Self-Directed Investing and Prohibited Transactions

Featured Image

With the benefits that self-directed IRAs, 401(k)s, and Health Savings Accounts offer, investors must be aware of unique limitations related to these types of accounts, primarily around prohibited transactions. While the IRS does not state what you can do with your IRA funds, they are clear on what you cannot do. Below we provide a brief overview of the rules and relevant definitions found in Internal Revenue Code, Section 4975 that self-directed investors should know.

 

Questions about prohibited transactions? Log in to your client portal at portal.ndtco.com to send questions directly to our staff or to securely submit documents.

 

What is a Prohibited Transaction?

The IRS defines prohibited transactions as any sale, exchange, or lease of property or asset between a plan and a disqualified person or entity. Furthermore, any transfer or furnishing of goods or funds between a plan and a disqualified entity (see below) 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 (such as an immediate member of the owner’s family, see below) 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, just as the IRA holder cannot directly benefit from the use of the property, the property should not directly and immediately benefit 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. As a reminder, all expenses incurred by the asset must be paid by the account itself, just as all income derived from the asset must be returned to and retained by the account.

What is a Disqualified Person or Entity?

A disqualified person or entity is used to describe certain individuals or entities who are not allowed to do business with tax-advantaged plans. This includes 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.

Maintaining Compliance

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.