How to Avoid the Dangers of Prohibited Transactions in Your Retirement Account | 367

How to Avoid the Dangers of Prohibited Transactions in Your Retirement Account | 367

How to Avoid the Dangers of Prohibitive Transactions in Your Retirement Account

Today on Tax Hacker Tuesday, Tim Berry dives deep into the tax code to dissect the alarming trend of IRAs “blowing up.” Listen now to get everything you need to know about prohibited transactions and keeping your IRA safe, even if you’re a seasoned real estate investor who’s “heard it all before.” Learn it all with Epic Real Estate and Tim Berry on Tax Hacker Tuesday!

How to Avoid the Dangers of Prohibited Transactions in Your Retirement Account

What You Will Learn About How to Avoid the Dangers of Prohibited Transactions in Your Retirement Account:

  • What it means to have an IRA that “blows up”
  • Why the popularity of self-directed IRAs have spiked (including with early Facebook employees)
  • What everyone with a self-directed IRA needs to know
  • The true qualifications of the people who drafted your IRA
  • The exact sections of the tax code you need to hear if you have an IRA
  • How accidental prohibited transactions could cost you tens of thousands of dollars
  • The shocking definition of what a “prohibited transaction” can be
  • Cautionary tales for even the most seasoned real estate investors
  • The judicial insanity surrounding your retirement accounts right now
  • The concrete steps you can take to protect your IRA (besides sticking your head in the sand)

Recommended Resources:

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  • Need someone to do it all for you? If you’re an Accredited Investor, you can diversify your portfolio by hitching your wagon to our train and share in the profits. Go to to download the executive summary.


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How to Avoid the Dangers of Prohibited Transactions in Your Retirement Account


Speaker 1: This is Theriault Media.

Did you know that up to 50% of your lifetime income will be wiped out by taxes? What if you could stop this madness? Isn’t it about time you play on a level playing field with the wealthiest 1%?

Now, you can. Tim Berry, attorney-at-law, shares here each and every week current tactics and strategies that anyone can implement to hack the tax code. Protect your assets and keep what’s rightfully yours. It’s time for Tax Hacker Tuesday.

Tim Berry: What we’re going to be talking about tonight is something that I find absolutely amazing. What that is is basically how most people’s IRAs are probably blown up, and they’re not going to want to accept this fact, and a lot of people are going to tell them that’s not the fact, but a lot of people’s IRAs are going to be considered blown up. We’re going to talk about how to fix those things.

Now, a couple of disclaimers I wanted to say before we get going is, one, I’m a little bit biased here. Number one, I help people set up 401k plans. I don’t mess with IRAs anymore. Way back when, I used to do self-directed IRAs quite a bit, but once I realized the issues with self-directed IRAs, I don’t even mess around with IRAs anymore. I set up 401ks.

Other disclaimer is, the stuff we’re going to be talking about is somewhat involved, and there’s a lot of legal technicalities on there. I am involved right now in various court cases on this stuff, so I just always like to let people know, before we go into a presentation, what are my particular biases – where am I coming from. I just wanted to give people these kind of disclaimers, before we get involved in the fun stuff. So, with that, let’s just kind of ramp up, and let’s just get right into the fun stuff of IRAs.

Joanne: Hi, Tim?

Tim: Yes, ma’am.

Joanne: Before you start, I know there’s people that are wondering what does it mean when their IRA blows up?

Tim: Well, what it means when their IRA blows up is literally their IRA is now fully subject to taxes. In fact, I said their IRA. That’s a misstatement. Their account that they thought was an IRA … It’s kind of like Prince. I don’t know if you guys remember the singer Prince. He changed his name from “Prince” to “The Singer Formerly Known as Prince.” Well, these IRAs are going to be the same thing. They’re going to be the accounts formerly known as IRAs because they’re no longer IRAs. They’re just mere investment accounts. You’re going to owe taxes on the dollar amount inside that account, and you’re going to lose tax deferral on that retirement account, and you’re also going to owe taxes on the dollar amounts that have grown on that over the years that you never paid taxes on it.

