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Subtle IRA Prohibited Transaction Rules

When a person first discovers that his retirement accounts don’t have been chained to Wall Street stocks his mind starts to think about the investment possibilities. However, prohibited transactions is an important topic when looking into self-directed IRA and Solo 401k investing. Typically people are limited by the investment options (only stocks, bonds, mutual funds, etc) but that can be eliminated by setting up a proper solo 401k account or setup an account with a proper custodian that allows such transactions. The other limitation is one that is bound by IRS rules and cannot be removed but is fairly simple to follow.

The general premise behind prohibited IRS transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make losing investments that actually put their retirement funds into their own hands. The prohibited transaction rules make the above scenario illegal. In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives.

Here are some common strategies that are wrongly believed to successfully circumvent the rules. One is when two people what to benefit from each other and each others IRA. They swap benefits for personal gain. For example, Bob and Tom each have a self-directed IRA. Tom’s IRA loans $10,000 to Bob and Bob’s IRA loans $10,000 to Tom . This doesn’t break the rules that are most focused on, but it does break the usually ignored rules. For each loan transaction the borrower is not a disqualified person. However, the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction. Another example would be if Bob’s IRA and Tom’s IRA each bought a vacation home and each let the other person stay in the condo. When An IRA owns real estate its owner and any disqualified individuals are not allowed to make personal use of the property even if paying rent. When Bob vacations in a property owned by Tom’s IRA and Tom vacationed in property owned by Bob’s IRA this is a prohibited transaction. Again, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit (whether direct or indirect) as a result of the transaction.

Another common work around is when people want to sell their house and can’t find a buyer. So the person finds a friend to buy the house and later the friend sell the house back to his/her IRA. People think this does not break any rules since the friend is not related and thus is not a disqualified person. The IRS see the friend as a strawperson who is involved for all the wrong reasons and really does not want the house but is helping to add separation to the real estate transaction. The law removes the strawperson to examine the real transacting parties. The IRS sees it as you sold your house to your IRA and that is a prohibited transaction.

You need to clearly understand the rules and don’t enter into these types of transactions. Focus on growing your retirement account without engaging in conflicts of interest.


Trading Futures In Your IRA

Futures trading is essentially buying and selling commodities (grains, cattle, OJ, etc) but in addition includes buying and selling contracts 0f foreign currency, precious metals, bonds, energy (oil/gas) and other items whose price fluctuates from day to day.  Futures traders make money by betting that prices will go up or down and trading the right to buy or sell at a given price and a set time frame.  You can trade futures in your self directed IRA.  However, while futures trading is not expressly prohibited in retirement accounts, there are a number of things to consider before executing trades.

Even though the IRS does not prohibit trading in an IRA, what you can and cannot do in your IRA will be determined by the custodian you use.  Many custodians or plan sponsors do not allow futures trading in your IRA and some just restrict trading certain commodities.  Most 401k and plan sponsors offer a limited selection of investment options.  In the same manner, many companies who offer IRA accounts place restrictions on types of investments to reduce their liability.  If you want to trade futures in your IRA or 401k, the key term is “self-directed.”  Self-directed accounts allow you to take complete control of your investment choices and typically allow futures and futures options trading.  You can also setup a proper solo 401k to be able to invest in many of these alternative investments.

In most cases, day traders make a large number of trades per week in order to generate a profit.  In order to trade a futures contract which are highly leverages, your broker will require that you keep a certain value of assets available in your account to cover all open trades, also known as margin.  Margin is not expressly prohibited by the IRS for IRAs, but have come under scrutiny in the last several years because some say they essentially use IRA assets as collateral for a loan which is an activity that is prohibited under IRA rules.  Traders should be extremely careful to get good advise from a competent attorney and follow all account rules to avoid losing the tax-protected status of their IRA accounts and incurring IRS penalties.

IRAs, 401ks and other qualified retirement plans are tax-protected, meaning that earnings in the account are not taxed immediately as they would be in a regular investment account.  Trading futures in an IRA or 401k allows you to defer your tax obligation and pay it over a longer period of time in retirement. If the account is a Roth IRA, you may not pay tax at all.  This is a great benefit to those who do well with futures trading.  However, futures trading can have a downside as well and if you have losses you cannot write off losses in retirement accounts like you could on your taxes.  This means that if you have a bad year you cannot deduct those losses from your taxable income and reduce the amount of tax you owe.  The National Futures Association warns that futures trading is very risky and as a trader myself I understand the pitfalls.  Therefore, if you chose to trade futures, choose a reputable broker and learn as much as you can about the processes and risks associated with speculative trading before you place your first order.  Also, get some training from a reputable trading education company.  Never trade with money you can’t afford to lose, and beware of any investment advisor or guru offering unrealistic profits or easy money.  Trading should not be looked at as a get rich quick scheme but should be looked at as long term wealth creation.



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IRA Prohibited Transactions

All the rules and restrictions are outlined in the IRS Publication 590.  Not following these rules set forth for Traditional IRAs could affect the tax status of your account and could result in disqualification of the account and severe tax consequences.

Everything in the IRA has to be an arm’s length transaction which means you as the IRA owner can’t benefit from the asset owned by the IRA.    You should always remember that the IRA is intended for your future retirement and not for you benefit now.  Therefore, you must always be asking yourself if there is any personal benefit for you now in doing such a transaction.

 In general, prohibited transactions are any improper use of your traditional IRA account by you, your beneficiary or any disqualified person.

Examples of prohibited transactions are:

  • Borrowing money from IRA
  • Selling property to the IRA
  • Receiving unreasonable compensation for managing the IRA
  • Uses IRA for security on a loan
  • Buying property for personal use with IRA funds – i.e Personally using IRA property for a residence, office, vacation home, etc.

It is also important to remember that the IRA has to be a closed loop in terms of expenses and income or profit.  The expenses related to the property must be paid from the IRA directly and all the income/profits be paid directly to the IRA as well.  For example,  if your IRA owns a rental property then all the rent must be returned directly to the IRA and all the expenses such as maintenance, insurance, taxes, etc must be paid directly from the IRA.

Who are disqualified persons? They are you, your IRA holder, your spouse, parents, children and their spouses, grand children, grand parents and great grand parents, grand children and great grand children and their spouses.  In other words your ascendents and descendants.  Also, anyone acting as a fiduciary and service providers of the IRA like your attorney, CPA or financial advisor.   The weird thing is that brothers and sisters are not included but I personally would not take a chance since I think this was an oversight in the rules.

Who is considered a fiduciary? The custodian of the IRA would be one.  Anyone who provides investment advice for your IRA for a fee would be another.  Anyone who has discretionary authority or control in managing your IRA or disposing of its assets would also be considered a fiduciary.

What happens when my IRA engages in a prohibited transaction?  

  1. The account stops being a IRA as of the first day of that year in which it occurred.
  2. The account is treated as if all assets were distributed to you at their fair market values on the first day of the year.
  3. If the total of those values is more than the basis in the IRA, you will have a taxable gain that is included in your income.