The individual retirement account (“IRA”) is arguably the most powerful tool you have available to save for retirement. Unlike employer-sponsored retirement plans such as 401(k)s (where you have only limited number of investment choices), the rules for IRAs are extremely permissive. Furthermore, when you open a self-directed IRA with a custodian such as Quest Trust Company, you’ll be able to take advantage of every type of investment that’s permitted by law.
But not every potential investment is authorized for IRAs. In fact, there are categories of investments and transaction structures that are explicitly prohibited, and which could have significantly negative consequences if you were to make them. It’s therefore worth refreshing your knowledge from time to time on these so-called “prohibited transactions,” in order to make sure that you stay on the right side of the IRS regulations.
One important overarching concept to understand is that you are prohibited from receiving any benefit from your IRA before you reach age 59½. For example, taking a withdrawal from your IRA before age 59 1/2 will incur a 10% penalty on the withdrawal amount (in addition to any taxes that may be due). In addition, you’ll need to be aware of the following:
Prohibited Transactions #1: No Transactions with Your IRA. While your IRA can hold a wide variety of investment types (including real estate, private equity and certain types of precious metals), you may not personally sell those assets to your IRA, even if the transaction reflects current market pricing. All such purchases must be made from an unrelated third party.
Prohibited Transactions #2: No Personal Use of IRA Property. If you do hold real estate within your self-directed IRA, it must be treated exclusively as an investment asset, and you may not use that property yourself. Furthermore, you may not permit members of your immediate family to use that property.
Prohibited Transactions #3: No Fees or Compensation from Your IRA. If you personally manage or maintain any rental properties that are held by your IRA, you may not receive compensation for providing such services. This is true even if such services are part of your normal line of work.
Prohibited Transactions #4: No Payment of Investment Carrying Costs from Personal Funds. If any of your IRA portfolio investments require maintenance or have any related fees that must be paid, these costs must be borne by the IRA itself. For example, you may not use outside funds to pay the annual real estate taxes on a piece of investment real estate your IRA holds – such funds must come from within the account. Similarly, if your IRA holds precious metal investments then any custodial fees must come from within your account. Keep in mind, however, that if you’re eligible to make a deposit to your IRA in a given tax year, those funds could be used to pay such fees.
Your self-directed IRA can be a vehicle for making investments that wouldn’t be permitted in any other type of tax advantaged retirement account. Be sure to understand the list of prohibited transactions to avoid any penalties or negative financial implications for your account.
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