If you are the owner of an Individual Retirement Account (IRA), you are aware of the fact that you can easily move your funds from one investment to another, choose from a diverse range of investment options, and take distributions at your convenience. However, it would help if you remember that certain limitations exist to what you can and cannot do.
It is important to exercise caution as there are strict rules against certain types of “prohibited transactions” in the tax law. Failure to be careful and comply with all the rules could lead to adverse tax consequences.
The Internal Revenue Service (IRS) defines a prohibited transaction as any misuse of an IRA by the owner, a beneficiary, or any other disqualified person. For this definition, a “disqualified person” includes IRA fiduciaries and members of the owner’s family. An IRA fiduciary is an individual who exercises any discretionary authority or control over the IRA or its assets, provides investment advice to the IRA for a fee, or has any responsibility or authority for managing or disposing of the IRA.
What types of actions are considered improper use of an IRA?
The IRS has specified that some common examples include borrowing money from it, selling property to it, using it as collateral for a loan, and purchasing property for personal use (present or future) using IRA funds. However, if you withdraw funds from an IRA and deposit the same amount back into the IRA or a different IRA within 60 days, this qualifies as a rollover and is not considered a prohibited transaction.
Additionally, other rules limit the types of investments allowed in an IRA. For instance, you cannot invest the funds in life insurance or collectibles such as artwork, stamps, jewelry, or most precious metals. There are some exceptions for gold or silver coins and certain bullion bars. An IRA cannot own property that the owner uses personally, such as a house or vacation home. While some custodians may allow other types of real estate holdings, such as raw land, they are few and far between.
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What are the consequences of violating these rules?
If a prohibited transaction occurs, the account will no longer qualify as an IRA as of the first day of the year the violation occurred. You will be treated as having acquired a distribution of all the IRA assets with a fair market value (FMV) on January 1. Assuming that the FMV exceeds your basis in the assets, you will owe tax on the difference, similar to any other withdrawal. Furthermore, you must pay a 10% penalty tax on any distributions made before age 59 ½.
To avoid any such violations, it is highly recommended that you strictly adhere to these rules. You would not want a prohibited transaction for an IRA to undo the benefits of your retirement savings.
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