Did you know that it’s possible to “kill” your own IRA? Now by “kill” I am referring to losing the tax qualified status of your retirement account by engaging in either a prohibited transaction, or making a prohibited investment.
This risk typically only arises within a “Self-Directed” IRA (SDIRA), where an investor eschews the traditional menu of investment options such as publicly traded stocks, bonds and mutual funds to gain flexibility in how their IRA is invested. While the rules can be complex and each individual’s unique situation should be discussed with a knowledgeable tax account, here are the two major pitfalls to avoid if you do decide to establish an SDIRA:
(1) Making a prohibited investment
Most types of investments are perfectly allowable in an IRA, but the IRS does maintain a short list of investments that are not allowed including S-Corp stock, gemstones and other collectibles such as artwork, coins, stamps or antiques. You are also not allowed to invest in insurance contracts in an IRA.
(See IRS Publication 590 for a complete list of prohibited investments.)
As for why the IRS prohibits these specific investments, it is important to remember that your IRA is intended to provide benefits to you only after retirement. Arguably, collectibles such as coins, stamps, or rare cars provide a certain level of enjoyment to the owner immediately and are thus prohibited.
(2) Making a prohibited transaction
You can also jeopardize the tax status of your IRA by engaging in a prohibited transaction. Again, the key issue has to do with the intent of the transaction, and whether the transaction can reasonably be construed as providing you (or those close to you) with a benefit or direct utility, prior to your retirement. As the recent U.S. Tax Court case (146 T.C. No. 7) “James E. and Judith T. Thiessen v. IRS” demonstrated, one of the surest ways to kill your IRA is to invest in a private business and then make or personally guarantee a loan to that business.
In their case, the tax court determined that the Thiessen’s loan guarantee to a closely held business inside their SDIRA was in fact a prohibited transaction, and the entire IRA lost its tax-deferred status.
Other prohibited IRA transactions include:
• Personally borrowing money from the IRA, or using the account as security for a loan
• Selling, leasing or exchanging property to the IRA
• Accepting unreasonable compensation for managing property or assets held by the IRA
• Transferring plan assets, lending money, or providing good and services to disqualified persons such as family members or business partners
(For the complete list of prohibited transactions, please see IRC Section 4975.)
While most IRA account holders who stick with traditional investments have nothing to fear, it is important to be aware of the serious penalties for violating the IRS rules against prohibited investments or transactions in an SDIRA. The rules that are in place also serve to highlight the ultimate purpose of an IRA, which is to benefit the individual account holder, and only after retirement.