In the vast majority of cases, IRAs are put in investments such as CDs, annuities, mutual funds, or a brokerage account of stocks and bonds. However, some clients desire to set up self-directed IRAs and place the money in nontraditional investments, including:
• Precious metals or coins;
• Other collectibles;
• Real estate;
• A new business started by the IRA owner.
Certain kinds of investments are specifically prohibited by the Internal Revenue Code from being owned by an IRA. Life insurance would fall into that category. Other investments, while not specifically prohibited, may be considered unsuitable for ownership, by an IRA. and some nontraditional investments can run afoul of the prohibited transaction rules that apply to IRAs.
Here’s what the IRS says about the prohibited transaction rules in Publication 590.
Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.
Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of prohibited transactions with a traditional IRA.
• Borrowing money from it.
• Selling property to it.
• Receiving unreasonable compensation for managing it.
• Using it as security for a loan.
• Buying property for personal use (present or future) with IRA funds.
The consequences of engaging in a prohibited transaction can be large. Code Section 4975(a) imposes a tax equal to 15 percent of the amount involved with respect to the prohibited transaction for each year (or part thereof) in the taxable period. Under Code Section 408(e) (2), an IRA is disqualified if it engages in a prohibited transaction. Finally if an IRA is disqualified, income taxes and a 10 percent penalty if the owner is under age 59 ½ will be due on the entire balance of the IRA.
Because of the severe consequences of the prohibited transaction rules, I strongly urge my clients to stick to traditional IRA investments and avoid nontraditional investments. Should a client be determined to invest in a nontraditional investment, it should only be done after consultation with a tax professional such as a CPA, or tax attorney experienced in the prohibited transaction rules. In cases involving large amounts, it would be prudent to ask the Department of Labor for an Opinion Letter or even an exemption from the prohibited transaction rules.
Sometimes in life it can be better to beg for forgiveness than ask for permission, but when it comes to the IRS, this is definitely not one of those times.