The prohibited transaction rules are the most important rules to understand when you self-direct your retirement account. These rules restrict not what investments your retirement plan may acquire but whom your plan may transact with.
How It Happens
A prohibited transaction occurs when a retirement plan (e.g. self directed IRA or 401k) transacts with a disqualified person. IRC § 4975. A transaction is pretty easy to identify and is defined in the code as a sale, lease, exchange, payment, or other transfer of money from a retirement plan. If that transaction is with a disqualified person then the retirement plan has engaged in a prohibited transaction. The consequence of a prohibited transaction for an IRA is distribution of entire IRA while the consequence to a 401(k) or other employer based plan is a 15% excise tax on the amount involved and an additional 100% penalty if the transaction is not corrected. Regardless of the type of retirement account you are self-directing, the consequences are significant. IRC § 4975 (c)(3), IRC § 408 (e)(2)(A). IRC § 4975 (a),(b).
Often times, a disqualified person is generically referred to as a family member. While that definition can be accurate, it really can cause problems when applied as some family members are disqualified (e.g. spouse of plan owner) while others are not (e.g. brother of plan owner). Also, it can be really confusing to determine when a company is disqualified to a retirement plan or when partners are disqualified. Because of the confusion, I’ve created a disqualified person diagram to help sort out the details. If a party is in red, that means they are a disqualified person and that your retirement plan cannot transact with them. If the party is green, that means they are NOT disqualified and your retirement plan may transact with them.
Keep in mind that a self-dealing prohibited transaction can also arise if any disqualified party personally benefits from a retirement plans investments. In summary, you should avoid all transactions with disqualified persons and should seek legal counsel whenever a disqualified person is involved in any retirement plan investment.
Many savvy investors have come to find Roth retirement accounts as a great tool to building long-term tax-free wealth. Roth IRAs were first introduced in 1997. Roth 401(k)s came around in 2006 but had many restrictions and were not widely offered. Under current 401(k) rules, you can contribute $17,500 a year to your Roth 401(k) account as an employee contribution. You can contribute up to an additional $34,500 to your 401(k) for the year, depending on your income, up to a total amount of $52,000 but the $34,500 would be employer contributions and must be Traditional dollars. So, if you’re self-employed and have a solo 401(k) and want to max-out your 401(k) contributions you could contribute $17,500 as Roth 401(k) dollars and $34,500 of Traditional 401(k) dollars. But what if you want all of the funds to be Roth 401(k) dollars? Well, have no fear; all you have to do is convert the Traditional 401(k) dollars to Roth. Also, what if you want to roll-over existing retirement accounts to your Roth 401(k)? This is also possible, you just have to roll the funds over and convert. This article outlines the brief history and details on how you can maximize your Roth 401(k) account.
The American Tax Payer Relief Act of 2012 (“ATRA”) totally changed the game for Roth 401(k)s. Following ATRA, Roth 401(k)s became significantly more beneficial to investors for one simple reason: you could more easily put your existing retirement plan dollars into it. Since 2012, any 401(k) account owner, whose plan offers a Roth 401(k) account (and most now do), is eligible to convert any and all of their existing Traditional 401(k) dollars to Roth 401(k) dollars. This includes Traditional IRA rollovers to the 401(k), 401(k) employee contributions, and vested 401(k) employer contributions. Keep in mind that when you convert any Traditional retirement plan dollars to Roth 401(k) dollars that you will be taxed on the amount converted. That’s what Roth retirement account dollars are. They are post-tax retirement plan funds (you’ve paid taxes on them already) that grow tax-free and are withdrawn at retirement tax-free (age 59 ½).
Transfer and Rollover Rules
Additionally, funds in prior employer Roth 401(k)’s may be rolled into your existing Roth 401(k). Unfortunately, one source of funds that cannot be rolled, transferred, or converted into a Roth 401(k) are Roth IRAs. Here’s a quick chart breaking down the rules.
Existing Retirement Plan Dollars
Can These Retirement Plan Dollars Go Into My Roth 401(k)?
Transfer/Rollover from a Traditional IRA or Prior Employer Traditional 401(k).
Yes, but tax will be due at the time of conversion on the amount converted to Roth.
Traditional Employee Contribution Made to Your Traditional 401(k) Account.
Yes, but tax will be due at the time of conversion on the amount converted to Roth.
Employer Contribution Made to Your 401(k). These Are Always Contributed as Traditional Dollars.
Yes, but tax will be due at the time of conversion on the amount converted.
Prior Employer Roth 401(k).
Yes, these are rolled from the old Roth 401(k) plan to the existing Roth 401(k).
Roth IRA
No, right now you cannot roll Roth IRA dollars into a Roth 401(k). We expect this law to change over time but not anytime soon.
In addition to the chart above, here’s a link to IRS Notice 2013-74 which discusses Roth 401(k) conversions and rollovers.
Keep in mind that conversions to Roth dollars are only permitted if your 401(k) plan allows it. Most Solo or Owner Only 401(k) plans allow for Roth contributions and conversions. Also, only vested amounts are available for conversion, which in a Solo 401(k) plan, all amounts contributed are usually immediately vested. Finally, keep in mind that any amounts converted are still subject to tax based on your personal tax rate liability. However, once converted, all subsequent distributions will be tax-free, so long as any converted funds remain in the Roth account for five years prior to distribution.
