When a transaction occurs between a retirement plan and a disqualified person, this generates a prohibited transaction. Such prohibited transaction are a violation of IRS rules, and result in severe tax penalties as defined in IRC Section 4975.
A prohibited transaction occurs when there is any direct or indirect:
- Sale or exchange, or leasing, of any property between a plan and a disqualified person;
- Lending of money or other extension of credit between a plan and a disqualified person;
- Furnishing of goods, services, or facilities between a plan and a disqualified person
- Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
The taxable period for a prohibited transaction starts on the transaction date and ends on the earliest of the following days:
- the day the IRS mails a notice of deficiency for the tax;
- the day the IRS assesses the tax; and
- the day the correction of the transaction is completed.
Prohibited Transaction Taxes – IRA
If the IRA account holder or IRA beneficiary engages in a prohibited transaction, then the entire IRA is disqualified and deemed to no longer be a retirement account. The full value of the account as of the first day of the year in which the prohibited transaction occurred is considered to be a taxable distribution. If the IRA account holder is under age 59 ½ at this time, an additional 10% penalty applies, as with any other early distribution.
If a prohibited transaction occurs between an IRA and a disqualified party other than the account owner or beneficiary, the IRA is not disqualified, and that person will be subject to excise taxes. This scenario may arise when some other family member or a plan fiduciary engages in a prohibited transaction with an IRA. There is a 15% tax on the amount involved in the transaction for each year or part of a year of the taxable period. If the transaction is not corrected within the taxable period, then an additional tax of 100% of the amount involved is imposed.
Prohibited Transaction Taxes – Solo 401(k)
In a Solo 401(k), the impact of a prohibited transaction is not necessarily as damaging as in an IRA. A 15% excise tax applies on the amount involved in the prohibited transaction for each year of part of a year of the taxable period. If the transaction is not corrected within the taxable period, then an additional tax of 100% of the amount involved is imposed.
This 100% tax can be avoided by correcting a prohibited transaction as soon as possible. Correcting the transaction means undoing the transaction as much as possible without putting the plan in a worse financial position than if it has not engaged in the transaction in the first place.