A self-directed IRA is a retirement savings plan that allows you to decide what investments will be made. These accounts can hold a variety of investments and provide opportunities that you may not have with other accounts. However, there are certain rules you must follow with a self-directed IRA, like the prohibited transactions rule. Violating this rule can bring penalties and tax consequences. Here's what you need to know.
A financial advisor can help you create a financial plan to reach your short- and long-term goals.
What Is a Self-Directed IRA?
Self-directed individual retirement accounts were established in 1974 by the Employee Retirement Income Security Act (ERISA). Unlike traditional IRAs that typically limit investments to stocks, bonds and mutual funds, self-directed IRAs can allow you to diversify your retirement savings beyond traditional markets. These investments can range from real estate to private company stock and precious metals.
The structure and operation of a self-directed IRA are similar to other IRAs, but what sets it apart is the role of the custodian or trustee.
For example, the custodian in a self-directed IRA is authorized to allow a broader range of investments. However, the investor holds the responsibility for directing the custodian to make specific investments.
What Are Prohibited Transactions?
Prohibited transactions are certain financial dealings that are not allowed within a self-directed individual retirement account (IRA). Essentially, it is any improper use of funds within the IRA by the owner or custodian, or another beneficiary.
The Internal Revenue Service (IRS) specifically outlines these under the Internal Revenue Code (IRC) Section 4975. They usually involve interactions between the IRA and what the IRS calls "disqualified persons". These could be the account owner, certain family members or entities in which the account owner holds a substantial interest.
Examples of Prohibited Transactions
According to the IRS, prohibited transactions can include:
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Borrowing money from the IRA
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Using the IRA as a security loan
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Buying real estate with IRA funds that is for personal use
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Selling property to the IRA
These are all prohibited transactions because they constitute an indirect benefit, which is also forbidden under IRC Section 4975(c)(1)(D) and (E).
Exclusive Benefit Rule
The exclusive benefit rule for a self-directed individual retirement account requires that the account must be managed and used exclusively for the benefit of the account holder and their designated beneficiaries.
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