We’ve all done it…..that crack in the sidewalk that most people would have to intentionally attempt to trip over and still maybe not fall…but, we are the ones who do that trip and are always embarrassed over it. When we trip on the crack, we look at the crack as if it jumped up and knocked us over when no one was looking.
The same can happen with our self-directed IRA and 401K plans. While the IRS rules related to what qualified retirement accounts cannot do are not difficult concepts to understand, almost like that crack in the sidewalk, they seem to creep up on some people and trip them up. And just like falling over that crack, some of us almost fall and then realize to our own embarrassment that we almost entered into an IRS prohibited transaction without even intending to do so.
So, what are some common scenarios that can “pop” up and trip us all. Let’s look at a few that have been addressed by this author over the last few months.
1) Qualifying for a 401K — Many people are enamored with the benefits associated with a 401K vs. its lesser counterpart, the IRA. In layman’s words, an individual who is establishing a self-directed 401K must qualify for the 401K. They are not allowed to establish the 401K unless they qualify for the plan. So, how does one qualify for a 401K? Well, an individual who is self-employed or a W-2 with a side business may qualify for the 401K. However, an individual who is strictly a W-2 and will never be anything but a W-2, simply does not qualify for the 401K.
Typically, a person will get confused with this simple concept and believe that as they may be utilizing their retirement funds to invest in assets such as real estate, that this endeavor makes them an entrepreneur and, therefore, self-employed. This is not the case. When serving as the fiduciary of your retirement plan you are making investments on behalf of the plan….not being self-employed as a real estate entrepreneur.
2) Commissions, Commissions and More Commissions — Many a real estate agent who also holds a self-directed IRA or 401K believes that they can earn a commission for buying into or selling a property from their self-directed IRA or 401K. Such is not the case and it is clearly a prohibited transaction per IRS regulations.
Another example of where earning commissions is a prohibited transaction deals with serving as a fiduciary of other family members’ retirement funds. This may be a situation where several family members establish an LLC to pool their funds and elect one of the family members to serve as the manager of the LLC and be compensated for their time and investment advice on particular investments. The problem that can easily arise is that the individuals are disqualified individuals to each other and, therefore, the receipt of any commissions in this example would constitute a prohibited transaction.
3) Buying That Property? Don’t Fix It? — Unlike what the heading suggests, no one is telling the self-directed IRA or 401K participant that they cannot fix the property they purchase for their plan. However, all expenses and work on the investment property must be born and paid by the retirement plan (assuming non-recourse funding is not being utilized).
This is an easy trap to enter into when purchasing real estate with a retirement account. Many people know that all expenses for the property must be paid by the retirement account as it is the plan, not the individual, who owns the property. However, just as many individuals inadvertently enter into a prohibited transaction by performing some of the work on the property as compared to having other, non-disqualified individuals execute these activities. In most cases, they are very innocent and well intentioned. For example, a person who is a handyman at heart or practice may think that he/she is “helping” their retirement plan if they can execute some of the work on the property in that it keeps more funds in the plan. While well intentioned or innocent in its focus, this type of transaction is clearly a prohibited transaction.
An easy concept to remember…an individual cannot enter into any activity that benefits the “plan” and the plan cannot enter into any activity that benefits the individual.
4) Loans to Another Individual With the Intent — We know that in almost all circumstances that engaging in “self-dealing” arrangements with your self-directed IRA will be a prohibited transaction (there is a great exception to this with a 401K). So, as a result, some entrepreneurial spirits will decide to have reciprocal loans with another individual who is not a disqualified individual. The logic is that IF they are unrelated parties to each other and IRS regulations would otherwise permit such a loan, then it is permissible. However, the very fact that they are “arranging” the loan would trigger the IRS’ “indirect” benefit. Obviously, without the “intent” to get around the regulations by entering into their agreement, the parties would not have otherwise made the loans.
So….don’t do it!
5) Personal Guarantees to the SD IRA or 401K — While addressed briefly in another point, this one bears greater emphasis as it is probably the most violated prohibited transaction…whether with intent or not. And, it typically happens with the purchase of real estate.
Typical scenario — An individual is purchasing property for their IRA or 401K and needs a loan to complete the investment transaction. While at their local bank securing a loan, the loan officer will advise the SD participant that they can secure lending by providing a personal guarantee on the loan based on their credit, or collateral. This is clearly a prohibited transaction. Remember, you cannot benefit from the plan and the plan cannot benefit from you…a simple but oh so true statement.