IRA Prohibited Transactions: Why IRA Investing is High Risk & High Reward Video
John Hyre: What are prohibited transactions? Here’s the bad side. High return, I showed you the return, high risk but the risk can be managed. A prohibited transaction is code section 4975. It kills anything but a 401(k). We’re going to talk about the 401(k) separately in this context.
Rule one, prohibited transaction kills anything but a 401(k). What does that mean? You have an IRA, it has $1.6 million in it. Now, between the distribution, because it’s usually taxable you have a 1.6 mil IRA, the money comes out, most of the time it’s taxable, that’s a pretty high bracket. Add it to your other income, you’re in a high bracket. Throw in a bunch of penalties.
I tell people especially in a state like California, a high tax state, you’re probably looking at a large IRA being destroyed about 60%. 60% will go to the government, that’s pretty normal. $1.6 million IRA does a $1 prohibited transaction. Let’s say I make a loan to mom, most of us know that a prohibited transaction includes the IRA doing business with me the owner, my ancestors, my descendants, my spouse, and the spouse of my descendants. Once again you, ancestors, descendants, spouse, and spouses of descendants are direct prohibited parties. Now, there are other disqualified persons as the strict term, that’s just the directly prohibited ones.
You do business with any of them, the IRA dies. The size does not matter. You guys remember Caddyshack? The guy throws the mounds bar in the pool and everybody clears out. One little mounds bar screws up the whole pool? It’s the same with prohibited transactions. I lend $1 out of my IRA to my mother, the IRA dies. What 60% of a 1.6 million dollar IRA? About a million bucks. Could a dollar cost you a million? Yes. Does anybody here think the IRS would not do that? Good. It’s nice to see a little reality, “They wouldn’t do that, it’s government they’re compassionate, they love us.” Okay, have some more mushrooms.
Just in case you doubt that the government would do it. Here’s the government’s quote. This is the tax court, your defender, your shield against the IRS. Here’s what they say about prohibited transactions and compassion, “We conclude that the prohibited transactions contained in section 4975 are just that. The fact that the transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence. Furthermore, the fact that the planned benefits from the transaction is irrelevant. Good intentions and a pure heart are no defense.”
Do you understand? Good, because the context we had previously in today’s conversation is aggressive is good, when the law is grey let’s be aggressive, this is an exception. Why? Because the penalty here is much larger. The penalty and a normal tax context is, “Oh I was aggressive. I got busted, it turns out that the grey position was white, not black, so I have to pay the tax and maybe some interest and if I’m having a really bad day maybe a 20% penalty, none of which is really a big deal.”
In this context, if we screw up a prohibited transaction the IRA dies. So we’re not just conservative, we are paranoid. You cannot have anything that could possibly be or even look like a prohibited transaction. Even the appearance of a prohibited transaction must be avoided. Do you understand why? Does anyone disagree?
Now, let me give you the one exception. Here’s the number one reason for 401(k)s. I’m going to give you multiple reasons. I love love love love self-directed 401(k). Why? The penalty for a prohibited transaction is only 15% of the transaction per year. 15% of the transaction, it does not kill the account. What does that mean? I lend mom a dollar, that’s my transaction amount. Let’s say we correct the transaction. How do we correct it? Mom pays the money back, we ended the transaction. I have a 15 cent penalty that year. It beats the hell out of a million bucks.
The number one reason I love 401(k) is it can be self-directed. If you can qualify, and we’ll talk about that, if you can qualify for a self-directed 401(k) the protection against prohibited transactions is so much better.
Now, there are other reasons. What are the other reasons I love 401(k)s? Higher contribution limit. Without going into details, you can contribute up to 53k a year to 401(k)s in an odd situation, very unusual but sometimes possible situations, you can contribute up to 100 grand for 401(k)s, and that’s just one of you. If you’re married and your spouse legitimately works for your business, two of you can do it. The contribution limits are higher.
There is no income limit on Roth contributions. Roth IRAs, if you make more than a certain amount, you cannot directly contribute. You can still indirectly contribute. All you do is contribute to a traditional IRA and then immediately 20 seconds later roll it to a Roth. There actually aren’t any contribution limits based on your income to Roths. You think there are, there aren’t there are ways around them.
401(k) don’t even have a direct contribution limit based on your income. How much can you contribute to a 401(k)? There’s the part you put in as an employee. You’re getting a salary presumably from your own company, how much can you put into the 401(k) as an employee? That’s $18,000 unless you’re 50 or older, in which case it’s $24,000.
Then, you can get the total number up to $53,000 total or up to $59,000 if you’re 50 year older by having the company make a contribution. The company can match up to 25% of your salary. That’s how you get 53K in there. There are some anomalous situations that you can actually get a hundred and am not going to go over them because it takes too long to explain it, with the time we’ve got.
What else do I like about 401(k)s? Better asset protection for most of them. 401(k) solos are a little different. A full blown 401(k) has asset protection under federal law. What do I mean by asset protection? Things that happen inside the account, you are not protected from. If you buy a rental in your 401(k), you buy a rental in your IRA and somebody trips and falls, can you be sued directly? Yes, in most jurisdictions and certainly the account is liable. The rest of the 401(k), the rest of the IRA, has liability. That’s not the kind of asset protection I’m talking about. Sometimes what we do is set up an LLC inside of a 401(k) or an IRA to provide that kind of asset protection, for the same reason you would set up an LLC instead of owning rentals directly in your name. Same reason.
The type of asset protection I’m talking about is from the outside. I always make fun of California on this one so I guess I might as well be consistent. Let’s say I accidentally– we got somebody who’s got one of those little purse animals, the animal jumps out, and I accidentally run over it with my humvee five times.
You guys California juries are so compassionate and kind and sensitive and giving. Let’s say that there’s a judgment against me for 5 million dollars, just a lot of harm and suffering and I don’t know peopleism. Yes favoring people over animals. I have to be punished there’s a $5,000 judgment against me. Can you seize what’s in my IRA? Depends, depends on state law. Most states provide some protection for IRAs, they don’t necessarily provide protection for Roth IRAs. Depends on the state there and there are exceptions under the state statute.
Is California the kind of state that is generous about protecting people? It is, it’s just that they protect the wrong people typically. A regular 401(k) is protected under federal law. There’s no busting open a regular 401(k). Now 401(k) solo is protected under state law.