Most people planning for retirement have a traditional IRA. Did you know there are certain things you cannot own in your IRA? The IRS considers these prohibited investments.
There are also transactions not permitted in your IRA. Prohibited transactions restrict who can enter into transactions in your IRA.
As an owner of an IRA, if you engage in a prohibited transaction, the penalties are among the most severe of all IRA penalties. In today's post, we're going to talk about both prohibited investments and prohibited transactions in an IRA.
Prohibited investments are pretty simple. Prohibited transactions are not. We will spend most of our time talking about what constitutes prohibited transactions and how to avoid them.
Prohibited Transactions in a Traditional IRA
Your 401(k), 403(b) or other employer retirement plan offer a limited choice of investments. The company determines the menu of funds. You decide on the fund choices within that menu.
In some cases, the plan has a brokerage option that, if selected, opens up the investment choices like any other investment account. However, this option is risky for the employer. As a result, fewer and fewer companies offer brokerage accounts.
An IRA, on the other hand, offers the broadest range of investment options. If you open your account at a brokerage firm, be it one of the big name national firms, or a do it yourself firm like TD Ameritrade, eTrade or others, your investment options are endless. You can choose from any listed stock, bond, option, mutual fund, ETF and many alternative investments. You can also select annuities in your IRA. Some buy annuities for the guaranteed future income feature.
There are two kinds of investments prohibited in an IRA – life insurance and collectibles. Collectibles are things like artwork, coin or stamp collections, metals, rugs, antiques, and gems. The list even includes stuff like baseball card collections.
If an investor owns any of the prohibited investments, the IRS considers the value of the investment to be a taxable distribution. If the investor is under age 59 1/2 at the time of the distribution, an additional 10% early withdrawal penalty may apply. The remaining balance in the IRA is not affected.
For example, let's say you have a traditional IRA valued at $100,000. $25,000 of that is from artwork put into the IRA. The IRS requires that you claim the $25,000 value as a distribution. The remaining $75,000 is not affected.
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Though not considered a prohibited investment under the IRA rules, an IRA cannot be an owner of S-corporation stock. The S-corporation rules state that if an IRA owns S-corporation stock, the corporation loses its favorable S-corporation status. Though technically allowed, the S-corporation rules say that owners of S-corporation stock must be naturalized U.S. citizens or Residents. An IRA doesn't qualify.
Now let's get to the discussion of prohibited transactions. In IRS Publication 590-A, it states the following about prohibited transactions:
“Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).”
A disqualified person cannot enter into any transaction with the IRA. Naming them as beneficiary is not an improper transaction. The beneficiary has no control or influence on the IRA until the owner dies.
The penalties for non-compliance are stiff. If the IRS determines that a disqualified person has improperly used your IRA, the entire balance of the IRA becomes taxable.
Let's go back to the IRA with $100,000. It doesn't matter if the prohibited transaction involved $5,000 or $50,000, the entire $100,000 IRA balance immediately becomes taxable. It's like you distributed the entire account on January 1 of the year in which the violation occurred. The IRS says, “the IRA stops being an IRA on the first day of that year.”
And if the IRA owner is under age 59 1/2, an additional 10% penalty would apply. If the IRA owner has an effective tax rate of 22% and is under age 59 1/2, they would have a tax bill of $32,000 (22% tax+ 10% penalty = 32% x $100,000) on their $100,000 IRA.
Note: This is a simple calculation on the IRA money only, not on the total tax picture of the IRA owner. It is meant for illustration purposes to show the potential tax impact on the IRA, not as tax advice.
What is a prohibited transaction
A prohibited transaction occurs when IRA funds get used for personal interest by the IRA owner or a disqualified person.
IRS Publication 590-A gives examples of prohibited transactions as follows:
- Borrowing money from your IRA – unlike employer-sponsored retirement plans, which often allow loans, you cannot borrow from IRAs
- Selling property you own to your IRA – IRAs can own property like real estate, land, etc. Selling property you or a disqualified person own is prohibited
- Buying a property, you use personally – The same logic applies. If you have personal use of the property, that's a prohibited transaction
- Using the IRA as security for a loan – unlike taxable investment accounts, you cannot pledge your IRA account as collateral for a loan.
The IRS cautions that if the IRA owns “non-publically traded assets or assets that you directly control, the risk of engaging in a prohibited transaction in connection with the account may be increased.”
