It’s your IRA, so you’ll use the funds in your account however you like ... right? Wrong.
Strategy: Be mindful of the rules concerning the use of IRAs. The tax law imposes a number of restrictions on IRA owners. You can’t simply do whatever you want.
What’s more, failing to observe these rules can turn into an unmitigated tax disaster.
Here’s the whole story: The IRA is a valuable tax-favored tool for retirement. If you qualify, contributions are fully or partially taxable. The contribution limit for the 2012 tax year is $5,000 (the same as 2011). In addition, if you’re age 50 or older, you can contribute an extra $1,000 in 2012 (the same as in 2011).
Nondeductible contributions are exempt from federal income tax when they are paid. And, if you establish a Roth IRA instead of a traditional IRA, qualified distributions are tax-free after the Roth has been in existence for at least five years (although Roth contributions are never tax-deductible).
Be mindful of ‘prohibited transactions’
To top things off, you can generally choose from a wide range of investment options for your IRA funds. But you could run into trouble if you engage in self-dealing or other “prohibited transactions.” The penalties for such occurrences are severe.
The IRS defines a prohibited transaction as the improper use of an IRA by the participant, the named beneficiaries or a disqualified person under the law. For this purpose, a “disqualified person” can be another family member, the participant’s closely held company or a financial or investment professional.
The list of prohibited transactions is a long one. It includes the following:
- Borrowing funds from the IRA
- Selling property to the IRA
- Using the IRA as security for a loan
- Buying personal property with IRA funds
- Receiving unreasonable compensation for managing IRA funds.
When a prohibited transaction occurs, the IRA owner is treated as having withdrawn the entire balance of his or her account. Therefore, if you violate the rules, the distribution will be fully taxed at ordinary income rates up to the top 35%.
To add insult to injury, you’ll be hit with a 10% penalty tax on the value of the IRA if you’re under age 59½ at the time of the prohibited transaction.
Tip: Usually, an IRA custodian won’t go along with a prohibited transaction if it’s aware of it. But you can’t rely on the custodian to police the situation.
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