To fulfill their intended purpose in supporting saving for retirement, Congress grants the Individual Retirement Account (IRA) certain tax preferences, from tax-deductible contributions (as in the case of traditional IRAs) to tax-free growth (for a Roth IRA). But to curtail potential tax abuse, the Internal Revenue Code also limits the range of permissible investments in an IRA, and explicitly bans life insurance contracts and collectibles (and under separate rules, S corporations cannot be owned in an IRA, either).
Furthermore, because an IRA is intended to be treated as a separate retirement account from the other assets of the IRA owner, the Internal Revenue Code also contains a series of “prohibited transaction” rules intended to prevent the IRA owner from using the account to enrich themselves or their family members (without actually taking a taxable withdrawal).
Fortunately, in the past the IRS has been fairly lax in pursuing and attempting to enforce against IRA prohibited transactions. But with the rise of self-directed IRAs buying real estate over the past decade, and more generally the popularity of using self-directed IRAs for alternative investments—which a recent GAO study estimates is now a $50B marketplace—there is a growing risk that the IRS will increase its enforcement on IRA prohibited transactions. That means it’s crucial for IRA owners to take a look at how they’re using their IRA, especially for accounts that are not simply invested in traditional publicly traded securities!
Permitted Investments For IRA Accounts
To ensure that retirement accounts are used appropriately for actual saving and long-term investing, though, the tax code places some limits on the types of investments that can be held inside of an IRA. Thus, while most types of traditional (i.e., publicly traded) investments are permissible—like stocks and bonds, or mutual funds—tax code explicitly prohibits IRA assets from being invested into life insurance contracts, and any form of collectibles (including artwork, rugs, antiques, gems, stamps, and coins, but not including certain gold, silver, or platinum coins or bullion).
However, the reality is that there’s still a wide space of potential alternative investments that lie between the extremes of permitted traditional stocks and bonds (or funds that hold them), and impermissible life insurance and collectibles (and S corporations). Other types of investments that might be held in an IRA, but aren’t traditional publicly traded securities, include limited partnership investments, stock in a small (privately-held) business, or even a direct investment in real estate.
Yet while those investments aren’t specifically prohibited from being owned in an IRA, additional complexities arise, because of the limitations that exist between IRA owners and their individual retirement accounts.
The additional complications derive from the fact that an IRA is technically a separate entity from its owner, who will ultimately use and benefit from the money. And as a result, the tax code requires that the assets of the two remain separate, and not be used in a manner where one indirectly enriches the other—also known as a “prohibited transaction.”
Tax Consequences And Penalties For A Self-Directed IRA Prohibited Transaction
For those IRA owners (or other disqualified persons) who do engage in a prohibited transaction with an IRA, the tax consequences are severe.
The ‘standard’ rule is that if a prohibited transaction occurs, there is a penalty tax of 15% of the amount involved in the transaction, imposed on any disqualified person engaged in the prohibited transaction. And if the prohibited transaction isn’t promptly unwound/corrected within the current tax year, the penalty tax is increased to 100%(!) of the transaction amount.
In the case of IRAs, the consequences of a prohibited transaction are slightly different, but similarly harsh. When an IRA engages in a prohibited transaction, the entire account is disqualified, which means it loses its tax-deferred status, and is treated as though it was fully liquidated in a taxable distribution at the beginning of that year!
Common Prohibited Transactions With Self-Directed IRAs
Fortunately, the reality is that prohibited transactions with IRAs are quite rare, due to the simple fact that the overwhelming majority of IRA assets are invested into traditional publicly traded securities, which doesn’t raise prohibited transaction concerns in the first place.
However, beyond traditional investments, prohibited transactions can sneak in surprisingly easily, especially when it comes to directly owning real estate in an IRA. For instance, if an IRA owner invests directly into a ‘fixer upper’, and then does repair work to it (e.g., fixing up the property), a prohibited transaction has occurred, because the IRA owner rendered services to/for an asset of the IRA. (Instead, the IRA itself needs to hire someone else to repair or otherwise provide services to the property. And the IRA itself must pay for those services out of the IRA’s own cash, as the IRA owner paying for services on behalf of the IRA asset would again be a prohibited transaction, or at least deemed a contribution.)
Other common prohibited transactions with direct real estate in an IRA involve renting out the real estate to the IRA owner or other members of his/her family (who are also disqualified persons), allowing family to stay for free in the real estate, or hiring family members to work on/in the real estate property. And of course, trying to transfer existing real estate the IRA owner already owns into the IRA would be prohibited (because even an arms’ length fair-market-value sale of the real estate from the IRA owner to the IRA is still a prohibited transaction, as the IRA owner is still a disqualified person).
The Rising Scrutiny Of IRA Prohibited Transactions
The reality is that the prohibited transaction rules for IRAs have existed as long as IRAs themselves. And for most of their history, they were largely ignored, because they were largely irrelevant. After all, in a world where most IRA custodians were investing in ‘traditional’ publicly traded investment securities, it was nearly impossible to create a prohibited transaction.
However, with the rise of new ‘self-directed IRA custodian’ platforms like Pensco, Equity Trust, and Entrust Group, there are more options for investors to pursue ‘non-traditional’ alternative investments in retirement accounts. Yet the rise of these types of self-directed retirement accounts has caused concern for the IRS. With good reason—there are now nearly half a million accounts with $50B of collective value being invested in ‘unconventional’ assets in IRAs.
And the lack of consumer education on the issue is concerning, given that avoiding ‘mistakes’ in an IRA that could cause a prohibited transaction is still the responsibility of the account owner. In fact, the GAO expresses concern that some types of alternative investments are sold into self-directed IRAs in a manner that enriches the salesperson or promoter if the deal closes, but disowns any liability if the investment turns out to be a prohibited transaction! Because in situations where the self-directed IRA provider offers ‘checkbook control’, it’s ultimately still up to the IRA owner to determine that each and every check is compliant with the prohibited transaction rules.
In other words, ignorance is no excuse when it comes to prohibited transactions in IRAs, which means it’s time to be more cognizant of the risks of prohibited transactions, and the situations that can trigger them.
If you have questions about the investments in your IRA, speak with your qualified Wealth Manager, and they can guide you through the rules.
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Note: This article is a summary of a piece that originally appeared on The Nerd’s Eye View.