Congress created individual retirement accounts to encourage long-term saving and investment. Traditional IRAs give you a tax deduction on the money you sock away, but you’ll have to fork over taxes on money you withdraw. A Roth IRA doesn’t provide a tax-deduction but you can remove money tax-free, if you follow the rules. Certain IRA transactions are prohibited.
The Internal Revenue Service lists five transactions that spell doom for your IRA. You will destroy your IRA if you borrow money from it or use it as security for a loan. You also can’t sell property to it or use IRA money to buy property for personal use. The last no-no applies to the person managing the fund, known as the “fiduciary.” The fiduciary is someone who can control what the IRA buys and sells, provides you with paid investment advice, or can make decision on how your IRA is administered. If the fiduciary receives too much money for managing your IRA, the account could be toast.
When the IRS discovers a prohibited transaction, it no longer recognizes your IRA as an IRA, effective Jan. 1 of the year of the transaction.The effect is as if you emptied out your IRA as of the first day of the year. The tax on this money is based on the fair market value of your investment on that date. Normally, the fair market value of an investment is its current price. You also may be liable for an additional 10 percent penalty if you were younger than 59 1/2 when the IRA lost its status. If your account is a Roth IRA, you won’t owe taxes on the money you contributed, but you might have to pay the 10 percent penalty on earnings if the IRA was under five years old or you were under 59 1/2 on Jan 1.
The law exacts extra punishment on employers or employee associations that act as your IRA trustee and perform a prohibited transaction without your knowledge. Your IRA won’t lose its status, but the trustee will be liable for a 15 percent excise tax on the amount of the prohibited transaction. If the trustee doesn’t correct the transaction, the excise tax can balloon up to 100 percent. However, if you participated in the trustee’s prohibited transaction, your IRA will lose its status.
Copyright 2013 Eric Bank, Freelance Writer