2 Areas To Avoid In Investing Retirement Funds

The availability of self-directed investments in retirement plans and individual retirement accounts (IRAs) may tempt plan participants and IRA owners to get creative in investing their retirement assets. Unfortunately, that can lead to some unexpected and adverse tax consequences.

These consequences aren't related to choosing from a menu of mutual funds or exchange-traded funds, or even hedge funds or limited partnerships. They stem from using retirement funds to purchase collectibles, second homes or other property for personal use, or to using them as seed money for a new business. These types of investments are generally prohibited, and the penalty for engaging in them can include accelerated taxation of the amounts used to purchase the investments and several types of penalty taxes.

Investment in collectibles

IRAs and participant-directed accounts in qualified defined contribution plans are prohibited from investing in collectibles of any sort, including coins (except for certain bullion coins), stamps, rugs or antiques, artwork, alcoholic beverages or gems. The result of these investments is that the cost of the item is treated as a distribution from the account, which is then subject to taxation, including the 10% early distribution penalty if the account holder is under age 59½. If the plan is a 401(k), this "deemed distribution" can be especially costly for someone under age 59½, because the plan would be prohibited from making an actual distribution, and the individual would have to come up with the amount necessary to pay the taxes from other assets.

Other prohibited transactions

Another type of investment can be even more problematic — the use of IRA or retirement plan assets to buy property used by the account holder or to purchase an interest in a business in which the account holder is involved. Both the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA) prohibit:

any direct or indirect sale or exchange of property between a plan and a disqualified person (ERISA uses the term "interested party"), or an act by a disqualified person who is a fiduciary, whereby the person deals with the income or assets of a plan in his or her own interest or for his or her own account. This situation was addressed in a Tax Court case, Ellis v. Commissioner, T.C. Memo. 2013-245. Terry L. Ellis established a corporation to operate a used-car business, and he directed his IRA to purchase 98% of the corporation for...