How to Rectify a Prohibited Transaction

Published on May 15, 2014

know the rulesAs discussed in a previous post, there are several ways investors can find themselves on the wrong side of a transaction in their self-directed IRAs. Whether the retirement account has invested in commercial paper, a private placement, real estate, a commodity or natural resource, or any of the many other allowable alternative assets, it is important to remember that:

  1. You personally are not the investor, the self-directed IRA is, and
  2. The account administrator must execute all transactions on your behalf, for the benefit of the self-directed retirement account.
  3. You cannot take funds out of any investment the IRA has made directly. All income and expenses related to the investments must go through the account that made the investment before being transferred or distributed elsewhere.

A common error investors make is to sell the investment that the IRA made and have the proceeds forwarded directly to them or to another IRA account; they then deposit that amount received personally into another IRA with another IRA custodian. Because the proceeds from the sale were not sent back directly to the self-directed IRA custodian first, this is a prohibited transaction.

In the case of a prohibited transaction you erroneously conducted, there are a few steps you can take to correct the transaction, and avoid undue tax penalties and protect the tax-advantaged status of your self-directed IRA.

Steps to take to rectify a prohibited transaction pertaining to an improper recipient of funds

  1. Send the funds back to the investment directly. You will need to contact the incorrect IRA custodian to have the funds returned to you before sending the funds back to the investment. Or, if the funds from the investment went directly to another custodian, that custodian should send them back to the investment.
  2. Once the funds are received by the investment, the investment would then further direct the funds back to the proper IRA at the original custodian (in our case, back to Next Generation TS).  Using our office as an example, the investment can make a check payable to your appropriate account (Next Generation TS FBO Client Name IRA ####) or send the funds via wire transfer.
  3. Once received by the NGTS IRA, the funds can then be further transferred or distributed at your discretion.  Should you choose to direct NGTS to issue the funds out of the IRA, the account can then be closed if you no longer wish to take advantage of self direction.

At Next Generation Trust Services, our goal is to help our clients protect the tax-advantaged status of their self-directed IRAs. We provide clients with a 14-day window, as the IRS instructs, to correct the transaction so that the funds are not distributed as a prohibited transaction; this would be a taxable event and may be subject to IRS penalties. The Next Generation staff can explain and assist you with expediting these steps, and provides guidance and information throughout the process as part of our customer service commitment.
Because of potential tax ramifications, we recommend you consult with an attorney or CPA that specializes in ERISA* law and IRA Rules set forth in the Internal Revenue Code’s Title 26 USC § 4975 or other applicable retirement plan specialists. We can provide contact information for known ERISA attorneys; however, we cannot endorse or guarantee their services.
As always, if you have a question about your self-directed retirement plan, the types of investments you can make, or if you need information about liquidating an asset, contact our self-direction experts at Info@NextGenerationTrust.com or (888) 857-8058.

*Employee Retirement Income Security Act