You don’t have to leave your 401(k) or other employer retirement plan money in an existing plan if you no longer work for that employer. The same rule applies to an inherited 401(k) or employer retirement plan. Whether it’s your plan or it’s inherited, you can legally and advantageously move those funds into an IRA where either you or your financial adviser can invest and manage the money much more effectively with a self-directed IRA from AET. This is called a roll over IRA. There are no penalties or taxes to pay for correctly handled roll over accounts. To see some of the far more beneficial things you can do with an IRA which you can’t do with the employer plan, Click Here.
One of the greatest errors made by self-directed IRA investors is to engage in a prohibited transaction, disqualifying the IRA and incurring substantial tax penalties for both the IRA owner and other parties to the transaction. The penalty for the self directed IRA owner is disqualification in the year of the transaction; the penalty for the other parties is 15% of the amount involved (and 115% if not corrected before the IRS discovers the transaction!). It is crucial to understand which transactions are off limits for your self directed IRA. Internal Revenue Code (IRC) § 4975, IRS Publication 590, and related Treasury and DOL regulations cover such transactions. American Estate & Trust and its affiliates do not provide legal or tax advice for your IRA investments. It is highly advisable that your personal legal/tax advisor consult these rules when discussing with you any potential nontraditional IRA investment or transaction you are considering.
The IRS prohibits transactions between an IRA and any “disqualified person.” The purpose of the rule is to prevent self-dealing and minimize conflicts of interest that could adversely impact the IRA. Persons and entities which automatically would be deemed a “disqualified person” include:
the IRA account owner and beneficiaries as well as certain members of the account owner’s family:
your lineal ancestors (parents, grandparents, etc)
your lineal descendants (children, grandchildren, etc)
the spouses of your lineal descendants (son-in-law, daughter-in-law, etc);
any party that exercises discretionary authority or control in managing the IRA or its assets;
any party that charges to provide investment advice with respect to the IRA or who has discretionary authority or responsibility to administer the IRA;
the IRA custodian or trustee; and
any entity (corporation, partnership, trust, etc) in which any of the above disqualified persons owns at least a 50% share (those with some ownership but less than 50% may still be prohibited).
There are a few “class exemptions” that permit certain interactions, such as the custodian and other service providers being able to collect a reasonable fee from the IRA for services performed. Other than those exemptions, your self directed IRA should not have any transactions involving you or any of the other persons listed above. Moreover, people who have significant influence over you (siblings, significant other, etc.) could also be deemed disqualified persons by the IRS due to the potential conflict of interest. Note that the terms of the deal are irrelevant. Making the transaction an “arms-length” deal at fair market value does not protect you – if the transaction involves any disqualified person, it is still prohibited.
Here are the general types of transactions that are prohibited:
sale, lease or exchange of any property between the plan and a disqualified person
lending of money or other extensions of credit between the plan and a disqualified person; this is why loans made to an IRA must be “nonrecourse” (the IRA owner, and other disqualified persons, cannot guarantee the loan; upon default, the lender has recourse against only the property itself)
furnishing of goods, services, or facilities between the plan and a disqualified person
transfer to, or use by or for the benefit of, a disqualified person of any interest in the assets of the plan
an act by a disqualified person who is a fiduciary whereby he deals with the income or assets of the plan in his own interests or for his own account
receipt of any consideration for his own personal account by any disqualified person who is fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan
Here are some specific examples of prohibited transactions:
Your IRA purchases real estate and then you, or other disqualified persons, live in the property. This is prohibited even if reasonable rent is paid to your IRA. You or another disqualified person would be receiving a direct benefit from the use of your IRA assets.
Your IRA purchases real estate, which is then rented out to an outside party at a discounted rate. The outside party explicitly or implicitly agrees to provide some benefit to you or another disqualified person in exchange for that discounted rent. You are receiving an indirect benefit.
Your IRA purchases real estate, which is then sold to an outside party at a discounted price. The outside party explicitly or implicitly agrees to provide some benefit to you or another disqualified person in exchange for that discounted sales price. You are receiving an indirect benefit.
Your IRA purchases real estate and at some later time, it lacks the funds to continue paying on its mortgage, insurance, taxes, or maintenance expenses. You, or another disqualified person, provides the funds to cover the deficit. You are providing a benefit to your IRA. [ Note: a DOL class exemption may permit short-term interest-free loans from you to the plan in these circumstances; have your personal advisor review and discuss PTE 80-26 with you.]
Your IRA enters into a transaction with an outside party who technically is not a disqualified person, but who nonetheless has undue influence or control over you (perhaps a sibling, a “significant other” or the employer of a fiduciary of the account). At least one DOL Advisory Opinion suggests that this arrangement likely would not pass the “smell test” and would be deemed a prohibited transaction.
You have personal funds to invest but do not meet the minimum investment amount. You direct your IRA to also invest along with your funds in order to take advantage of the opportunity (such as a hedge fund). You are receiving a benefit from the use of your IRA assets. This is also prohibited the other way – if the IRA needs your funds to enter into a transaction.
You, or another disqualified person, used your IRA assets as collateral to secure a personal loan. You are receiving a direct or indirect benefit from the use of your IRA assets.
Your IRA needs additional money to purchase an asset. You, or another disqualified person, agreed to loan the additional funds to your IRA or agreed to use personal assets as security for a third-party loan to the IRA.
Your IRA purchases real estate, which is then rented out to an outside party. The outside party writes its rent checks to you personally or to another disqualified person, who deposits the check in a personal bank account and then writes a check for the same amount to your IRA. No disqualified person can act as an intermediary between your IRA and its use of its assets. In cases where your IRA invests in rental property, the tenants must always write their checks to your IRA directly, never to you or another disqualified person. You can collect the checks and have them directly deposited into your IRA but you cannot have personal use or control over the funds at any time.
Your IRA enters into any of the above transactions with an entity (corporation, partnership, trust, etc) that is managed by, or partially owned by, a disqualified person. Although the ownership may be much less than 50%, the IRS can still argue that a (not insignificant) benefit was conferred. It would be your responsibility (called “burden of proof”) to show that no significant benefit was conferred to either the disqualified person or your IRA. Failure to provide such proof could result in the disqualification of your IRA. [See Joseph R. Rollins v. Commissioner, T.C. Memo 2004-60.]
Note that even prohibited transactions that ultimately benefit your IRA are still prohibited! It is not necessary for the IRS to show that harm was done to your IRA, only that your IRA and a disqualified person were involved. Likewise, “trying to do what’s best for your IRA” or claiming ignorance of the rules is no defense. [See Ralf Zacky v. Commissioner, T.C. Memo 2004-130.]
These are just some common examples of prohibited transactions that could cause your self directed IRA to become disqualified, causing a taxable distribution (with penalties) of the funds involved. The simple rule is to avoid any hint of self-dealing altogether and focus on profitable, independent investment opportunities.