We have reviewed how IRS rules on disallowed investments, prohibited transactions and disqualified persons affect all Retirement Plans (RP). Specifically, let's now look at how a prohibited transaction affects quite negatively an IRA account....whether self-directed or not.
Specifically relating to self-directed status, one of the first and biggest questions that a person should ask themselves is: Should I self-direct (SD) through an IRA or a 401(k)? In answering this question, it is imperative to know the difference in qualifying for either. And, it is important to know that many facilitators, administrators and custodians do not have the mechanisms in place to assist a client in setting up SD 401(k)s.
Simply stated, a person who is self-employed or meets the DOL definition of self-employment (either truly self-employed as their sole employment or while still employed as well as a W-2 employee), may qualify for a self-directed 401(k). This is true whether the individual is rolling over previous IRA/401(k) assets into a newly established SD 401(k) OR commencing a SD 401(k) plan with new contributions OR both combined.
What is interesting with the IRS code as it relates to a prohibited transaction within an IRA is that entering into such a transaction is literally like a death sentence. The Code is specific as to how a prohibited transaction affects an IRA. While both the IRA and 401(k) are negatively affected by the excise tax that was addressed in the blog post titled: Prohibited Transactions -- What if I Make a Mistake?, the IRA is given a virtual noose around the neck. While the 401(k) is permitted the opportunity to correct the intentional or unintentional error that occurred with a prohibited transaction, see what the IRS states about an IRA:
"However, in this case, with an individual retirement account, instead of imposing an excise tax on the parties to the transaction, the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred. (Code 408(e)(2).
This is huge! What it is virtually saying is that if an IRA conducts a prohibited transaction, the plan, for all practical purposes, blows up. In fancy parlance, blows up simply means that the plan is considered fully distributed by the IRS and is therefore subject to any and all penalties and taxes for early and full distribution. Ouch!
It continues by noting:
"A prohibited transaction can also occur between an IRA and a disqualified person other than the IRA owner or beneficiary, such as a relative of the owner or beneficiary or a fiduciary. If a prohibited transaction with respect to an IRA involves a disqualified person other than the IRA owner or beneficiary, then that person is subject to the prohibited transactions excise tax."
So, when considering whether you wish to self-direct your retirement assets (both past accumulations and future contributions), you may give good thought to starting a SD 401(k) plan (if you qualify for one). While significant penalties exist for both the IRA and 401(k), the 401(k) does not have the virtual death penalty of full distribution attached to it. If a mistake is made under the umbrella of the 401(k) plan, a reporting must occur and a financial penalty may not even apply. The same cannot be said for the IRA. And, an important note.....the automatic consideration of the IRA being fully distributed due to the prohibited transaction...this cannot even be appealed. Yikes!
Word to the wise....be circumspect in your investment choices and always review your investment interests with a qualified individual who can assist you in determining if you might be entering into a prohibited transaction.
John R. Park is President of PGI SelfDirected and co-founding Partner of Fulcrum Investment Network.
