By Andy Ives, CFP®, AIF®
If I decide to climb on the roof of my house and try to ride a unicycle while blindfolded, it is not illegal. Dangerous, yes, but not in violation of any laws.
If I elect to randomly jump off a bridge under the guidance of the Usually Successful Bungee Jump Company, it is my prerogative. Again, not against the law, but potentially destructive.
And if I choose to empty my IRA account and bet it all on the Superbowl in Las Vegas, hoping to win big, pocket the winnings, and roll the withdrawn dollars back into my account before the 60-day rollover window closes, I can do that, too. Treacherous, risky and dumb, but not a prohibited IRA transaction.
So, what constitutes a “prohibited transaction” within an IRA? Prohibited transaction rules are in place to discourage account owners from acting in a self-serving or “self-dealing” manner. IRA assets are to be invested in a way that benefit the account itself as opposed to the account owner personally or other “disqualified persons.” (Essentially, “disqualified persons” include the IRA account owner, the owner’s spouse, ancestors and lineal descendants, investment managers and advisors, those providing services to the IRA, and entities in which the IRA holder owns a controlling equity or management interest.)
Isn’t using IRA dollars to wager on the Superbowl self-serving? Yes, but this foolish act occurs outside the walls of the IRA, after a distribution and before a rollover. Therefore, it does not qualify as an investment within the IRA account.
Example 1 – David purchases 200 shares of the Usually Successful Bungee Jump Company within his IRA because a friend told him that all shareholders receive 5 free jumps per year. If he accepts the free bungee jumps as a shareholder, this constitutes a prohibited transaction because David is investing his IRA assets for personal benefit. Even if David believed the Usually Successful Bungee Jump Co. was a great long-term investment, and even if the stock price doubled in a year, it is a prohibited transaction. Profitability is not a factor in the determination.
Example 2 – Jim’s daughter Sally is opening a nightclub and is looking for investors. Jim anticipates that he will never visit the club because he is always asleep by 10:00 PM. Nevertheless, he is very supportive of his daughter and wants to help. Jim invests just $25,000 from his $500,000 IRA into her club. This is a prohibited transaction since Sally is a disqualified person.
The penalty for completing a prohibited transaction is severe. The tax-deferred status for the entire IRA (not just the prohibited transaction dollars) is lost and the account owner is deemed to have received a full payout of the IRA on the first day of the year in which the prohibited transaction occurred. The full balance is potentially subject to tax and the 10% early distribution penalty. (This penalty applies to the affected IRA only, not across all of the taxpayer’s IRA accounts.) In Example 2 above, Jim’s investment into his daughter’s nightclub created a $500,000 distribution event.
Bungee jump with an unreliable company? Ride a unicycle on your roof? Gamble in Vegas with Retirement dollars? Probably not the wisest decisions, but not illegal. Engaging in a prohibited transaction within an IRA? Now that’s a dangerous violation of written rules that carries a heavy and well-defined penalty.