Taking Care of Mom and Dad: Prohibited Transactions
I'll end this chapter with a quick note about defined contribution plan dealings that the tax code discourages.
Because these accounts often contain large amounts of money, the investment advisors and other people around your parents may be tempted to use or abuse the funds. That abuse may be criminal, separate of tax issues. But the tax code does try to prohibit certain types of sleazy transactions.
Generally, a prohibited transaction is any improper use of an IRA account or annuity by your parents, their beneficiaries or any disqualified person. (Disqualified persons include any fiduciary and family members -- spouses, ancestors, lineal descendants and spouses of lineal descendants).
A fiduciary includes anyone who exercises any discretionary authority or discretionary control in managing an IRA or exercises any authority or control in managing or disposing of its assets; charges a fee to provide investment advice with respect to an IRA or has any authority or responsibility to do so; and has any discretionary authority or discretionary responsibility in administering an IRA.
The following are examples of prohibited transactions with an IRA:
- borrowing money from it;
- selling property to it;
- receiving unreasonable compensation for managing it;
- using it as security for a loan; and
- buying property for personal use (present or future) with IRA funds.
Generally, if your parents or their beneficiaries engage in a prohibited transaction in connection with an IRA at any time during the year, the account stops being an IRA as of the first day of that year. Your parents will have to pay taxes on the complete balance of the IRA as of that first day of the year; and they may have to pay the 10 percent additional tax on early distributions.
You may recognize these terms as the same that apply to forgiven loans or any other early withdrawal of retirement monies. Merely from a tax perspective, they are best to avoid.
If someone other than the owner or beneficiary of an IRA engages in a prohibited transaction, that person may be liable for additional, larger taxes. In general, there is a 15 percent tax on the amount of the prohibited transaction and a 100 percent additional tax if the transaction is not corrected within the year it occurred.
