an employer) of a person who is an employer or employee organization, the owner of 50 percent or more of an employer or employee organization, or a corporation, partnership, trust or estate that is itself a disqualified person.
- A ten percent or more (in capital or profits) partner or joint venture of a person who is an employer or employee organization, the owner of 50 percent or more of an employer or employee organization, or a corporation, partnership, trust or estate that is itself a disqualified person.
Being able to understand prohibited transactions in you self-directed IRA is very important. All of this information may seem a little bit daunting at first, but it’s not as complicated as it appears. The key to remember from all of this is that your IRA account was meant for your retirement. It cannot be used to directly or indirectly benefit you or any other disqualified person until you remove your assets from your retirement plan after you retire. Keep your investments at an arm’s length and you shouldn’t have any problems.