Let me just give a simple illustration. Let’s say somebody has $100,000 IRA, and in 2004, they do something to cause that IRA to be considered blown up. Well, under the tax code, they owed taxes on that $100,000 inside that account as of 2004. Then, also, any earnings in that account from 2004 would be subject to taxes, and the other things is they wouldn’t have asset protection on that account, so if they find out in 2012 that they messed up on 2004, they owe a ton in back taxes, penalties, and interest. If any creditor comes after them, that account’s up for grabs. That’s what I mean by blown up, and that’s a great question. A lot of people don’t get that right up front, the enormity of it, but it’s an absolute disaster. That answer it, Joanne?

Joanne: Wow. Yeah. That answers it. So, this is important information for everybody that has a self-directed IRA.

Tim: It’s super important information. Now, the question mark is, how many people are going to act on it? But it’s super important to be aware of, so that if you’re facing a situation where you might have to file bankruptcy or creditors might come after you due to some deficiency judgements, you’ve got to be aware of this. Otherwise, you could potentially lose your nest egg, your life savings. It’s up for grabs.

All right. Now, let me go back to the basics though on these IRAs. Why do so many people have these self-directed IRAs? Here’s an article that’s going to be coming out in the April 9th edition of Forbes Magazine – very timely for us, actually. What they were talking about is a lot of these people who were early investors in Facebook, early workers at Facebook, the ones who made billions, hundreds of millions of dollars – evidently, a lot of these people bought that stock inside of their Roth IRA.

As most of the listeners know, the fun and excitement of a Roth IRA is you don’t get a tax deduction for putting the money in there, but now the investments grow on a tax-free basis, and whenever you take them out, they come out completely and totally tax free. The geniuses at Facebook – and I mean that sincerely – they were probably geniuses. They got into that stock at a very low value with the Roth IRA accounts, and now literally hundreds of millions of dollars have grown in those Roth IRAS, and they’re all tax free. They’re all sheltered from taxes. That’s kind of the big American dream of why a lot of people have these retirement plans – these self-directed IRAs, if you will.

Now, here’s kind of the challenge, though. I was thinking about this. How can I get the point across to people about the dangers of these self-directed retirement plans? I know in my personal life, I hate flying. I absolutely hate flying. Why do I hate flying? Because I’m a control freak, and I always go back to… There is a bad air crash. I guess pretty much aircraft is bad, but there was a bad one, gosh, about 10 years ago. It was an Alaska Airlines, where they were coming back from Cabo San Lucas going back to Seattle, and a screw fell out of the back of the airplane that caused it to crash into the Pacific. I’m always thinking, “You know, they don’t hire airplane mechanics from Harvard, from Yale. There’s probably a lot of mistakes going on in this aircraft maintenance.” So I’m not very comfortable flying.

What’s that have to do with the IRAs? Unfortunately, a lot of the people who have drafted these IRA documents, they just followed each other, and if one document had an error in the document, a lot of the other people are going to have the exact same errors – a lot of the other custodians. So, self-directed IRAs to me are kind of like going to the airport, waiting for your plane, and you get an announcement saying, “Hey, everybody. Just be aware. There’s a 30% chance of an accident today.” If you heard that loudspeaker and you had to get on a plane, how many people would get on that plane? I’m guessing not too many.

That’s kind of the way I see IRAs – self-directed IRAs and IRAs. Here’s another example. You’ve got a nice, pretty bridge here, beautiful bridge, but what if there was a chance this bridge could fail? What if you’re zipping down the highway, and you’re on this bridge, and all of a sudden you saw the span was missing? That, to me, was the situation of self-directed IRAs right now. A lot of people think that these retirement plans are all safe, they’re a great way to do investments, things of that nature, but my position, my point is the self-directed retirement plans could potentially be some of the bigger financial disasters that you’re getting into, and it’s all just due to the lax language that the various brokerage firms – and I say brokerage firms, but also the self-directed IRA custodians and administrators – have inside their language applications.

Enough of the little hoopla and, I don’t know, the tantalizing information. Let’s just get right down to it. Guys, I’m sorry for doing this to you at 9:00 at night on Eastern time. Some of you might go to sleep during the presentation, but what I’m going to do is I’m going to be very fact intensive and law intensive. I want to show you the exact sections of the tax code that say what’s going to cause this effect.

