OVERVIEW & FAQ
- What is a prohibited transaction? A prohibited transaction is a transaction between your retirement plan (solo 401k) and a disqualified person.
- What is a disqualified person? You, your spouse, direct family members, owners and fiduciaries of the business are disqualified from transacting with your retirement plan.
- What’s the point of a prohibited transaction rule? Prohibited transactions prevent plan owners to use their retirement plans to bypass taxes and directly benefit themselves, their business, or their family.
- What is the penalty for prohibited transactions? 15% penalty tax on the amount involved in the transaction. If the error is not fixed within the taxable period, the penalty tax increases to 100% of the amount involved.
In a solo 401k, the assets are owned by the plan, not you or your business. When you open a solo 401k account, the plan registers for its own Employer Identification Number (EIN). The IRS identifies the plan as its own entity, separate from you and your business. The solo 401k trust uses the EIN to open its own bank accounts and brokerage accounts. All assets purchased through a solo 401k is owned by the solo 401k trust. Therefore, it’s a conflict of interest if you use your plan to transact with yourself, your business, or your direct family members.
Prohibited transactions are a tricky subject. And some of the rules may not make a lot of sense at first glance.
For example, here’s a wild one: If your plan owns a vacation home, you’re technically not allowed to use it. It might not make much sense since you feel like it’s yours and you should be free to do with it as you like. But in the IRS’ eyes, that vacation home is NOT yours. It belongs to your solo 401k trust. And since you’re a disqualified person, using it would be considered a prohibited transaction.
If you pay rent to use the vacation home, that’s a transaction – not allowed. If you use it for free, that’s also a transaction – that’s taking advantage of the plan’s assets to give yourself a free vacation – also not allowed. If your parents wanted to get away for the weekend and use your vacation home, the same rule applies.
There are a lot of little nuances with prohibited transactions and it can get a little tricky. This guide will explain what a disqualified person is, types and examples of prohibited transactions, and the penalties for violating the rules.
Who is a disqualified person?
Here’s the full list of who the IRS deems as a disqualified person:
- Your spouse
- Your lineal ascendants (parents, grandparents)
- Your lineal descendants (children, grandchildren)
- Spouses of your lineal descendants (son-in-law, daughter-in-law)
- Fiduciaries (someone who makes investment decisions for your solo 401k plan)
- Anyone who provides services to your plan (such as your accountant)
- Highly compensated employees of your business
- Companies where you, your spouse, or your lineal ascendants/descendants own 50% or more of the business
- Companies where your lineal ascendants or descendants own 50% or more of the business
- Anyone who owns more than 10% of the business
- Officers and directors of the business
Your siblings, step-parents, step-children, friends, and relatives (like your aunt and uncle) are not considered as a disqualified person.
What is a prohibited transaction
A prohibited transaction is when your plan participant transacts with a disqualified person. Put bluntly, any transactions made within a solo 401k plan must not directly benefit you, your direct family, or your business.
Why this restriction exists
Imagine you wanted to take out $10,000 from your solo 401k. The government lets you take out early distributions (or a solo 401k loan) if you need to take money out before the eligible withdrawal age. You’ll have to pay a 10% fee and income taxes for taking the early withdrawal.
If a prohibited transaction rule didn’t exist, you could technically just give the money to your spouse, who would then give it to you. You’d be able to bypass the fees and taxes set into place by the IRS. Or, if you got more creative, you could hire yourself as a contractor to work for the plan (for example, as a bookkeeper) and pay yourself $10,000. It would be such a massive loophole, and nobody would ever pay taxes for plan withdrawals.
Types of prohibited transactions
IRC 4975(c)(1) lists the following as prohibited transactions:
- Sale or exchange, or leasing, of any property between a plan and a disqualified person;
- Lending of money or other extension of credit between a plan and a disqualified person;
- Furnishing of goods, services, or facilities between a plan and a disqualified person;
- Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Examples of prohibited transactions
Understanding prohibited transactions is complicating. The language used by the IRS and the specifics behind the rules are a bit of a grey area. Real estate dealings can be especially tricky.
Let’s try and break it down in plain English with some specific scenarios.
Sale or exchange, or leasing, of any property between a plan and a disqualified person
- A disqualified person is not allowed to purchase an asset that the solo 401k trust owns.
- Your plan is not allowed to purchase or lease property from a disqualified person.
- Your plan and a disqualified person cannot trade any assets with each other.
Lending of money or other extension of credit between a plan and a disqualified person
- A disqualified person is not allowed to lend money to your solo 401k, and vice versa.
- A disqualified person is not allowed to act as a guarantor of any debt or credit accounts for the plan.
Furnishing of goods, services, or facilities between a plan and a disqualified person
- A disqualified person is not allowed to provide services for any rental properties owned by your plan.
- A disqualified person is not allowed to use their personal belongings to furnish any rental properties owned by your plan.
- A disqualified person is not allowed to act as the realtor of the plan for any real estate deals.
- A disqualified person is not allowed to act as a general contractor for the plan, such as issuing insurance or registering business permits.
Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan
- A disqualified person is not allowed to use or rent a vacation home that’s owned by your plan.
- A disqualified person is not allowed to have any cash owned by the plan in their personal accounts.
Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account
- Your plan is not allowed to lend money to any plan fiduciary, such as an accountant or CPA.
Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan
- A disqualified person is not allowed to receive any form of compensation or commission from the plan.
- Your plan cannot invest in any companies that can help you personally land a job. For instance, if your first requests you buy in to the company to become a partner and receive a promotion, you cannot use the funds from your plan.
Penalties for prohibited transactions
The penalties for prohibited transactions are very steep.
According to IRC Section 408(e)(2), when a prohibited transaction violation is found, the disqualified person has to pay a 15% penalty tax on the amount involved in the transaction. If the prohibited transaction is not corrected within the taxable period, the penalty increases to 100% of the amount involved.
So if you used your solo 401k trust funds to purchase your parent’s house for $100,000, your initial penalty would be $15,000 (15%). If you don’t fix the mistake within the taxable period, you’ll have to pay the full $100,000 to the IRS.
How do I “fix” the prohibited transaction?
The IRS determines fixing the prohibited transaction as undoing the transaction as much as you can without putting the plan in a worse financial shape than if you had acted under the highest fiduciary standards.
When is the taxable period?
The taxable period starts on the date the transaction took place, and ends on the earliest of the following days:
- The day the IRS mails a notice of deficiency for the tax.
- The day the IRS assesses the tax.
- The day the correction of the transaction is completed.
How do I pay the 15% fee?
To pay the 15% fee, use Form 5330.
The IRS and the Department of Labor (DOL) work together to enforce prohibited transactions. The IRS finds them, and then hands suspicious cases to the DOL, who then have the final say in whether it’s a violation or not.