Prohibited Transaction

A Prohibited Transaction is a specific deal or interaction involving a tax-advantaged retirement plan, like an IRA or 401(k), and a “disqualified person” that is strictly forbidden by law. Think of it as a set of guardrails designed to protect your retirement savings from conflicts of interest and self-dealing. The U.S. government, through laws like the ERISA (Employee Retirement Income Security Act), wants to ensure that the money in your retirement account is used for one purpose only: your actual retirement. These rules prevent you (and your close relatives or business associates) from using the plan's assets for your personal benefit before retirement. For example, you can't borrow money from your IRA, sell your personal car to your 401(k), or have your retirement plan pay your son's company to renovate a property the plan owns. Violating these rules isn't a simple mistake; it can trigger severe penalties from the IRS, potentially costing you a huge chunk of your nest egg.

This is where many investors get tripped up. A “disqualified person” isn't just you. The law casts a wide net to prevent you from indirectly benefiting from your retirement account's special tax status. A disqualified person generally includes:

• The plan's fiduciary (that's usually you, the account owner).
• Your spouse.
• Your direct ancestors (e.g., parents, grandparents).
• Your lineal descendants (e.g., children, grandchildren) and their spouses.
• Any corporation, partnership, or trust in which you own 50% or more.
• An officer, director, or highly compensated employee of a business you own.

Essentially, if the transaction involves your retirement plan and anyone on this list, a massive red flag should go up.

To make this crystal clear, here are some classic “don'ts” for your retirement plan. Engaging in any of these activities is a surefire way to get into hot water.

• Selling, leasing, or exchanging property. You cannot sell a piece of land you personally own to your Self-Directed IRA. Likewise, your IRA cannot buy a property and lease it to your daughter.
• Lending money or extending credit. You cannot take a personal loan from your IRA, nor can you personally lend money to your IRA to help it complete a purchase.
• Furnishing goods, services, or facilities. If your IRA owns a rental property, you cannot personally perform the maintenance work, even if you don't pay yourself. Your unpaid labor is considered furnishing a “service.”
• Using plan assets for personal benefit. This is the big one. A classic example is buying a beach house with your IRA and then using it for your family's vacation. The benefit (the vacation) is going to a disqualified person (you and your family), not the plan itself.
• Acts of self-dealing. This is where a fiduciary uses their position to benefit themselves, such as paying themselves an unreasonable management fee from the plan's assets.

Ignoring these rules is like playing with financial fire. The penalties are designed to be a powerful deterrent, and they can be financially devastating.

• For 401(k)s and other ERISA plans: The IRS can impose a two-tier excise tax. The first tier is a 15% tax on the amount involved in the transaction for each year it remains uncorrected. If you fail to fix the issue, a second-tier tax of a whopping 100% of the amount can be levied.
• For IRAs: The consequences are even more drastic. If you engage in a prohibited transaction, the entire IRA is treated as being distributed to you as of the first day of that tax year. This means you will owe income tax on the entire balance, plus a potential 10% early withdrawal penalty if you're under age 59 ½. It can effectively destroy your entire retirement account in one fell swoop.

For value investors, especially those using Self-Directed IRAs to invest in non-traditional assets like real estate or private businesses, understanding prohibited transactions is non-negotiable. The allure of finding an undervalued asset is strong, but the temptation to bend the rules to make a deal work can be disastrous. The core principle must be that every transaction is conducted at “arm's length”—meaning it's purely a business deal, exactly as it would be between two complete strangers. Never mix your personal finances, assets, labor, or family dealings with your retirement plan's investments. The potential upside of a single “clever” but prohibited deal is dwarfed by the catastrophic risk of losing your entire tax-advantaged account. When in doubt, always consult with a qualified tax professional or an attorney specializing in ERISA law. It's the cheapest insurance you can buy.