IRA owner fiduciary
If you have an IRA, the IRS considers you a fiduciary. The IRS calls others fiduciaries including anyone who does any of the following:
- Exercises discretionary control over managing the IRA, including investing or disposing of assets in the IRA
- Provides investment advice to the IRA for a fee
- Has discretionary authority to administer the IRA
Engaging in any prohibited transactions with fiduciaries on the account would mean the account would no longer be an IRA.
You saw the IRS description of disqualified persons earlier. Let's get more specific about who is a disqualified person.
- The IRA owner
- The IRA owner's spouse
- A parent, grandparent, child or grandchild (lineal descendants)
- Any entities in which the IRA owner of lineal descendants fully own or have an interest of 50% or more. These could be companies, partnerships, estates or trusts
- Officers, directors, and highly compensated employees or shareholders who own 10% or more of the companies in which the IRA owner or disqualified person who owns 50% or more of the company
Prohibited transactions happen most frequently in self-directed IRAs where individuals do their own investing (DIYers). When the custodian of an IRA is one of the traditional firms or banks, their rules often help investors steer clear of both prohibited investments and transactions. Following the IRS caution about non-publically traded assets or assets in which your or a lineal descendant exercise control makes it easier to avoid prohibited transactions.
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Example of prohibited transaction
I read a case in an educational course on IRA planning that illustrates the potential complication of some seemingly acceptable investments. The example in the course involved farmland.
A farmer, we'll call him John, decided to purchase farmland with his IRA money. Farmland is a perfectly acceptable investment in an IRA. It is not life insurance or a collectible. The land is not part of an S-corporation. All is well so far.
Here's where the complications can come.
Neither John nor his lineal descendants can farm the land themselves. They would have to hire someone who is not a disqualified person to work the land. It can't be his spouse, children, or grandchildren (lineal descendants) as they are disqualified persons. The IRA must pay all expenses related to the land. That includes any property taxes. If John pays the taxes or costs out of his non-IRA money, he receives a personal benefit from the land in the form of a potential deduction for the taxes or expenses. The IRS considers this a kind of self-dealing.
In that case, the IRA no longer is an IRA.
Avoiding prohibited transactions
The best way to avoid prohibited transactions is to keep your IRA investments in the more traditional publically traded investments (stocks, bonds, mutual funds, ETFs, etc.). Alternative investments in which you have no control are fine as well (hedge funds, private equity, etc.).
Investing in closely held businesses with family members, or projects in an entity you control puts you at a higher risk of violating the rules. If there is any chance an investment in which you have an interest might qualify as a prohibited transaction, it's best to hold that in a separate IRA. Comingling that with other IRA money could cause a more significant tax problem should the transaction be prohibited.
Remember, if the IRS deems an investment or transaction is with a disqualified person, the entire IRA ceases to be an IRA. Comingling a questionable investment with other IRA money can be extremely costly. That gives you a potentially significant, surely unwanted, tax bill. You can reduce that tax bill if you segregate any questionable asset into its own IRA. If the IRS rules against it, at least that's the only money impacted. Other IRAs are not.
My advice – avoid anything questionable. Ask yourself – is this investment worth the risk of losing the tax status of my IRA? I can't imagine a situation where the answer would be yes.
There are hundreds, if not thousands, of rules governing IRAs and retirement plans. The penalties for non-compliance can be stiff. I've previously written about the penalties for non-compliance of the RMD rules. That's one of the stiffest penalties at 50% of what the required minimum should have been.
Having an entire IRA disqualified because you engaged in a prohibited transaction brings a penalty that is much worse. Paying taxes on your entire IRA balance plus an additional 10% if you're under age 59 1/2 makes the 50% penalty seem benign.
As a financial advisor, I've had to steer clients away from things they wanted to put in their IRAs that would have cost them a lot of money and taxes. It is just not worth it.
It's best to avoid any transactions or investments in your IRAs that are remotely in the neighborhood of a prohibited transaction. Many are obvious. Some, like the farmland example, can be complicated.
Stay with traditional investments. Avoid anything that might raise a red flag with the IRS under the prohibited transaction rules. When it comes to IRA investments, keep it simple, and you'll be OK.
Now it's your turn. Did you know about prohibited investments and transactions? Have you thought about investing in any non-traditional assets in your IRA? As always, I welcome your thoughts and comments.
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