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IRA
Prohibition Laws:
Before you let your clients buy exotic investments for their IRAs, make
sure they know what transactions could put their retirement accounts at
risk.
May 1, 2006- Are your clients bored with traditional IRA investments in
stodgy old stocks, bonds, mutual funds or CDs? Are they looking for
more exotic nontraditional investments for their IRA assets such as
real estate, stock in nonpublic or closely held companies, mortgages
and loans, equipment leasing, receivables or startup companies?
Before you give them suggestions, look closely at what the Internal
Revenue Service has to say on the topic. Tax law does not stipulate
what people can invest their IRA funds in. Instead, it spells out what
they cannot do with their IRA funds. You can't put just any investment
in your IRA, or recklessly use IRA property.
This is an area where clients can face numerous tax land mines and need
guidance from their advisers. If an IRA investment isn't handled
correctly or the property in the IRA is used improperly, it could be
deemed a prohibited transaction. Clients who are thinking about
unconventional or exotic investments for their IRA funds must be
careful.
Prohitibited
Investments:
If your clients want to use IRA funds to buy a life insurance policy,
dissuade them. Life insurance is a prohibited investment under tax law.
Clients also can't invest their IRA funds in collectibles, including
art works, rugs, antiques, metals, gems, stamps, coins and baseball
cards. IRS Code Section 408(m) includes alcoholic beverages as
collectibles, so wine collections are off-limits. Any IRA money used to
buy collectibles will be treated as a taxable distribution. There is an
exception, however, for gold, silver and platinum coins minted by the
Treasury Department and state-issued coins.
Prohibited
Transactions:
Once you know that a particular investment is allowed in an IRA, you
must make sure it's used properly or risk having it treated as a
prohibited transaction. If a prohibited transaction occurs, the account
will be treated as if all of the assets were withdrawn, and the account
will be subject to income tax plus a 10% early withdrawal penalty if
the owner is under age 5912. The owner can keep whatever is left after
taxes, but the account cannot be an IRA, and the tax shelter is lost
forever.
Simply put, prohibited transactions are investments or forms of
self-dealing that put the government at risk of losing its tax on the
IRA. Account owners can always withdraw funds from their IRAs, pay the
tax (and penalty if they are under 5912 and no exceptions apply) and
spend the money, because the government has received its tax and the
money they are spending is no longer IRA money.
There are three types of prohibited transactions: those between an IRA
owner and a disqualified person; those that directly benefit the IRA
owner or other disqualified person and those where the IRA owner has a
conflict of interest. There is no self-dealing allowed in IRA
transactions. If the IRA owner receives a benefit from the transaction,
(other than IRA earnings), it is probably a prohibited transaction and
should be avoided.
In general, a "disqualified person" is anyone connected to the IRA
owner through a family, ownership or business relationship. More
specifically, the following are disqualified persons:
- An IRA fiduciary (including the owner)
- An IRA owner's spouse
- Ancestors
- Descendants
- Spouses of descendants
- Entities, including corporations, partnerships,
trusts or estates that are 50% or more controlled by anyone listed above
- Anyone providing an indirect benefit to the IRA
owner.
Note that IRA owners are
considered fiduciaries, even though they're not the plan custodian.
This is because they have discretion and control over the plan's
investments. If your clients misuse their IRAs, it's their fault; they
can't blame it on the bank.
Siblings, live-in friends or partners are not considered disqualified
persons, but transactions with these people that provide an indirect
benefit to the IRA owner are prohibited. Likewise, business associates
who don't control more than 50% of an entity may be permitted, but not
if there is a conflict of interest or a direct benefit to the IRA owner.
What
to avoid:
Internal Revenue Code Section 4975 specifically prohibits these
transactions:
Buying, selling or leasing any property to or from your IRA. This is
self-dealing, and your IRA plan cannot engage in these transactions
with you, even if the price is reasonable and fair. This would include
setting up your own corporation and funding it with your IRA, which
buys the stock of your new company. Also, as a fiduciary, you have an
obligation to invest prudently. Investing in your own business may seem
more prudent to you than investing in the stock market, but the IRS
doesn't see it that way. It believes you'll lose all your IRA money, or
possibly withdraw it as salary or for other personal use.
Borrowing from or lending money to your IRA. You can't borrow from your
IRA or use it as collateral for a loan, even if the interest rate and
other loan terms are fair. Any amount pledged as security for a loan
will be treated as a taxable distribution and subject to the 10%
penalty (unless an exception applies). Nor can you personally guarantee
a loan given to your IRA to buy property. That would be deemed the same
as loaning the money to your IRA. You can, of course, borrow from the
bank to make an IRA contribution. But you can't borrow your IRA money,
and your IRA cannot borrow from you.
Receiving
compensation for managing your own IRA.
Your IRA cannot pay you for managing it.
Buying property for personal use with IRA funds. You cannot use your
IRA money to buy property that you (or your family) use personally. For
example, you cannot use IRA funds to buy a home you use as your
personal residence.
Reducing
the Risk
If your clients insist on using nontraditional investments in their
IRAs, here are some steps they can take to make sure they don't run
afoul of the tax laws on prohibited investments and transactions:
Use separate IRAs.
If there's concern that an investment or transaction
may be prohibited, use a separate account. For example, a client who
buys real estate with IRA funds should buy each property in a separate
IRA. If there's a problem with the investment, it doesn't taint other
IRA funds or trigger their taxation.
Use a Roth IRA.
Tell clients to put nontraditional IRA investments in a
Roth IRA. If a transaction is deemed prohibited, there will generally
be no tax effect. If the transaction works, then the income from the
investment will be exempt from income tax in the Roth.
Assemble a team of
professional experts and use them. Many people want
to do everything themselves, which could lead to self-dealing and
trigger the disqualification of an IRA. Tell your clients not to use
their professional expertise to benefit their IRA asset (i.e., buy a
piece of land and have their own architectural firm design the building
to go on it). Nor should they use the professional expertise of family
members or business associates.
Set up a self-directed
IRA. Generally, you'll need a self-directed IRA
custodian to make nontraditional IRA investments. Check the investment
with the self-directed IRA custodian. (See also, Summit Trust's Unlimited IRA)
Get a ruling. If
you're unsure if a client's proposed IRA transaction
will be prohibited, request a Prohibited Transaction Exemption ruling
from The Department of Labor for advance approval.
Structure the IRA
investment properly. Proper timing and titling is
critical to avoid prohibited transactions. Any assets bought by the IRA
must be in the name of the IRA and paid for entirely with IRA dollars.
Clients can't write a check from their own checkbook and pay the
balance with IRA funds. Similarly, if clients are going to use an
entity in their IRA to purchase and hold the assets, the entity must be
set up and funded before they start the asset acquisition process.
Don't provide services
to a personal IRA. IRA owners can't provide any
goods or services to property in their IRAs. These are prohibited
transactions. In addition, the monetary value of those goods or
services could become an excess contribution to the IRA. This is
assignment of income. Excess contributions are subject to a 6% per year
penalty until they are withdrawn or until the amount is "used up" in
subsequent years as allowable contributions. For example, using tools
and supplies from a professional business to benefit an IRA is a
prohibited transaction. Clients could even be guilty of tax evasion if
the income generated by the goods and services goes into the IRA
instead of being declared on their personal tax return.
The next time your clients clamor for nontraditional investments in
their IRAs, remind them that if done improperly, these investments
could ultimately cost them their IRAs.
Ed Slott, a CPA in
Rockville Centre, N.Y., is a nationally recognized IRA distribution
expert, professional speaker and author.
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