When researching Self-Directed IRAs, you may come across the term "prohibited transaction." Self-Directed IRA prohibited transactions are improper transactions that occur between an IRA and a disqualified person. IRA account holders need to understand exactly what an improper transaction is and who is considered a disqualified person. A general rule of thumb is that an IRA may transact with third parties but may not transact with close family members or closely held entities.
In essence, IRS Self-Directed IRA prohibited transactions do not limit WHAT an IRA can invest in but rather WHO an IRA can transact with. For example, an IRA may purchase a well-priced rental property from a friend, but that same IRA cannot purchase property from a parent, spouse, or child.
Congress passed the Employee Retirement Income Security Act of 1974, commonly known as ERISA, with the intention of helping Americans save for retirement. Tax advantages were offered to encourage Americans to participate in such plans. But Congress incorporated prohibited transaction rules into the act to prevent people from taking advantage of these specialized retirement accounts.
All of the above transactions are perfectly permissible when performed with third parties; they only become problematic when performed with disqualified persons.
If a prohibited transaction was performed by an IRA owner, the IRA is considered distributed as of Jan. 1 of the year in which the transaction occurred. The distribution amount is based on fair market value. Regardless of the amount involved in the prohibited transaction, the entire account is considered distributed and the IRA owner is subject to any applicable taxes on the distributed amount. Additionally, a 10% early withdrawal penalty would apply if the IRA owner is below age 59 ½ at the time of the transaction. Lastly, taxes apply to any income and gains earned by the IRA after the prohibited transaction took place.
If a prohibited transaction was entered into by an individual other than the IRA owner (e.g., a broker, financial planner, or advisor engaged by the IRA), then a 15% excise tax applies to the amount involved. If the IRA owner does not correct the prohibited transaction, then a 100% penalty may apply.
The Self-Directed IRA account holder and their spouse.
The account holder’s direct ancestors, such as parents and grandparents.
The owner’s descendants, such as their children and grandchildren, and their spouses.
The fiduciary of the Self-Directed IRA and anyone else that provides services to the account/plan (e.g., accountant or financial advisor).
Any entity (e.g. corporation, partnership, LLC) that is owned 50% or more, singularly or collectively, by disqualified persons (i.e., the persons described above).