With the large swings in the stock market of late, many investors are looking for safer alternatives to invest their IRAs. A self-directed Retirement Account is an excellent option, giving the account holder the freedom to choose their preferred investments outside of the stock market. The types of accounts included in this term are a traditional IRA, Solo 401k, Roth IRA, SEP IRA, and a SIMPLE investment account. However, though these self-directed Retirement Accounts allow for a greater level of investment freedom, they also come with some specific restrictions enacted by Congress. If the account holder engages in what is known as a prohibited transaction, they are liable for severe penalties. Therefore, it is important to know what types of investments are off limits when owning an account of this kind.
Understand The Tax Code
Before examining specific transactions which are prohibited, it is necessary to first make another distinction. The IRS tax code sections 408 and 4975 lay out an important rule which must be followed. These sections define who is a Disqualified Person, and these individuals are not allowed to transact with the self-directed Retirement Account in any way. Any investment engaged in with a Disqualified Person is automatically deemed a prohibited transaction, so it is important to know how to define this term.
Make Sure You Are Not Doing Business With A Disqualified Person
Congress has implemented this rule as a preventative measure, citing that Retirement Accounts are for the express purpose of growing a fund on which to retire, rather than accruing tax benefits for account holder’s personal assets. This law is in place to reduce conflicts of interest and questionable self-dealing. Therefore, any transactions between the account holder’s other assets, or those of their family or extended family are expressly forbidden. The full list of Disqualified Persons is as follows:
- the self-directed Retirement Account holder and their beneficiaries
- the account holder’s spouse
- ancestors such as their parents or grandparents
- descendants such as their children or grandchildren
- the spouses of the account holder’s descendants such as their daughter-in-law or son-in-law
- any person who has management part in the Retirement Account or any of its assets
- any person or company which has been hired to give financial guidance or advice to the Retirement Account holder
- any Retirement Account trustee
- any entity (corporation, partnership, trust, etc) that is owned by a Disqualified Person (ownership being defined as 50 percent stake or more)
Keep The List Of Disqualified Persons In Mind At All Times
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As any transaction carried out with any of the above parties will result in a prohibited transaction taking place, it is vital to keep this list of Disqualified Persons in mind at all times. Now that this term has been properly defined, it is possible to move onto the list of prohibited transactions themselves.
Review The IRS Tax Code To See Which Transactions Are Spelled Out As Prohibited
The IRS tax code specifies only what a self-directed Retirement Account cannot invest in, rather than spelling out what transactions are permitted. This is true for all types of self-directed vehicles, whether it be a traditional IRA, Solo 401k, Roth IRA, SEP IRA, or a SIMPLE investment account. These disallowed investments are termed prohibited transactions, and the penalty for engaging in one can be severe. For the fullest understanding of this concept, it can be broken up into three distinct categories: conflict of interest, self-dealing and direct prohibited transactions. While there are several exemptions to these rules, they hold sway the majority of the time, and are therefore instructive to examine.
Understand "Conflict Of Interest Prohibited Transactions"
First, “Conflict of Interest Prohibited Transactions” are defined as those which involve the account holder’s other assets or their place of employment. Examples of this include lending money to a company in which the self-directed Retirement Account holder has an ownership stake in or is currently employed by.
Learn About "Self-Dealing Prohibited Transactions"
Second, “Self-Dealing Prohibited Transactions” typically involve a Disqualified Person using the self-directed Retirement Account’s assets for their personal interest or other investments. Examples of this are purchasing a piece of real estate in the account holder’s name, but using the assets of the self-directed Retirement Account for the down payment. Also, this could include investing with a fund which is managed by a family member, whereby that person gets a bonus for procuring the investment.
Avoid "Direct Prohibited Transactions"
Third, “Direct Prohibited Transactions” can be understood as the sale or lease of property, lending of money, furnishing of goods or dispersion of assets or income to Disqualified Persons from the Retirement Account. Examples include leasing a house owned by the self-directed Retirement Account to the account holder’s child. Another would be purchasing a rental real estate property, and hiring a family member to manage it. A third example would be the account holder withdrawing funds from the self-directed account to pay personal bills, like their mortgage or credit card payments.
Employee A Reputable Professional Firm To Administer Your Self Directed Account
Clearly, the area of prohibited transactions when dealing with self-directed retirement vehicles such as a traditional IRA, solo 401k, SEP IRA and SIMPLE investment account is not complicated if the basic rules are followed. It is highly advisable to employ the services of a reputable professional firm when undertaking the self-direction of such accounts.