Generally, a prohibited transaction is any improper use of an IRA account by a disqualified person, which can include you as the owner or others who have access to the account. Prohibited transactions can lead to severe consequences, including penalties and taxes on the full balance of the IRA, so it’s important to be aware of what is not permissible.
Who is a disqualified person?
According to the IRS, a disqualified person includes:
The IRA owner
Beneficiary(ies) of the IRA
Family members (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant) of the IRA owner
Fiduciary of the IRA (someone who has discretionary authority or control in managing the IRA or its assets or provides IRA investment advice for a fee)
What are examples of prohibited transactions?
Prohibited transactions can include the following:
Borrowing money from the IRA
Selling your own property to the IRA
Using the IRA as security for a loan
Using the IRA to buy property for personal use
Using the IRA to invest in collectibles
Using any IRA assets for personal use
What are the consequences of prohibited transactions?
If prohibited transactions occur, the IRA will be subject to negative tax and other consequences.
Loss of taxed-advantaged status: Taxes will be applied to the income and gains from the IRA from the time the account engaged in the prohibited transaction.
Distribution of the entire account based on the fair market value: The owner may be required to withdraw all assets in the account as of January 1 of the tax year in which the prohibited transaction took place.
Taxes and penalties apply to distribution: The IRA owner will be responsible for paying all applicable taxes on the balance. Additionally, a 10% early withdrawal penalty could then be applied if the IRA owner is not yet age 59 ½.
If any of these prohibited transactions occur with your IRA, it could be treated as if you withdrew the entire balance, as of January 1 of the year the event occurred. However, if you pledged only a portion of your IRA as security for a loan, then only the pledged amount would be treated as a distribution to you.
If you need assistance determining whether a transaction could be prohibited, or, if you think that your IRA might have been involved in a prohibited transaction, we recommend contacting your tax advisor.
If a prohibited transaction results in distribution of your funds, it will be reported on IRS Form 1099-R. For prohibited transactions, Code 5 is input in Box 7 of the Form 1099-R that is issued to report distribution from your IRA.