Everyone wants to retire in comfort; no one wants to make a mistake when it comes to Self-Directed IRAs and taxes. Yet too few people spend the time necessary to familiarize themselves with what prohibited transactions in an IRA might be. For some, that may be because they are using IRAs in very straightforward, traditional ways: investing in the stock market. But whether you Self-Directed your IRA or not, there are always reasons to know what the mistakes are. Because you will want to avoid them.
With that in mind, let’s look at what constitutes a “prohibited transaction” in a Self-Directed IRA—as well as the mindset retirement investors need to adopt if they’re going to easily avoid these mistakes.
What is a Prohibited Transaction in a Self-Directed IRA?
To understand a prohibited transaction, there are two essential things you will need to know:
- What you cannot invest in with a Self-Directed IRA (i.e., collector’s items, art, wine, etc.).
- Who you cannot transact with a Self-Directed IRA.
That second point is the key point. It’s not difficult for investors to understand that they cannot keep a collection of wine within their retirement account; it’s hard for the IRS to track such an account.
But when it comes to legitimate transactions that then become prohibited because of who those transactions involve, that’s where many retirement investors find themselves getting stuck.
The key to understanding this is the rule of a “disqualified person.”
A disqualified person is someone that you know—such as a spouse, a son, a daughter—with whom you cannot interact.
For example, while you can invest in real estate with a Self-Directed IRA, using that real estate for your personal benefit rather than as an investment property would then become a prohibited transaction. That means that while you can invest in residential property within a Self-Directed Real Estate IRA, you cannot then live in it for your personal use.
The same rules apply to other people whom you know. For example, you could not rent out a real estate property to a son or daughter, because then you would be deriving some personal benefit for a property that’s supposed to be giving you retirement benefits.
When you understand the basic rules of disqualified persons, you then understand how prohibited transactions work. You would not use an IRA to loan out money to your parents, for example, because this creates a similar personal benefit in funds that are supposed to be for retirement.
Using Rules of Thumb to Invest with Confidence
When you understand why the rules work this way, you’ll find it’s not hard to avoid prohibited transactions with your Self-Directed IRA. After all, these limits may seem stringent, but keep in mind that you can work with everyone else in the world with your IRA. While there may be a few disqualified persons in your area, you can rent out real estate in a Self-Directed Real Estate IRA to anyone else giving you access to the vast majority of the population of tenants.
The key is to treat your retirement property as separate entities from your personal properties. Once you can make the distinction between the two, you will find that it’s not hard to avoid prohibited transactions at all. You will view the assets you have in your retirement account as separate from your personal accounts—because they are. This is a healthy way of viewing your retirement strategy, as it will help prevent you from carrying out prohibited transactions and teach you the most effective ways to invest.