Prohibited Transactions— IRAs vs Solo 401(k) Plans

Many individuals who invest through self-directed retirement plans may worry about inadvertently engaging in prohibited transactions and putting their plans at risk. However, with a clear understanding of the rules and regulations, there's no need for concern. Let's explore these rules, focusing on how to protect the tax benefits of your retirement account and ensure it serves its intended purpose – saving for your retirement.

Common prohibited transactions include self-dealing (using the account for personal gain), transacting with disqualified persons (certain individuals closely related to the account holder), and investing in certain prohibited assets. These rules are generally consistent for both IRAs and Solo 401(k) plans.

Understanding Prohibited Transactions

Prohibited Transactions (PT) can be found in Internal Revenue Code 4975. This was added to the code to prohibit self-dealing and to avoid conflicts of interest in retirement plans. The IRS provides information on its website on how the rules work, the ramifications of engaging in a PT associated with each type of plan, and their differences.

Prohibited transactions are activities or deals that should not take place between a retirement plan and a disqualified person. Engaging in such transactions can lead to severe penalties and, in some cases, disqualification of the retirement account, resulting in the loss of its tax-advantaged status.

Before we jump into some examples of prohibited transactions, let’s look at who your retirement account cannot transact with.

Identifying Disqualified Persons and Entities

The Internal Revenue Code (IRC) Section 4975 provides a list of disqualified persons and entities that retirement plans should avoid engaging with. These disqualified persons rules apply to both IRAs and Solo 401(k)s, this includes Solo 401(k)s also known as an Individual 401(k). Disqualified persons include the IRA holder or 401(k) plan participant, their spouse, lineal ascendants, and descendants (such as parents, children, grandchildren, great-grandchildren, and the spouses of the children), and fiduciaries of the plan.

One example of disqualified entities could be a business where a disqualified individual holds majority ownership of 50% or more or serves as a fiduciary or officer of a company and has discretionary authority over the business.    

Examples of Prohibited Transactions with Disqualified People in a Solo 401(k)

Examples of prohibited transactions in a Solo 401(k) stated under IRC 4975 include a sale, exchange, or leasing of properties; lending money or extending credit; and furnishing of goods, services, or facilities.  

Furthermore, it states that any disqualified person who acts as a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account or receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan are deemed to be engaging in a prohibited transaction.

Nevertheless, there are certain exceptions to these rules. The law exempts specific transactions from being classified as prohibited. For instance, in a Solo 401(k) plan,   there is a prohibited transaction exemption that allows for a plan participant to borrow the lesser of 50% of their plan balance up to $50,000 as long as the loan is repaid within 5 years or 30 years if used to purchase a primary residence. This wouldn't be considered a prohibited transaction. On the other hand, IRA holders are not allowed to borrow from their IRA nor allowed to pledge their IRA as a means of securing a loan.

Here are some examples of prohibited transactions in a Solo 401(k):

• A Solo 401(k) plan administrator chooses to direct funds to fund a loan for the purchase of commercial property under their own name
• A Solo 401(k) loans money to a business where the son-in-law is the CEO of the plan’s trustee
• A Solo 401(k) plan administrator decides to use the funds of the plan to finance a personal construction loan.          

Examples of Prohibited Transactions in Individual Retirement Accounts (IRA)

As stated earlier, prohibited transactions in IRAs are any inappropriate use of the IRA account by the IRA owner, their beneficiary, or any disqualified person. This applies to all types of IRAs: Traditional IRA, Roth IRA, SEP IRA, and SIMPLE IRA. It also applies to other tax-favored accounts such as a Health Savings Account, Coverdell Education Savings Account, or a Medical Savings Account.

Here are some examples of potential prohibited transactions with an IRA:

• An IRA owner borrowing money from the IRA
• An IRA owner selling property they own to the IRA.
• An IRA owner uses the IRA as collateral for a personal loan.

Prohibited Investments in Retirement Plans

The other important rule to take note of is that the law does not permit retirement accounts such as an IRA to be invested in life insurance or collectibles.

Here are some examples of collectibles:

• Artwork
• Rugs
• Antiques
• Metals (with exceptions for certain kinds of bullion)
• Gems
• Stamps
• Coins (with exceptions for certain coins)
• Alcoholic beverages

Prohibited Transaction Penalties

The repercussions of engaging in a prohibited transaction have a different treatment when it comes to IRAs vs. Solo 401(k) Plans.

For IRAs, IRC 408(e)(2) states that if an IRA engages in a prohibited transaction “such account ceases to be an individual retirement account as of the first day of such taxable year.” This means that not only does the IRA investment become taxable it also means that any investment under the same IRA also loses its tax-advantaged status and will be taxable as well as of the first of the year.

The good news is, that these rules only apply to IRAs and do not apply to Solo 401(k) plans such as a Solo(k), Individual 401(k), Uni (k), or One Participant 401(k) plan. If a 401(k) plan engages in a prohibited transaction, the repercussions only involve a 15% penalty based on the asset’s value that was a part of the prohibited transaction and does not disqualify the other assets under the plan. The 15% penalty does not go up to 100% only if such a transaction was reversed to put back as if the transaction never happened. 15% goes up to 100% of the value of the assets that are engaged in a PT if not corrected timely.

Conclusion

By familiarizing yourself with these regulations, you gain the power to make informed decisions, protect yourself from IRS penalties, preserve the tax-favored status of your retirement plans, and secure a financially stable retirement. Following the IRS guidelines is not only your legal requirement, but also a strategic move that allows you to maximize the benefits of your retirement savings. Most importantly, it grants you peace of mind knowing that you have nothing to worry about. Lastly, involve your team of tax, legal, and investment advisors to help you navigate through your retirement investing journey.