A self-directed IRA is a retirement savings plan that allows you to decide what investments will be made. These accounts can hold a variety of investments and provide opportunities that you may not have with other accounts. However, there are certain rules you must follow with a self-directed IRA, like the prohibited transactions rule. Violating this rule can bring penalties and tax consequences. Here’s what you need to know.
A financial advisor can help you create a financial plan to reach your short- and long-term goals.
What Is a Self-Directed IRA?
Self-directed individual retirement accounts were established in 1974 by the Employee Retirement Income Security Act (ERISA). Unlike traditional IRAs that typically limit investments to stocks, bonds and mutual funds, self-directed IRAs can allow you to diversify your retirement savings beyond traditional markets. These investments can range from real estate to private company stock and precious metals.
The structure and operation of a self-directed IRA are similar to other IRAs, but what sets it apart is the role of the custodian or trustee.
For example, the custodian in a self-directed IRA is authorized to allow a broader range of investments. However, the investor holds the responsibility for directing the custodian to make specific investments.
What Are Prohibited Transactions?
Prohibited transactions are certain financial dealings that are not allowed within a self-directed individual retirement account (IRA). Essentially, it is any improper use of funds within the IRA by the owner or custodian, or another beneficiary.
The Internal Revenue Service (IRS) specifically outlines these under the Internal Revenue Code (IRC) Section 4975. They usually involve interactions between the IRA and what the IRS calls “disqualified persons”. These could be the account owner, certain family members or entities in which the account owner holds a substantial interest.
Examples of Prohibited Transactions
According to the IRS, prohibited transactions can include:
- Borrowing money from the IRA
- Using the IRA as a security loan
- Buying real estate with IRA funds that is for personal use
- Selling property to the IRA
These are all prohibited transactions because they constitute an indirect benefit, which is also forbidden under IRC Section 4975(c)(1)(D) and (E).
Exclusive Benefit Rule
The exclusive benefit rule for a self-directed individual retirement account requires that the account must be managed and used exclusively for the benefit of the account holder and their designated beneficiaries.
As explained earlier, the IRS allows self-directed IRA account holders to have more control over their investment choices. But, the exclusive benefit rule limits that control to the objective of advancing the financial well-being and retirement goals of the account owner their beneficiaries.
Specifically, the rule prohibits transactions like the IRS examples that were already covered, which would provide immediate personal benefits to account holders or other disqualified persons.
The rule emphasizes that all transactions within the IRA should work towards enhancing your retirement funds, thereby protecting you from potential tax penalties.
Consequences of Prohibited Transactions
The IRS takes prohibited transactions seriously. Penalties can range from excise taxes of 15% of the amount involved for each year the transaction continues, up to 100% for certain violations under IRC Section 4975(b).
The federal agency also has the power to disqualify the entire IRA, beginning with the first day of the year of the violation. This means that the whole account balance is considered distributed, and thus taxable in the year the prohibited transaction occurred.
A prohibited transaction could potentially lead to a significant financial burden for the account holder.
Exemptions From Prohibited Transactions
An exemption could be granted if a transaction is deemed to be for the IRA’s benefit, rather than the IRA owner’s. This means the transaction should contribute to the IRA’s value or growth potential.
Another possible condition for an exemption could happen is if the transaction is conducted at arm’s length. This term describes a situation where the transaction’s terms mirror those an unrelated party would agree to.
To know for sure if there is a potential exemption, you should discuss your personal situation with a professional, like a financial advisor or experienced attorney.
Tips for Avoiding Prohibited Transactions
Engaging in a prohibited transaction could make you lose the tax-exempt status of your self-directed IRA. Therefore, maintaining the tax-advantaged status of this account is critical for its growth and your retirement savings goals. Here are three common tips to help you avoid prohibited transactions:
- Identify potential risk areas: You can protect your retirement funds by conducting a thorough risk assessment. This means understanding the rules, identifying potential risk areas and taking steps to mitigate those risks. Transactions involving disqualified persons, or those that personally benefit the IRA owner, could potentially be considered prohibited.
- Take preventive measures: To protect your retirement savings from tax penalties, it’s vital to implement preventive strategies to avoid prohibited transactions. Strategies such as maintaining separate accounts for personal and IRA funds, consulting with a tax or legal professional and staying updated with IRA rules can help prevent prohibited transactions.
- Stay informed: Understanding the rules and keeping up to date with any changes is part of the battle in staying compliant with any regulation. Keeping on top of this can help you avoid anything you don’t want to find yourself doing regarding prohibited transactions.
Bottom Line
A self-directed IRA can offer you greater flexibility and higher returns. But this retirement savings account also comes with specific IRS rules that require it to be managed for your retirement goals, and potentially your beneficiaries. Breaking these rules can lead to a significant tax penalty. So you should be careful not to engage in prohibited transactions.
Tips for Retirement Investing
- A financial advisor can help you create a retirement plan for your needs and goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may want to use a free investment calculator if you are trying to estimate how your money might grow over time. This can help you make sure to stay on track.
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