A prohibited transaction is a deal your IRA isn't allowed to make, usually because it helps you or your family right now instead of later in retirement. Break the rule and the IRS can treat your whole IRA as if you cashed it out.
This is the part of self-directed IRAs that trips people up most. Here's what to watch for.
The basic idea
Your IRA is for your retirement. It's not for you to use today. So the rules block deals between your IRA and you, your close family, and certain businesses you control. These people are called disqualified persons.
Who is a disqualified person?
- You
- Your spouse
- Your parents, grandparents, and great-grandparents
- Your children, grandchildren, and their spouses
- Anyone who manages or advises on your IRA, like your custodian
- Businesses that any of these people own 50% or more of
Not on the list: brothers, sisters, aunts, uncles, cousins, and friends. Deals with them can still be risky, so talk with a CPA first.
Free lender guide: 5 questions to ask before you lend to anyone, plus a 12-item document checklist.
The most common mistakes
- Lending to yourself or your family. Your IRA can't lend to your son, buy your mom's house, or lend to your business.
- Using IRA property. You can't live in, vacation in, or rent out to family a home your IRA owns.
- Paying yourself. You can't pay yourself a fee for managing your IRA's investments.
- Mixing money. Paying an IRA expense with your own money, or putting IRA income in your own account.
- Personally guaranteeing an IRA loan. If your IRA borrows money, you can't sign for it personally.
- Using your IRA as collateral. Pledging your IRA for a personal loan counts as taking that money out.
What happens if you break the rules
For an IRA, a prohibited transaction can disqualify the whole account. The IRS treats it as if you took everything out on January 1 of that year. That means income tax on the full amount, and a 10% penalty if you're under 59 and a half. It's one of the most costly mistakes in retirement planning.
How to stay safe
- Ask before every deal: does this help me or my family right now?
- Keep IRA money and your own money completely separate.
- Run anything unusual by your custodian and a CPA first.
- Be extra careful with a checkbook IRA, since you sign the checks yourself.
Lending to an unrelated note investor isn't a prohibited transaction by itself. Here's how to lend from your IRA, step by step.
Common questions
Can my IRA lend money to my brother?
Siblings aren't disqualified persons, so it isn't automatically prohibited. But the deal can't help you personally, and it gets close scrutiny. Talk with a CPA first.
Can I buy a rental property with my IRA and fix it up myself?
No. Doing the work yourself counts as providing services to your IRA. Hire an unrelated contractor and pay from the IRA.
What happens if my IRA makes a prohibited transaction?
For an IRA, the account can be treated as fully distributed as of January 1 of that year. You'd owe income tax on all of it, plus a 10% penalty if you're under 59 and a half.
Written by Larry Hoffman
Managing Member of LJH Investments, LLC in Madison, Indiana. In real estate since 2006, with 300+ mortgage notes bought. Author of Mailbox Money Retirement.
General education, not tax, legal, or investment advice. IRA rules are strict and change over time. Confirm everything with your custodian and a CPA or tax attorney. All investing has risk, including loss of principal.