Entrust Learning Center > Investments > Understanding your IRA: Prohibited Transactions and Self Dealing

Understanding your IRA: Prohibited Transactions and Self Dealing

The most frequently asked questions about self-directed retirement plans are about which kinds of transactions are permitted, and which are not. How much freedom do you have when it comes to investing with your tax-free or tax-deferred IRA?

The most frequently asked questions about self-directed retirement plans are about which kinds of transactions are permitted, and which are not. How much freedom do you have when it comes to investing with your tax-free or tax-deferred IRA?
 
It is interesting to note that the IRS tax code addresses this question by outlining and defining what is prohibited, or what you cannot do. Self dealing transactions are prohibited. The terms "self dealing" and "prohibited transaction" may be used interchangeably. There is little in the way of guidance or direction regarding what is allowed, in specific terms. Therefore it is important to understand the basic intent of your retirement plan, and the language that defines prohibited transactions.
 
Fundamentally, your retirement plan is intended to benefit you when you retire, and not before then. This simple concept is helpful in understanding the rules on permitted uses of your IRA . If you are planning any transaction which clearly appears to confer direct benefits to you prior to retirement, you should carefully examine the legality of such a transaction.
 
A working knowledge of several terms is invaluable in examining your options. The meanings of words like "You," "Individual Retirement Account," "Plan," "Disqualified Persons" and "Transactions" may not apply in obvious ways. Exploring these phrases in the context of this specialized subject helps to simplify things:
 

• "You" are not the Individual Retirement Account. You and the IRA are two entirely separate entities. You establish a trust for your benefit, through a legally permitted entity, such as a bank, savings association, or non-bank trustee. Your trustee or custodian acts on your behalf, based on your direction.
• An "Individual Retirement Account," also known as a "Plan," is a type of individual retirement arrangement which allows tax deferrals or permits tax-free accumulation of money. This account (IRA) is opened so that transactions you direct may be processed on your behalf by your trustee or custodian.
• "Transactions" are the means of moving funds into your account, and making use of the funds in the account. These include contributions, purchases, sales, and distributions.
• Contributions are those transactions in which you deposit money to your account based on the legal limits in accordance with your earned income. Rollover's are a different kind of contribution that is permitted. Purchases are the acquisition of assets which you direct through your custodian or trustee. ( Accounts opened with insurance companies generally purchase Individual Retirement Annuities). You may never purchase an asset and then contribute it to your IRA- purchases must be done inside your plan. Only cash may be contributed, as noted previously. Sales are transactions in which you direct your trustee or custodian to sell an asset from your account; the proceeds of which (cash or other property) remain in your account. Distributions are withdrawals from your account. You request withdrawals, in cash or in kind, from the trustee or custodian, to be made payable to you. If you ask that such withdrawal payments or assets be conveyed to a third party, it still counts as a withdrawal to you. This is very important information as regards traditional IRAs, where distributions or withdrawals are taxable events; while distributions from Roth IRAs are generally tax-free, the same principals generally apply. 
  

By now it is clear that "You" and your IRA are different, and your trustee or custodian acts on your behalf based on your direction. By inference, it is clear that "you" never "buy" an IRA. Instead, you open an Individual Retirement Account, and then direct the purchase of an asset, which may be through the process of opening the account, or by a separate direction. A prohibited transaction is generally defined as the improper use of your IRA by you or any disqualified person.     
 
For IRAs a disqualified person is:

• the IRA holder and his or her spouse;
• the IRA holders ancestors, lineal descendants and their spouses;
• investment advisors and managers;
• any corporation, partnership, trust or estate in which the IRA holder has a 50 percent or greater interest; and
• anyone providing services to the IRA such as the trustee or custodian. 
  

So, what is prohibited?
 
Your Plan may not, directly or indirectly, sell, exchange, or lease any property to or with you or a disqualified person. This includes lending money or extending credit. Your Plan cannot furnish goods, services, or facilities to you or a disqualified person. Neither you nor a disqualified person can transfer assets to each other, or use or benefit from an asset in the plan.

There are some exemptions.

A contract or reasonable arrangement made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan is allowable, if no more than reasonable compensation is paid therefore.
 
The exemption may include servicing notes which you have directed to be purchased, and managing property which you have directed to be purchased. It does not include leasing back property to yourself or a disqualified person, if acquired by your direction in a plan. Nor does it include compensation to you or a disqualified person for rehab work performed on an asset in your plan.
 
The actions which cannot be performed by you or a disqualified person may, however, be accomplished through some other party. You may locate a person who handles similar types of investments with their plan assets, and arrange a mutually satisfactory arrangement. In other cases, siblings can accomplish what would otherwise be prohibited.
 
In summary, prohibited transactions (self dealing) are those transactions that violate the basic intent of your IRA. They do not impose unacceptable limitations. On the contrary, there are numerous methods which do not violate the law that can be used to meet your long term objectives, and allow you to get the most out of your plan. A complete understanding of the applicable rules is encouraged, in order that you realize all the benefits available to you in directing your IRA.

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