Don’t Blow Up Your IRA
Every now and again, I receive calls asking curious questions about what a person may be able to do with their IRA (Individual Retirement Arrangement). Often, they’ve heard an angle from a friend, a pitch from someone trying to sell them something, may have misunderstood a strategy or are being just completely creative in their thinking. I have cautioned many a questioner about a term they usually have never heard of: a “Prohibited Transaction” in an IRA or retirement plan.
According to irs.gov, “Generally, a prohibited transaction in an IRA is any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary or any disqualified person. Disqualified persons include the IRA owner’s fiduciary and members of his or her family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).” (1) Examples of possible prohibited transactions with an IRA include borrowing money from it, selling property to the IRA, using it as security for a loan, or buying property for personal use (present or future) while money is still in the IRA.
So, what happens if you engage in a prohibited transaction, even unintentional, in your IRA? The IRS says this: “Generally, if an IRA owner or his or her beneficiaries engage in a prohibited transaction in connection with an IRA account at any time during the year, the account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.” (2)
Therefore, distributing all of it’s assets to the IRA owner means that taxes and premature distribution penalties if under age 59 ½ will apply. Depending upon your tax bracket, which may increase with the distribution of the IRA (as it is included in your ordinary income), the taxes and penalties can be upwards of 50% of the balance of your IRA!
The Secure Act 2.0 which was signed into law on 12/29/2022 offered clarification to the rule. “Section 322 clarifies that if an individual has multiple IRAs, only the IRA with respect to which the prohibited transaction occurred will be disqualified. Section 322 is effective for taxable years beginning after the date of enactment of this Act.” (3)
Specifically, the three most common questions that I hear related to the above are, Can I borrow money from my IRA? Answer: No. Can I use my IRA as collateral for a loan? Answer: No. Can I buy real estate in my IRA? Answer: Maybe.
I often receive questions about investing in various types of real estate. It’s a broad asset class that can be a used as a diversifier in your portfolio. You may own many types of REITs (Real Estate Investment Trust) in your IRA, either traded or non-traded. However, if the real estate is in another entity such as a Private Placement or an LLC, it may be subject to UBTI (Unrelated Business Tax Income) which can become overly complex and problematic. I would recommend you contact a qualified professional such as your tax advisor before making such an investment with your IRA. Conversely, if such an investment is attractive to you, consider this allocation with your non-retirement funds instead.
Self-Directed IRA’s may legally purchase Real Estate directly, but I highly recommend you fully understand your risks. Consequently, this is not something I would recommend or assist a client with. There are custodians who will aid you in buying investment property to be held in your retirement account, but be aware of the words in the title, “Self-Directed”. This means that YOU are ultimately responsible for the transactions in the IRA. In fact, in September of 2011, the SEC issued an investor alert warning of the risks involving self-directed IRA’s, cautioning that custodians for self-directed IRA’s have limited duties to account holders and that investors should be mindful of potential fraudulent schemes. Read the entire alert at https://www.sec.gov/investor/alerts/sdira.pdf .
Directly purchasing Real Estate in your IRA includes disadvantages and risks which an investor may not have considered. Among others, these may include subjecting your IRA to liability exposure that comes with owning investment property or forgetting that neither you nor your family members may personally use the property. There are limits to contributions made to IRAs. This can become a problem if you need to do repairs or improve the property, as you may not add dollars to the IRA beyond annual contribution limits. IRAs are subject to distribution rules upon death which could be difficult particularly for a non-spouse beneficiary if real estate is owned in the IRA, as it is illiquid. You may forego tax benefits that you would have otherwise enjoyed had you bought the investment property with non-retirement dollars, because in an IRA you do not receive deductions, depreciation or long-term capital gains rates. These are just a few examples.
The word “RISK” is most associated with the potential for market losses in an investment. Often people forget there are many other risks to be concerned with, like the risk of “you don’t know what you don’t know”, and that could blow up your IRA.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
- Retirement Topics - Prohibited Transactions | Internal Revenue Service (irs.gov)
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.