This slide right here – this is out of section 408 of the tax code. Section 408 is the section that deals with IRAs. It says… and I’m going to read this, really bore you guys to death here. It says, “If during any taxable year of the individual for whose benefits any IRA is established, the individual or his beneficiary engages in any transaction prohibited by section 4975, respect to such account, such account ceases to be an IRA as of the first day of such taxable year.” Once again, straight black and white, out of the tax code. If you engage in a prohibited transaction with your IRA, that IRA ceases to be an IRA as of the first day of such taxable year. We’ve got a disaster.

Trying to put it in plain English, give a plain English transaction, kind of going back to the example we talked about in the very beginning, Joanne, if you had a $100,000 IRA in 2005, and it accidentally engages in a prohibited transaction, we’ve got a disaster. We have a full distribution. If you engaged in the prohibited transaction with that IRA in 2005, going straight by the tax code, we’ve got a fully taxable event on your IRA in 2005. If we had a fully taxable event on your IRA in 2005, I don’t know, my guess is between state and federal income taxes that could take away about 35% of the value of your IRA right then and there. You would have lost $35,000.

Oh, yeah. If you’re under 59 and a half, you probably had a 10% early withdraw penalty, so that’s another $10,000, so now you’ve lost $45,000 of that IRA. Oh, yeah. You weren’t aware that you did the faux pa in 2005. Instead, you finally found out about the mistake in 2011, so that was a seven year difference. Now interest and penalties have racked up all during that time. Good chance you’re looking at owing about $75,000, if not more of that initial $100,000 on your IRA just by one tiny mistake. That’s the simple results of accidentally engaging in a prohibited transaction with your IRA. This is why I have started to run from doing any work with IRAs because the challenge with an IRA is one tiny mistake and it’s blown up. Just that simple. That’s the results of engaging in a prohibited transaction with your IRA.

Let’s now kind of shift gears and talk about, well, what the heck is this awful, horrendous thing called a prohibited transaction? Well, a couple different things. Number one here – and this is straight out of the tax code also – section 4875 of the tax code. First thing is subsection A here, “A sale, or exchange, or a leasing of any property between a plan and a disqualified person.” So, a sale or exchange between you, because you’d be a disqualified person to your retirement plan, if you sell or exchange any asset or lease any asset to your retirement plan, that’s a prohibited transaction that causes a full distribution.

Along the same lines, lending of money – and here’s the really catchy one – or other extension of credit between a plan and a disqualified person. Pretty much everybody who does self-directed IRAs and they do real estate investments for their self-directed IRAs, I think it’s safe to say that pretty much most of the people know you cannot give a personal guarantee on the real estate. If you buy that real estate using leverage inside your IRA or your retirement plan, pretty much everybody knows you can’t give a personal guarantee.

Why can’t you give a personal guarantee? Because if you gave a personal guarantee on that retirement plan, it’s going to fall under this area of a lending of money or other extension of credit between a plan and a disqualified person. Lending of money or other extension between a plan and a disqualified person causes a prohibited transaction. If you give a personal guarantee for the benefit of your retirement plan, that’s an extension of credit, and that causes a prohibited transaction. Your IRA is fully blown up. Another part of the tax code, it says, “A sale or exchange of encumbered property. If you transfer real or personal property.” So basically if you transfer anything that has a loan on it, that’s going to be treated as a sale or exchange, and that’s going to be treated as a prohibited transaction.

Okay. Let’s start going into some reality. That’s the law. Let’s start talking about some cases that I see almost all the time. Here’s the situation where we have a warranty deed. This is where somebody is buying a property, and the person’s name is Daniel, and they’re buying lot 125 of [Seville 00:13:24] Parcel Two. I’m blanking out their names, because I don’t want to get anybody in trouble. By the way, whenever you buy a piece of real estate, is that public record? Yeah. Anybody on the internet, they can just go onto the internet. They can go to your County Recorder’s Office, and they can just do a search, and all this stuff is out there, and it’s going to be out there for probably the next 10,000 years, where people can look back 5, 10, 20 years, and see what happened then, and catch you.

So, here we have a situation. We’ve got Daniel. He buys this property from Capital Pacific Holdings, lot 125 of Seville Parcel Two. He purchases the property. Okay. No big deal there. Now, the property’s in his name, his and his wife’s name. Now, what’s this. This is a form for a deed of trust, this security instrument. This is the deed of trust, where the lender is saying, “We want you to give us a personal guarantee.” Now, Daniel is a reasonable guy. He goes ahead, and he initials, and these deeds of trust go for 20 pages. I didn’t want to have the whole thing, but he went and agreed to give the lender a personal guarantee on this property that was in his name, which the property, lot 125 of Seville Parcel Two, the exact same property.

