Retirement savers bored with traditional investments are on the hunt for the exotic. After all, why own plain old stocks and bonds when you can own real estate, equipment leases or stock in a start-up company?
Before leaping at the latest investment fad, it’s important to understand what the IRS permits when it comes to IRAs. In fact, it’s more of an understanding of what isn’t permitted that’s needed. The IRS doesn’t bless transactions – they simply tell us what can’t be done.
The IRS is hands off for the most part but their parental finger wagging kicks in for two major categories of activity – certain prohibited investments and transactions. Let’s take a look at each.
It’s pretty cut and dry here. No life insurance in an IRA – period.
Same goes for collectibles. This includes, but is not limited to, antiques, art, coins, stamps, rugs, wine collections and baseball cards.
Metals aren’t allowed either except for gold, silver and platinum coins minted by the Treasury Department.
The IRS is clear about self-dealing. Putting it bluntly, don’t do it!
Any transaction where the government risks losing tax revenue will be disallowed. The result of such a transaction is the immediate trigger of income taxation and, if the IRA owner is under age 59 1/2, a 10% early withdrawal penalty. The owner keeps the net but the IRA tax shelter is lost forever.
Prohibited transactions fall into three main categories. Disallowed transactions include those where the IRA owner has a conflict of interest (e.g. self-dealing), those between an IRA owner and a “disqualified person” and those that directly benefit the IRA owner or other “disqualified persons”.
OK, we know that these “disqualified persons” are people to be mindful of if we hope to avoid a prohibited transaction but what is it exactly that disqualifies someone from being a permitted party?
Generally, anyone connected to the IRA owner through a business or family relationship is going to be off-limits. Examples include the IRA fiduciary, the IRA owner’s spouse, his/her ancestors, descendants or their spouses and corporations, partnerships, trusts and estates where at least 50% of the control is in the hands of any of the aforementioned people.
IS AN IRA OWNER A FIDUCIARY?
Oddly enough, yes. The rationale is, although they’re not plan custodian, they maintain investment control and discretion.
SOME THINGS AREN’T BLACK AND WHITE
Friends and siblings don’t fit the standard of a disqualified person.
However, don’t leap to recruit these people into a questionable transaction. Any transaction with them where there’s an indirect benefit to the IRA owner is prohibited. What’s more, business associates who fail the “at least 50% control test” are OK but not if there’s a conflict of interest or a self-dealing type of direct benefit accruing to the IRA owner.
WHAT TO AVOID
By no means exhaustive, the following transactions are examples of what to stay away from when putting IRA money to work. Specifically, here’s what you shouldn’t do:
- lend money to or borrow money from your IRA
- pledge your IRA as collateral for a loan
- buy/lease property from or sell/lease property to your IRA
- buy personal use property with IRA funds
- establish a company and have your IRA invest in it
- compensate yourself for managing your IRA
OK, you’re an IRA expert. In fact, you’re a walking Internal Revenue Code. In that case, you must know a few time-tested strategies. So do we…
Roth IRAs eliminate the tax issue. A transaction deemed prohibited triggers immediate income taxation but that’s a non-issue with this special type of IRA.
Separate IRAs put a wall between legitimate transactions and their questionable brethren. For example, buying properties in individual IRAs will protect all other properties if a problem is found with any one individual transaction.
Enlisting an intermediary, hopefully a professional who isn’t a family member or business associate, should solve any self-dealing issues.
Proper structure and timing create a paper trail. For example, IRA purchases should be made with IRA funds as opposed to personal funds with a subsequent reimbursement of the individual by the IRA.
The Department of Labor issues Prohibited Transaction Exemption rulings. These are the people to contact ahead of time if there’s a question about whether a transaction may run afoul of regulations.
Finally, stay away from providing services to your IRA. It’s a common sense way of avoiding any appearance of self-dealing.