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Disqualified Persons: What IRA Investors Need to Know

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Estimated reading time: 2 minutes

In today’s uncertain economy, savers are exploring other investment opportunities to invest their retirement plan assets as an alternative to stocks, bonds, CDs, and mutual funds. The retirement industry has coined the term ”self-directed” for this type of retirement plan. Although most retirement plans are technically self-directed, the distinct characteristic of the investments held in self-directed retirement plans is the non-traditional nature of the assets invested in them. Among the most popular self-directed investments are real estate, mortgages, and precious metals.

Self-directed retirement investors however, must be mindful of avoiding certain transactions that may affect the tax-advantaged status of their retirement plan. Prohibited transactions are the most common pitfall related to alternative types of investments. To avoid engaging in a prohibited transaction, the retirement plan must avoid interactions with disqualified persons. The basic transactions include the sale, exchange, lease, or performance of services between the plan and a disqualified person.

Engaging in a prohibited transaction has grave tax consequences for the tax payer. If an IRA engages in a prohibited transaction, under Internal Revenue Code 408(e)(2), the IRA ceases to be an IRA as of January 1 of the year the prohibited transaction occurred. All assets in the IRA become taxable and may be subject to an early distribution penalty if the IRA holder is under the age of 59 ½.

Prohibited transactions may occur directly or indirectly. Here are some examples of direct prohibited transactions:

  • Selling property owned by your IRA to your son-in-law
  • Buying a property owned by your wife’s IRA
  • Lending money to your IRA
  • Living in a condominium owned by your IRA
  • Having your son manage an apartment complex owned by your IRA

Here’s an example of an indirect prohibited transaction:

You sell a property owned by your IRA to your brother with the intent of the brother selling the property back to you, the IRA holder. This kind of circumvention of the law is a prohibited transaction with the same ramifications as a direct transaction. To avoid prohibited transactions, the tax payer should avoid any conflicts of interest between the IRA and a disqualified party. 

Disqualified Persons

As mentioned earlier, prohibited transactions occur between the IRA and a disqualified person. Here is a short list describing who disqualified persons or entities are:

  • IRA holder
  • Spouse
  • Lineal ascendants, i.e., parents and grandparents
  • Lineal descendants, i.e., children and grandchildren
  • Certain business partners
  • Beneficiaries of the IRA
  • A company owned at least 50% by an IRA holder or IRA

Before proceeding with transactions using retirement assets to purchase or manage alternative investments, it is best to seek the assistance of a competent tax or legal advisor. For more information, please contact The Entrust Group for a free consultation by clicking the image below.

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