If you own an IRA, you probably know that you can easily move funds from one investment to another, choose from a wide array of investment options and take distributions whenever you want, although you’ll have to pay tax—and maybe a penalty—for the latter privilege. But that doesn’t mean that anything goes.
Caution: The tax law contains strict rules against certain types of “prohibited transactions.” If you’re not careful and comply with all the rules, you could trigger adverse tax consequences.
Generally, the IRS defines a prohibited transaction as any improper use of an IRA by the owner, a beneficiary or any other disqualified person. For these purpose, a “disqualified person” includes IRA fiduciaries and members of the owner’s family. An IRA fiduciary is a person who exercises any discretionary authority or discretionary control over the IRA or in managing or disposing of its assets; provides investment advice to the IRA for a fee or has any authority or responsibility for doing so; or has discretionary authority or responsibility for administering the IRA.
What kinds of actions are considered to constitute improper use of an IRA? The IRS says some common examples are as follows:
- Borrowing money from it.
- Selling property to it.
- Using it as security for a loan.
- Buying property for personal use (present or future) with IRA funds.
However, if you withdraw funds from an IRA and then deposit the same amount back into the IRA, or a different IRA, within 60 days, this technically qualifies as a rollover. Thus, it is not treated as a prohibited transaction.
Furthermore, other rules restrict the types of investments allowed in an IRA. For instance, you can’t invest the money in life insurance or collectibles like artwork, stamps, jewelry and most precious metals. (There are a few limited exceptions for gold or silver coins and certain bullion bars.) Nor can an IRA own property that you personally use such as your house or a vacation home. Certain other types of real estate holdings, like raw land, may be permitted, but few custodians provide this option.
What are the consequences of a violation? If a prohibited transaction occurs, the account no longer qualifies as an IRA as of the first day of the year of the violation. In effect, you’re treated as having received a distribution of all the IRA assets equal to their fair market value (FMV) on January 1. Assuming the total FMV exceeds your basis in the assets, you’ll owe tax on the difference, just like you would on any other withdrawal. To top things off, you’re generally required to pay a 10% penalty tax on distributions made prior to age 59½.
Practical advice: Adhere strictly to these rules. You don’t want a prohibited transaction for an IRA to undo the good from your retirement savings.
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