You may already be aware of the many rules and penalties your friends at the IRS have when it comes to prohibited transactions. The penalty tax for prohibited transactions begins at 15% for most type of retirement plans. But wait, there’s more! For those of us trying to pay less taxes by going the self directed route it comes as no surprise that the IRS has harsher penalties for self-directed IRAs who engage in prohibited transactions. Here we go. What happens when an IRA owner or beneficiary engages in a prohibited transaction? When a self-directed IRA or Roth IRA owner or beneficiary is involved in a transaction that is deemed prohibited pursuant to Internal Revenue Code Section 4975, pursuant to Internal Revenue Code Section 408(e), the IRA loses its tax-exempt status. Also, the IRA holder (or beneficiary) is treated for tax purposes to have received a distribution on the first day of the tax year in which the prohibited transaction occurred. The distribution amount that the IRA holder is deemed to have received is equal to the fair market value of the IRA as of the first day of such tax year, and is required to be included in the IRA holder’s income for the year. Additionally, unless the IRA holder qualified for an exception to the early distribution penalty (i.e. over the age of 591/2, disabled, etc.), the 10% early distribution penalty would also apply. (Ouch!) Summary of the above. If you own an IRA or are a beneficiary of one, and you engage in a transaction that violates the prohibited transaction rules, your IRA will lose its tax exempt status. The entire fair market value of the IRA will also be treated as taxable distribution, subject to ordinary income tax. Note: You would also be subject to a 15% penalty as well as a 10% early distribution penalty if you’re under the age of 59 and a half. What happens if a non-IRA owner or non-IRA beneficiary engages in a prohibited transaction Under IRC 4975? In the case where someone other than the IRA holder or IRA beneficiary (for example, another disqualified person) engages in a prohibited transaction, that disqualified person may be liable for certain penalties. In general, a 15% penalty is imposed on the amount of the prohibited transaction and a 100% additional penalty could be imposed if the transaction is not corrected. Note: fiduciaries to an IRA or plan are not subject to the 15% or 100% additional penalty. What are the penalties for engaging in a prohibited transaction under internal revenue code section 408? (Yes, more sections!) The penalty for engaging in an Internal Revenue Code Section 408 prohibited transaction differs from the Internal Revenue Code Section 4975 penalty. (Your friends at the IRS have many, many penalties dear reader.) If an IRA assets are invested in collectibles or life insurance, only the assets used to purchase the investment are considered distributed, not the entire IRA. In addition, pledging an IRA as a security for a loan is a prohibited transaction under Internal Revenue Code Section 408(e)(4). If an IRA holder pledges a portion of his or her as security for a loan, only the amount pledged is deemed distributed – not the entire IRA. IRS penalties can be costly. The prohibited transaction rules are extremely broad and the penalties extremely harsh. (Instant disbandment of your entire IRA plus a penalty fee.) So yes, anyone using a self-directed IRA should be cautious in engaging in transactions that would anger their friends at the IRS, because angering them could cost you big time.