Retirement plans like IRAs, 401(k)s, and other qualified accounts offer valuable tax advantages to help individuals save for the future. However, to safeguard these benefits and prevent misuse, the IRS has strict rules against certain types of transactions called “prohibited transactions.”

What Are Prohibited Transactions?

Prohibited transactions refer to specific dealings or arrangements involving a retirement plan (such as an Individual Retirement Account or a 401(k)) and disqualified persons—individuals or entities with a personal interest in the plan—that are forbidden by the IRS. These rules prevent conflicts of interest, self-dealing, or personal use of plan assets that could abuse the plan’s tax-favored status.

Who Are Disqualified Persons?

Disqualified persons typically include:

  • The account owner or plan participant
  • Family members, such as spouses, ancestors, and lineal descendants
  • Employers sponsoring the plan or their key employees
  • Service providers or fiduciaries associated with the plan
  • Businesses owned by the plan participant or related parties

Common Examples of Prohibited Transactions

  • Selling property between the retirement plan and the owner: For example, using an IRA to buy real estate directly from yourself or a family member without a fair market transaction.
  • Lending money to disqualified persons: Such as lending money from your 401(k) to a family member.
  • Using plan assets for personal benefit: Borrowing funds from your IRA to buy a car or paying yourself for non-investment services with plan assets.
  • Buying or selling goods or services between the plan and a business you control.

These transactions violate IRS rules because they create conflicts of interest and can divert retirement savings for personal gain.

Why Do Prohibited Transactions Matter?

Engaging in prohibited transactions can have severe consequences. The IRS may disqualify your entire retirement plan, making all assets immediately taxable as distributions—potentially triggering significant taxes and early withdrawal penalties. Additionally, you may face excise taxes specifically imposed on prohibited transactions.

How to Avoid Prohibited Transactions

  • Never use your retirement plan assets for personal loans or personal benefits.
  • Avoid transactions with family or entities classified as disqualified persons.
  • Consult with financial advisors or tax professionals knowledgeable in retirement plans before making unusual investments.
  • Maintain accurate records of all transactions to demonstrate compliance.

Real-World Scenarios

  • Jane’s IRA Property Purchase: Jane’s IRA buys an apartment directly from herself. Since she is a disqualified person, this self-dealing violates IRS rules.
  • Mike’s Family Loan: Mike’s 401(k) lends money to his brother. Lending to family members is prohibited.
  • Sarah’s Business Inventory Sale: Sarah’s IRA purchases inventory from a company she owns. This creates a conflict of interest and is prohibited.

Correcting Prohibited Transactions

If you inadvertently engage in a prohibited transaction, the IRS offers correction programs like the Voluntary Correction Program (VCP). Acting quickly can reduce or eliminate penalties, but timely and professional handling is essential.

FAQs

What are the penalties for prohibited transactions? Penalties can include plan disqualification, taxes on the full plan balance, excise taxes, and loss of tax-advantaged status.

Do these rules apply to all retirement accounts? They primarily apply to IRAs, 401(k)s, and qualified plans, though specific rules may vary.

Can a financial advisor help? Yes, professional guidance can prevent prohibited transactions and keep your retirement savings safe.

Summary Table: Common Prohibited Transactions

Transaction Type Example Reason Prohibited
Sale or purchase between plan and owner IRA buys property from owner Self-dealing benefits disqualified person
Loans to disqualified persons 401(k) lends money to family member Loans to disqualified persons are forbidden
Personal service transactions Paying yourself with IRA funds unrelated to investing Personal benefit from plan assets
Use of plan assets for personal use Borrowing IRA funds for personal expenses Retirement assets can’t fund personal uses

Useful Resources

Understanding and avoiding prohibited transactions is essential to protecting your retirement savings from unexpected taxes and penalties. Consult trusted tax professionals to ensure your retirement plan complies with IRS regulations.