With the benefits that self-directed IRAs, 401(k)s, and Health Savings Accounts offer, investors must be aware of unique limitations. Below we provide an overview of the rules and relevant definitions found in IRC, Section 4975 that investors should know.
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What Are Prohibited Transactions?
The IRS defines prohibited transactions as any sale, exchange, or lease of an asset between disqualified parties. Furthermore, any transfer or furnishing of goods or funds between a plan and a disqualified entity is equally prohibited. The account cannot conduct any business with a disqualified entity to prevent misuse and abuse of tax-advantaged funds.
For example, a prohibited transaction could be a disqualified person using an IRA-held property for personal vacations or rental purposes. Similarly, a prohibited transaction could be an IRA-held commercial property used to house the IRA holder’s personal business. In both instances, economics could be shifted between the account and the account owner, potentially skirting contribution and distribution rules.
Conversely, the property cannot directly and immediately benefit, be it financial or otherwise, from the IRA holder. For instance, he or she cannot personally perform repairs and renovations or pay for them with personal funds. Doing so would effectively contribute to the value of the tax-deferred account and potentially exceed the annual contribution limits. Expenses incurred must be paid by the account, just as income enjoyed must be retained by the account.
What is a Disqualified Person or Entity?
A disqualified person or entity is not allowed to do business with one’s tax-advantaged plan. Disqualified persons include the account holder, his or her spouse, any of the account holder’s ascendants (parents, grandparents) and their spouses, or descendants (children, grandchildren) and their spouses. This also includes any business partners or financial advisors of the account holder. While this specific list is not exhaustive, it does provide general principles regarding who can and cannot do business with a self-directed IRA, 401(k), or Health Savings Account. Again, the reasoning for this limitation is these entities would benefit from the account’s funds, bypassing contribution and withdrawal limits, through receipt of economic benefit.
While prohibited transactions can be an intimidating area within the self-directed investing field, they can be avoided by ensuring your IRA does not conduct business with disqualified persons or entities. As a self-directed plan custodian, New Direction Trust Company reviews and executes transactions if they appear to be in IRS compliance, but prohibited elements within these transactions are not always apparent. The account holder is responsible for ensuring an investment or prospective transaction follows IRS rules, but feel free to let us know if you have any questions.