3 Things You Didn't Know About IRA Prohibited Transactions | Ed Slott and Company, LLC

3 Things You Didn't Know About IRA Prohibited Transactions

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

Prohibited transactions are a list of things that you cannot do with your retirement account. In fact, they are one of the worst things you can do with a retirement account. When a prohibited transaction occurs, your entire IRA is deemed distributed as of January 1 of the year you made the prohibited transaction.

This can lead to any number of negative consequences, the least of which include massive taxation and penalties. Since the prohibited transaction rules are so important, the basic information can be readily found in IRS publications and other places on the web, but here are 3 things most people don’t know about them

1) Buying collectibles with your IRA money is not a prohibited transaction
If you know the IRA rules pretty well, right about now you might be thinking to yourself, “But I thought that buying collectible with IRA money isn’t allowed?” And if you were thinking that, you’d be right. You cannot buy collectibles, such as artwork, with IRA money, but doing so is not a prohibited transaction, it’s a prohibited investment. That might sound like splitting hairs, but it’s not. Unlike a prohibited transaction, where your entire account is deemed distributed, if you make a prohibited investment, only the portion of your IRA that is invested in such assets is deemed distributed.

Example: You have a $300,000 IRA and invested $20,000 in collectible stamps. At the time of purchase, $20,000 is treated as having been distributed from your IRA and is subject to tax. If you’re under 59 ½, you’ll also be subject to the 10% penalty. The remaining $280,000 in your IRA, however, remains intact and tax-deferred.

2) Transactions with parents or children aren’t okay, but transactions with brothers or sisters are… sort of… but not really…
Okay, I can understand where that would confuse just about anyone, but here’s the deal in a nutshell… There are certain people and entities that are specifically designated by the tax code as disqualified persons with respect to your IRA. That means that, under no circumstances (with the extraordinarily remote exception being if the Department of Labor has granted a Prohibited Transaction Exemption), can your IRA engage in any transaction with such an individual or entity. Such statutorily disqualified persons include parents, children, businesses and trusts for which you directly or indirectly own 50% or more and, of course, yourself. It doesn’t matter what the circumstances of the transaction are, such as for how much the transaction is for or whether it was made using fair market value. A transaction of just $1 with the wrong person can destroy your IRA.

You have a $500,000 in an IRA and own a few shares of privately held stock that your son would like to purchase. The shares have a fair market value of $2,000. Being a good parent, you decide to appease junior and sell him the shares for $2,000, their fair market value. Well, junior may be happy, but you sure won’t be. You just committed a prohibited transaction and your entire IRA – the full $500,000 – is deemed distributed. You no longer have an IRA but instead, have a hefty, hefty tax bill.

Now, however, suppose that you had the same situation, but your brother wanted to buy the private held stock from your IRA instead of your son. Well, interestingly enough, brothers and sisters are not disqualified persons. However – and this is a big however – there is another part of the prohibited transaction rules that says, in layman’s terms, “If you benefit from an IRA transaction in any way other than through your IRA, it’s a prohibited transaction.” Would that be the case in the example above? Maybe not, but I wouldn’t tempt fate. Remember, just one small prohibited transaction can wipe out your IRA and a lifetime of savings.

3) A prohibited transaction can cost you bankruptcy or creditor protection
As mentioned above, prohibited transactions treat your IRA as if it were distributed from your IRA account when the prohibited transaction is made. That’s true even if your funds are still physically in an account designated as an IRA (i.e., you’re still getting monthly statements from your custodian – who may not know about your prohibited transaction – that say “IRA”). Thankfully, IRAs and other retirement accounts have extremely strong bankruptcy protection under federal law. In addition, many states have chosen to enact laws that provide strong protection from creditors in non-bankruptcy situations as well. Here’s the rub… If you commit a prohibited transaction, your money is no longer deemed to be in an IRA and, therefore, any bankruptcy or creditor protection that may have been available to you could be lost. Now, on top of a tax bill, your creditors will have access to the rest of your (former) IRA funds.

 

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