Most people know that they can use the money in their self-directed individual retirement arrangement to invest in stocks, bonds and mutual funds. What many people don't realize is that they can take money from their IRA to invest in real estate and even a start-up company. You cannot invest IRA money in an S corporation, however, because it falls under what the IRS classifies as a "prohibited transaction."
Individual Retirement Arrangement
Most brokerage firms give the option to invest your IRA in mutual funds that you control but, in fact, an IRA gives you flexibility to invest your money outside of the traditional investment classes. The IRS allows you to invest your money among 40 asset classes, such as all forms of income-producing real estate. Other permissible asset classes that you wouldn't think of include fishing rights and cattle. The IRS prohibits the practice of "self-dealing," which is using the tax-deferred money in your IRA to invest in something that benefits you today. For example, you can use the money in your IRA to invest in a beach house, but only if you plan to rent it out and not use it for personal use.
Even though an IRA gives you investing flexibility, some types of investments are off limits. These are what the IRS refers to as "prohibited transactions." Examples of prohibited transactions include artwork, jewelry and life insurance. Unfortunately, the restrictions of an S corporation prevent you from using the money in your IRA to invest in one. An S corporation falls under Subchapter S of the Internal Revenue Code. An S corporation is a "pass-through" entity that avoids paying federal income tax by distributing its profits and losses to shareholders.
S Corporation Restrictions
The main problem with taking your IRA money and investing it in an S corporation is that the tax law restricts S corporation shareholders to individuals, estates of deceased individuals and certain types of trusts. According to the law, even though an IRA is a type of trust, it doesn't fit the bill as a qualified S corporation shareholder.
If you really want to invest directly in an S corporation, you can take an early withdrawal from your IRA. However, you'll have to pay an early withdrawal penalty of 10 percent of the value of your holdings if you are under 59 1/2 years old. You can withdraw money without penalty after 59 1/2, but you'll have to pay income taxes, unless it is a qualified distribution from a Roth IRA.