December 3, 2022

Avoiding Prohibited Transactions for IRAs

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Individual retirement accounts, or IRAs, provide a valuable opportunity to achieve two goals at once: saving for retirement while enjoying tax benefits in the present. While the comparatively new “Roth IRA” taxes contributions for tax-free distributions in retirement, the money that you place into a traditional IRA grows before being taxed, leading to comfortable tax breaks in the meantime while that money grows. Traditional self-directed IRAs build upon this framework by drastically expanding the potential avenues for investment, augmenting the conventional stocks, bonds, and other familiar investment instruments with diverse, sometimes volatile, but always exciting opportunities: cryptocurrency, real estate, and hard-money lending, among others.

Diversification of IRA investing also comes with pitfalls. The IRS lays out a number of prohibited transactions—instances of money changing hands that compromise the integrity of the IRA. If the IRS catches you making a prohibited transaction, you can face steep consequences. Not only can the IRS hit you with a 15 percent penalty, but an unresolved transgression can raise that penalty to an eye-popping 100 percent. This is particularly dangerous to homeowners who make property part of their IRA. Self-directed IRA investors must know how to avoid prohibited transactions for IRAs.

No Keeping It in the Family

The IRS requires investors to keep their IRAs at arm’s length from family members. This comes into play when investors use their self-directed IRA as a hard-money lender. The government knows that lending money to family members can be a dodgy proposition. Investors could engage in tax evasion through loans to spouses and relatives. While certain forms of high-interest or secured lending can enrich a self-directed IRA, the IRS disqualifies family members, no matter the interest rate, as recipients. Real estate that your self-directed IRA owns is closed to taking on family members as tenants.

Keep Custodians Out

Individual retirement accounts, whether they’re traditional or Roth, involve designating a custodian who will oversee the account on your behalf. Custodians and other financial advisors who handle the affairs of your IRA are disqualified from conducting business with your IRA as an entity. In other words, you can’t pay your financial advisor’s fees out of the IRA itself.

No Self-Dealing

The following is one of the hardest parts of avoiding prohibited transactions for IRAs: you can’t engage in business between the IRA and yourself. This means that you must invest in real estate with great care. The IRS usually looks at rental properties. If you perform maintenance on your own self-directed-IRA-owned property, the government will consider this an example of your IRA enjoying an unpaid service. This means paying market value for services through your IRA—and to anyone but yourself. While self-directed IRAs can have promising returns, consult an advisor about its details before going forward.

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