What is the penalty for a self-directed IRA?

There are two main categories of penalties associated with a self-directed IRA. The first involves early withdrawal penalties, and the second, which is far more severe, involves penalties triggered by prohibited transactions.

For early withdrawals from a traditional self-directed IRA before age 59 and a half, the IRS imposes a 10 percent penalty on top of ordinary income taxes owed on the distribution. The same penalty applies to a self-directed Roth IRA if you withdraw earnings before meeting both the five-year rule and the age requirement. These are the same early distribution penalties that apply to standard IRAs.

The far more serious penalty in a self-directed IRA involves prohibited transactions. Self-directed IRA prohibited transactions occur when you engage in a financial deal between your IRA and a disqualified person. Disqualified persons include yourself, your spouse, your parents, your children, and any business entity where you or a family member owns more than 50 percent. If a prohibited transaction is found to have occurred, the IRS can disqualify your entire IRA as of January 1 of the year the transaction happened. The entire account balance is then treated as a taxable distribution subject to income taxes and the 10 percent early withdrawal penalty if you are under 59 and a half.

In real estate terms, this means you cannot sell property to your IRA, buy IRA property back for personal use, have a family member live in IRA-owned property, or personally perform repair work on a self-directed IRA rental property. These self-directed IRA real estate rules exist to prevent self-dealing and are enforced strictly.

Additionally, self-directed IRA prohibited investments such as life insurance contracts and collectibles will also trigger penalties. If your account holds a prohibited investment, the IRS treats the amount used to purchase it as a distribution.

At BullioniteAssetGroup, prohibited transaction compliance is one of the most critical services we provide. Understanding self-directed IRA irs rules before making any investment is the single best way to protect your retirement account from avoidable penalties.