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.

Prohibited 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 If a prohibited transaction occurs, the account will be treated as if all of the assets were withdrawn, and the account will be subject to income tax plus a 10% early withdrawal penalty if the owner is under age 5912.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.