Congress created IRAs so that individuals could set aside funds for their future retirement, and as an incentive to contribute to an IRA, permitted the contribution to be tax-deductible, unless the individual also participated in an employer’s retirement plan and had income exceeding a specific threshold. However, Congress put safeguards in place to make sure the IRA funds are not used for purposes inconsistent with prudent retirement savings.
If the IRA owner or his or her beneficiary engages in a prohibited transaction, the IRA is disqualified as of the first day of the tax year in which the prohibited transaction takes place. In this event, the IRA owner or beneficiary is treated as having received a taxable distribution equal to the FMV of the assets in the account as of the first day of the tax year. In addition, if under age 59½, the distribution is subject to a 10% early distribution penalty. The following are examples of prohibited transactions:
- Using the IRA Account as Security – If the individual for whom an IRA is established uses the account or any portion of it as security for a loan, the portion so used is treated as distributed to that individual, and as such, is both taxable and subject to the 10% early distribution penalty if the taxpayer is under age 59½.
- Borrowing from an IRA Account – If an individual borrows money against his IRA annuity contract, the entire annuity ceases to be an IRA annuity as of the first day of the tax year in which the loan is made, and will result in the inclusion in income of the entire FMV of the annuity as of the first day of that year.
Here are additional examples of traditional IRA prohibited transactions:
- Using IRA funds to purchase property for personal use (either currently or in the future)
- Receiving unreasonable compensation for managing the IRA
- Selling property to the IRA
If you have questions related to prohibited transactions, please give this office a call.