Tax and financial advice from the Silicon Valley expert.

What kinds of transactions can you do with your Roth or IRA account?

When you have a self-directed Roth or IRA account, it can feel like you have a tax sheltered checkbook. As I discussed in another blog post, there is a wide range of choices of possible investments that you can make using these accounts.

The liberalized ability to convert other accounts to Roth accounts is especially exciting, because by meeting fairly liberal requirements, amounts withdrawn from a Roth are tax-free. (Of course there is that small problem of paying the income taxes for a conversion…) Not only that, but you aren’t required to take required minimum distributions during your lifetime and, if you have personal service income, you can continue contributing to a Roth even when you are older than age 70 1/2.

In order to have the most choices of investments, you will probably have to use a custodian that is not a bank, brokerage company or mutual fund. Conventional custodians will offer a more restricted menu of choices.

There are three constraints to be concerned about:

1) Roths and IRAs aren’t permitted to own some investments, like collectibles and S corporation stock.

2) Roths and IRAs can be subject to income taxes on Unrelated Business Taxable Income. This is not a deal killer, but should be considered when estimating your return on investment for an investment alternative.

3) Certain transactions aren’t permitted for Roths and IRAs. They are called “prohibited transactions”, and can result in disqualification of an IRA or Roth IRA, and acceleration of taxable income. (Internal Revenue Code Section 408(e)(2).)

In this post, I’m going to focus on prohibited transactions. I am only going to hit some highlights so you will be aware of some red flags. When you are using a self-directed Roth or IRA for alternative investments (investments other than stocks, bonds, savings accounts and mutual funds), you should consult with a team of advisors including an investment advisor, a tax advisor (CPA, enrolled agent, enrolled actuary or tax attorney) and an attorney schooled in retirement accounts.

As part of its service, a custodian for a self-directed Roth or IRA account should educate its clients about prohibited transactions and watch the activity of its account owners for potential prohibited transactions.

Prohibited transactions are defined at Internal Revenue Code Section 4975. For a Roth IRA or IRA, a prohibited transaction results in disqualification of the the account and acceleration of any income. The account is treated as distributed on the first day of a taxable year in which the prohibited transaction occurs.

Red flags should go up any time there is a transaction between the Roth or IRA and a “party in interest”. A party in interest includes a plan fiduciary (custodian or owner), and family members of the account owner including the spouse, descendents (children, grandchildren), and ancestors (parents, grandparents), and entities controlled (50% or more of capital interest or voting power) by a fiduciary or listed family member of the owner or fiduciary. Employees and 10% owners of capital or profits of controlled entities are also parties in interest. However, employees aren’t disqualified persons unless they are highly compensated, meaning they individually earn 10% or more of the aggregate wages paid by the employer.

I’m not going to discuss this in depth, but here are a few items to be aware of.

The owner of the account can’t use or rent a house owned by the account. However, a house can be rented at fair market value to a brother or sister of the owner.

The owner can’t “do the work” to rehabilitate an investment property. (No tearing out sheet rock and hammering new sheet rock yourself!) The owner should find an unrelated independent contractor to do the work.

The Roth or IRA can’t make a loan to the owner or a disqualified person, but can make a loan to a brother or sister of the owner. The loan should be handled in a businesslike manner, with a written note and security, and paid promptly. The transaction should not be a disguised gift.

A Roth or IRA can participate in an investment together with a disqualified person, such as forming a new C corporation (not S corporation) or limited liability company (LLC). The rationale for this being permitted is the Tax Court has said a disqualified interest doesn’t exist until the entity is formed. (Swanson v. Commissioner, 106 T.C. No. 76, February 14, 1996.) You need to be very careful in operating these entities to avoid prohibited transactions after the entity is formed.

The Roth or IRA can’t buy real estate from a disqualified person.

When the account owner meets requirements such as reaching age 59 1/2, he or she can distribute assets, such as a house, from a Roth account tax-free. So, a strategy to buy a retiremnt home could be to buy it in a Roth account, rent it to someone other than a disqualified person until it’s paid off (subject to unrelated busines income tax on the financed part of income), and then distribute it tax-free after retirement.

Just as with other tax benefits, Roths and IRAs have special requirements to be navigated in order to maximize returns from them.

With disappointing returns from traditional investments, plan owners should investigate making alternative investments using a self-directed Roth or IRA, at least for diversification purposes.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Tax and financial advice from the Silicon Valley expert.