If you are tired of the plain investment offerings with regular individual retirement arrangement accounts, you may look to the excitement of non-traditional IRA investments offered in self-directed accounts. While these investments may offer unique opportunities, they also open you up to more possibilities of mistakes with your account. Caution is indicated, because critical self-directed IRA mistakes cannot be undone, and they may expose you to unnecessary taxes and penalties.
Examples of prohibited transactions with an IRA account include using the account as security for a loan or borrowing from the account, as well as an owner receiving unreasonable compensation for managing the IRA account. If you engage in what the IRS defines as a prohibited transaction, your IRA account ceases to be an IRA, as of the first day of the tax year, regardless of the day that the transaction occurred. You cannot correct these types of transactions.
Improper Real Estate Transactions
Real estate transactions are an area where self-directed IRAs often run into trouble. Any property owned by your IRA cannot be used for your benefit or the benefit of immediate family members. This includes a rental vacation home that you use for your own benefit. In addition, you must make the purchase of the real estate entirely with funds from your IRA -- you cannot use your own funds, because this is an additional investment that could exceed your yearly maximum IRA contribution. Making an improper real estate transaction will invalidate your IRA, eliminating its tax-advantaged status. You can correct an excess contribution by withdrawing the amount contributed, but an improper real estate transaction will invalidate the account.
While poor investments may end up costing you money, if you make a mistake investing in an allowed investment, you can correct this mistake by selling the investment and making a new investment. Direct your trustee to make the sale as you want. As long as the transaction is carried out completely inside of your IRA, you will not face any penalties or taxes from this transaction.
If you engage in a prohibited transaction, and your IRA loses its tax-advantaged status, you may be responsible for taxes and penalties on the account. With a traditional IRA, all of your investment gains and any pre-tax contributions will be subject to income taxes at your regular income tax rate. If you are under age 59 1/2, you will also have to pay a 10 percent tax penalty on this money. With a Roth IRA, contributions that you made to the account are not subject to taxes and penalties, but investment gains are if you are under age 59 1/2.
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