April 15, 2024

2 Prohibited Transactions To Avoid In Investing Retirement Funds

Updated: November 25 2013
Article by Paul Anderson

self directed ira rulesThe availability of self-directed investments in retirement plans and individual retirement accounts (IRAs) may tempt plan participants and IRA owners to get creative in investing their retirement assets. Unfortunately, that can lead to some unexpected and adverse tax consequences.

These consequences aren’t related to choosing from a menu of mutual funds or exchange-traded funds, or even hedge funds or limited partnerships. They stem from using retirement funds to purchase collectibles, second homes or other property for personal use, or to using them as seed money for a new business. These types of investments are generally prohibited, and the penalty for engaging in them can include accelerated taxation of the amounts used to purchase the investments and several types of penalty taxes.

Investment in collectibles

IRAs and participant-directed accounts in qualified defined contribution plans are prohibited from investing in collectibles of any sort, including coins (except for certain bullion coins), stamps, rugs or antiques, artwork, alcoholic beverages or gems. The result of these investments is that the cost of the item is treated as a distribution from the account, which is then subject to taxation, including the 10% early distribution penalty if the account holder is under age 59½. If the plan is a 401(k), this “deemed distribution” can be especially costly for someone under age 59½, because the plan would be prohibited from making an actual distribution, and the individual would have to come up with the amount necessary to pay the taxes from other assets.

Other IRA prohibited transactions

Another type of investment can be even more problematic — the use of IRA or retirement plan assets to buy property used by the account holder or to purchase an interest in a business in which the account holder is involved. Both the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA) prohibit:

any direct or indirect sale or exchange of property between a plan and a disqualified person (ERISA uses the term “interested party”), or

an act by a disqualified person who is a fiduciary, whereby the person deals with the income or assets of a plan in his or her own interest or for his or her own account.

This situation was addressed in a Tax Court case, Ellis v. Commissioner, T.C. Memo. 2013-245. Terry L. Ellis established a corporation to operate a used-car business, and he directed his IRA to purchase 98% of the corporation for $319,500. As the court pointed out, this transaction itself was not a prohibited sale or exchange of property, since the corporation was not initially a “disqualified person” with respect to the IRA. (The court did not rule on whether the purchase was a prohibited use of plan assets for the individual’s own interest.) However, after the IRA became the principal owner of the corporation, Ellis directed the corporation to pay him compensation for his role in the day-to-day operation of the business. The court ruled that this was an act of dealing with the assets of the IRA in his own interest and was therefore prohibited.

Since the prohibited transaction in the Ellis case involved an IRA, the result was that the IRA ceased to be an IRA as of the first day of its taxable year. Therefore, more than $321,000 was taxable to Ellis as of the date the IRA was established. Because Ellis was not older than age 59½, the sum was also subject to the 10% penalty on early distributions. To make things worse, the court assessed an additional 20% penalty for the “substantial understatement of income tax.”

If the plan had been a qualified retirement plan rather than an IRA, the prohibited transaction would have had different, albeit equally severe, tax consequences. As the disqualified person involved in the transaction, Ellis would have been subject to excise tax penalties under the tax code of 15% of the amount involved in the prohibited transaction — applied for each year the transaction remained outstanding, with a 100% penalty if the transaction was not “corrected” in a timely fashion — and he would have been subject to potential civil and criminal penalties under ERISA. He also would have had to undo the prohibited transaction and restore the plan to the financial position it would have been in if the prohibited transaction had not occurred.

Large accumulations in retirement plans and IRAs can tempt some people to put the money to uses other than pure investments. As the court pointed out, that is precisely the kind of self-dealing the law was enacted to prevent, and the penalties for succumbing to such temptation can be severe.