In summary, Roth 401(k) sums can be accumulated from many different sources. They can be accumulated from conversions of traditional IRAs, old employer Traditional 401(k)s, and from existing Traditional 401(k) contributions (employee or employer). You aren’t just limited to putting in your annual $17,500 of Roth 401(k) dollars each year. So, if you want to maximize your Roth 401(k) account, all you need to do is rollover and/or convert your existing dollars to Roth.
A Self-Directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self-Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self-directed IRA investment, your IRA custodian holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being a manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.
Examples
Here’s a few examples of earners who can establish and fund a Roth IRA.
I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers.
The Process
The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction the amounts contributed but the funds are held in a Roth IRA and grow and come at tax-free upon retirement (just like a Roth IRA). Here’s how it works.
Step 1: Fund a new non-deductible traditional IRA
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. Don’t worry about having non-deductible contributions though as you’re converting to a Roth IRA so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, since 2010 all taxpayers are able to covert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.
If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.
There are two work-arounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer based plan as employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allows for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner only 401(k) plan and you can roll over your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill now so careful planning must be taken.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.
There are numerous laws, cases, and regulations to consider in analyzing whether your IRA can own an LLC (commonly referred to as an “IRA/LLC” or a “checkbook control IRA”). Despite the complexity of the law, your IRA can own 100% of the ownership interest of an LLC and you as the IRA owner may serve as the Manager of this LLC. This proposition was first supported by the case of Swanson v. Commissioner, 106 T.C. 76 in 1996 where the U.S. Tax Court held that it is not a prohibited transaction under IRC Section 4975 for a retirement plan to invest and own 100% of newly created corporation nor was it prohibited for the IRA owner to serve as an officer of that company where no salary or compensation was paid to the IRA owner. In summary, the U.S. Tax Court has supported the structure whereby a new created company is wholly owned by a retirement plan and managed by the retirement plan owner and that is the same rationale used in many IRA/LLC’s.
So what does the IRS think about IRA/LLC’s? The IRS issued IRS Field Service Advisory #200128011 in April of 2001 which indicated that the IRS will not contend that there is a prohibited transaction when there is a newly formed and capitalized company that is 100% owned by a retirement plan. Keep in mind that both of these cases deal with newly formed companies and do not apply to LLC’s or corporations (or other companies) which a retirement plan owner may have already established. Also, it is possible to partner your retirement plan with others into one IRA/LLC but you must carefully consult with professional who are experienced in this area as there are numerous prohibited transaction issues that may arise when you partner your IRA with others.
Serving as the Manager of the IRA/LLC allows the IRA account owner to enter into contracts on behalf of the IRA/LLC and to sign checks on behalf of the IRA/LLC. There are restrictions on the amount of work you may do (for example, if the IRA/LLC owned a property you may not work on the property) but you may oversee the administrative matters like the signing of contracts and checks. The prohibited transaction rules still apply to IRA/LLC’s in the same way they apply to your self-directed IRA so you still must pay careful attention to these rules and most consult with professionals who are competent in the laws that apply to retirement plans. Moreover, an IRA/LLC is different from your typical LLC and the IRA/LLC documents should include numerous provisions which protect your IRA from a prohibited transaction. This doesn’t mean that an IRA/LLC should costs thousands of dollars. In fact, our law firm sets IRA/LLC’s up for $750 plus the state filing fee if the IRA/LLC is owned by one IRA or $1,500 if owned by multiple IRA’s or partners. In the end, an IRA/LLC can be a powerful tool to gain more control of your IRA’s investments but you must do so with adherence to the rules and laws that apply to your IRA. Written by Mathew Sorensen, Attorney at Law and Partner at Kyler Kohler Ostermiller & Sorensen, LLP, a law firm assisting self directed retirement plan owners across the U.S. for over ten years from offices in Arizona, Utah and California. To learn more about our law firm, please visit our website at ww.kkoslawyers.com or call us at 435-586-9366.
The "Self Directed IRA Handbook" by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA. Mat has performed the impossible by effectively delivering complex information in an easily understandable manner for the layperson, while providing the necessary legal basis to suit the professional. Mat's book is a "must read" for investors, attorneys, CPAs, and other professionals and other interested individuals wanting to learn about all there is to know about Self-Directed IRAs.
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Pamela Constantino
Mat's book is an excellent resource for self directed IRA owners and their advisors. It is the first of its kind in our industry. Mat has truly written an “Authoritative Guide” for self directed IRAs.
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Mathew is an excellent attorney, well versed in the Self-Directed IRA market…His ability to distil the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none. Anyone interested in this Self-Directed IRA Market would do well to connect with Mathew and learn from the best.
"Mat's book is an excellent resource for self directed IRA owners and their advisors. It is the first of its kind in our industry. Mat has truly written an“Authoritative Guide” for self directed IRAs."
"Mat is an excellent attorney, well versed in the Self-Directed IRA market...His ability to distill the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none.
"Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs."
"The Self Directed IRA Handbook by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA."
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Founder and Retired CEO, PENSCO Trust Company
J.P. Dahdah
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.