As a retirement investor using the Self-Directed IRA, you must be wary of Self-Directed IRA prohibited transactions before you make an investment. Understanding the rules and regulations surrounding IRA investing ensures that you and your retirement plan remain IRS compliant. If you fail to follow the rules, it can lead to steep penalties and the disqualification of the retirement account.

Self-Directed IRA Prohibited Transactions

IRA owners must fully understand the regulations surrounding IRAs, particularly Self-Directed IRAs, to avoid disqualification. They must be aware of prohibited transactions and adhere to legal guidelines to ensure the status of their IRAs is not jeopardized.

The Internal Revenue Code (the Code) does not state what investments you can make, only what investments you cannot make. Under IRC section 4975, the Code states that the IRA holder cannot purchase life insurance or collectibles (art, stamp, rugs, etc.) with his or her IRA funds.

In general, Self-Directed IRA prohibited transactions fall under three categories:

1. Direct prohibited transaction
2. Self-dealing prohibited transaction
3. Conflict-of-interest prohibited transaction

Understanding Self-Directed IRA Prohibited Transactions

Definition of Prohibited Transactions

A prohibited transaction is any improper use of an IRA account or annuity, as defined by the Code. This includes any transaction that benefits a disqualified person, such as a fiduciary or family member, or involves self-dealing or receiving indirect benefits.

Prohibited transactions can result in severe tax consequences, including the disqualification of an IRA account. The IRS takes these rules seriously to ensure that retirement funds are used solely for their intended purpose—securing your financial future.

Direct Prohibited Transaction

This type of transaction involves a disqualified person and his/her retirement account. An example of a direct prohibited transaction is as follows:

Mark uses funds from his Self-Directed IRA to purchase an interest in an entity that his father owns. This transaction is between two disqualified persons (Mark, the IRA holder, and his father, a lineal descendant). Furthermore, it personally benefits one of the disqualified persons.

IRA-owned property must remain distinct from personal assets, and engaging disqualified persons in transactions related to these properties is not allowed to prevent any indirect benefits that could violate IRS rules.

Self-Dealing Prohibited Transaction

A self-dealing prohibited transaction occurs when an individual uses his or her IRA income or assets for personal gains. For example, Pam uses her Self-Directed Roth IRA funds to make an investment in a company she controls. Ultimately, this transaction will benefit her personally.

The IRS prohibits the use of retirement funds for the benefit of the IRA holder’s personal interests. It is crucial to keep personal funds and IRA-held assets separate to avoid prohibited transactions.

Conflict-of-interest Prohibited Transaction

This prohibited transaction occurs when a disqualified person, who is also a fiduciary, and is involved in a transaction regarding the income or assets of the individual’s IRA. For example, France uses her IRA funds to loan money to a company she owns a small interest in. She also manages and controls the daily operations, therefore has a close connection to the investment.

The Prohibited Transaction rules were created to encourage people to save for retirement and increase their retirement funds through tax-free or tax-deferred growth. However, it also prevents individuals from taking advantage of tax benefits for their personal account.

Disqualified Persons

Another prohibited transaction is the engagement of IRA funds with a disqualified person. The majority of Self-Directed IRA prohibited transaction rules pertain to transactions with such persons. The reason that transactions with disqualified persons are prohibited is because the IRC views such dealings as suspicious, therefore should not be allowed.

Understanding the legal boundaries of IRA investment is crucial, as certain investments, like life insurance policies and collectibles, are not permissible under IRS regulations.

The definition of a disqualified person extends in a variety of scenarios that can be complex. Disqualified persons include the IRA holder and his/her lineal descendants or ascendants (parents, children, etc.). It also includes entities of which disqualified persons own 50%.

Who is a Disqualified Person?

A disqualified person is an individual who is prohibited from engaging in transactions with a retirement plan, which includes:

• The IRA owner and his/her spouse
• The IRA owner’s direct ancestors, such as parents and grandparents
• The IRA owner’s descendants, such as their children and grandchildren, and their spouses
• Any entity in which the IRA owner has a 50% or greater interest
• Fiduciaries of the IRA, such as the custodian or administrator

Disqualified persons cannot engage in transactions with the IRA, except in certain circumstances. Transactions with disqualified persons are considered prohibited and can result in penalties and taxes for the IRA owner. Understanding who qualifies as a disqualified person is crucial to avoid inadvertent prohibited transactions and protect your retirement funds.

Prohibited Investments

The IRS dictates what is NOT permitted for IRA investments. Examples of prohibited IRA investments include:

• Collectibles (such as artwork, stamps, rugs, antiques, and gems)
• Certain coins
• Life insurance contracts
• S corporation stock

These investments are considered prohibited because they are not allowed to be held in an IRA account. Self-Directed IRAs have restrictions on investments, including prohibited investments, which include investments that are not federally legal (like marijuana). It’s essential to be aware of these limitations to ensure your IRA remains compliant and avoids any potential penalties.

Permitted Investments

While the IRS does not provide guidance on permitted investments for self-directed IRAs, it is generally understood that IRAs can invest in a wide range of assets, including:

• Stocks and bonds
• Mutual funds
• Real estate
• Private equity
• Limited liability companies (LLCs)
• Limited partnerships (LPs)

However, it is essential to note that even if an investment is permitted, it may still be subject to prohibited transaction rules if it involves a disqualified person or self-dealing. It is recommended to seek advice from a CPA or other professional to navigate permissible investments and dealings with disqualified persons. By doing so, you can maximize the potential of your self-directed IRA while staying within the bounds of IRS regulations.

Internal Revenue Code Provisions

Below are some of the IRC provisions. Each of these rules fall under different Code sections.

• Prohibiting IRAs from investing in life insurance contracts.
• Referencing tax on prohibited transactions.
• Defining an IRA’s loss of tax-exempt status upon engaging in a prohibited transaction.
• Describing the effect of pledging an IRA or any IRA assets as security for a loan.
• Expressing impermissible investment in collectibles.
• Describing unrelated business taxable income.
• Imposing tax on unrelated business income.
• Describing an unrelated trade or business.
• Swanson v. Commissioner (1996)

Frequently Asked Questions

Bottom Line

A Self-Directed IRA offers incredible investment flexibility, but breaking the IRS prohibited transaction rules can cost you big. Always consult a professional before making investments involving family members, businesses, or personal assets. Have a question about the rules? Contact us today to become a smarter investor!