Prohibited Transaction [CapiPedia]

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======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.
===== Who is a 'Disqualified Person'? =====
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.
===== Common Examples of Prohibited Transactions =====
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.
===== The Painful Consequences: Penalties =====
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.
===== A Value Investor's Take =====
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.