Okay. Now, it starts getting exciting. One day Daniel wakes up and he says, “You know what? I want to transfer that property that’s in my name and that I have a loan on it, I want to transfer it to an LLC.” Daniel transfers lot 125 of Seville Parcel Two over to an LLC. Let’s just call it the Holdings LLC. I’m keeping that name private too. He did this back in 2003. Now, by the way, I just pulled this up yesterday or the day before yesterday. So, this was a transaction that happened nine years ago, and it was simple as it could be for me to pull this up. If I know what I’m looking for, I can pull up hundreds of these things within probably one or two days. I just wanted to show that I can pull up something that happened nine years ago fairly easily, and back trace it, and see everything that happened.

Why am I emphasizing that? Because a lot of you have probably done transactions similar to this, and it happened four years ago, three years ago, five years ago, and you think, “Well, that’s in the past. I don’t need to worry about it. It’s all over with.” Uh-uh (negative). If it has to do with real estate, if it has to do with making a promissory note on real estate, chances are, it’s in the County Recorder’s Office, and it’s there for the world to see for the next 10,000 years.

Getting back to our situation, Daniel transfers this property that was in his name and that he personally guaranteed a loan on it to an entity, an LLC, with the last name of Holdings. I’m a curious guy, so I go to the secretary of state, and I say, “Okay. Who is the owner of this Holdings LLC?” I think most of you are already going to jump to the punchline and guess and know. Here’s the Arizona Public Access System, finding things out. Who’s the owner? IRA Express. I’m not sure what this [Inky 00:16:35] is, for the benefit of this Daniel individual. So, wrapping this up, what has just happened? What has just happened is Daniel went out and bought a piece of property. He got a loan on that property. He gave his personal guarantee on that loan for that property. Then he transferred that property into an LLC that was owned by his IRA.

Let’s do a pop quiz here. What is a prohibited transaction? Sale, or exchange, or leasing of any property between a plan and a disqualified person. Did Daniel enter into a sale or exchange of that property with his retirement plan? Yup. Sure did. How about lending of money or other extension of credit between a plan and a disqualified person? Did he give his personal guarantee? Yup. Sure did. How about he transferred property that was encumbered with a loan, did he do that also? Yup. Sure did. Does Daniel still have a valid IRA? No. He doesn’t. Daniel no longer has an IRA. It’s blown up.

By the way, when did it blow up? It blew up in 2003, the date that he signed the deed to transfer the property into the LLC owned by his IRA. If the IRS were to go back into the County Recorder’s Office and check this thing out, they would probably have one heck of a big tax hit against poor Daniel. What were the results? His IRA is considered fully distributed. He owes taxes on the distribution from the date he signed the quick claim, 2003. He owes interest and penalties.

Oh. Oh. Here’s another big one, and hardly anyone ever talks about this. Most IRAs are exempt from the claims of creditors. If you have a bank coming after you because you’ve got, I don’t know, a deficiency judgment on a loan, the banks typically cannot touch your IRA, your individual retirement accounts, your retirement accounts. They can’t touch those in most states. If you file bankruptcy, the bankruptcy code specifically states your IRA is exempt from the claims of creditors. Now, what happened here though? Does Daniel still have an IRA? No. He doesn’t have an IRA anymore. Since he doesn’t have an IRA anymore, he no longer has the asset protection, is no longer exempt from the claims of creditors, and is no longer an exempt asset in bankruptcy. Daniel is absolutely out of luck on this one.

He’s kind of got the worst of both worlds. He’s got one heck of a massive tax hit, and he’s also lost his asset protection on that account. That’s the type of challenges we’re going to be talking about. Now, I know a lot of you guys, you’re probably grisled, old veterans of real estate, and you’re saying, “Tim, thanks for nothing. This information – it’s been out there for years. Everybody knows this. You can’t give personal guarantees on these IRAs. That might have been the fault of one guy did something wrong, or you made some mistake, but us grisled, old veterans – we know better than to do that.” Well, let’s talk about some situations that even grisled, old veterans might fun afoul of.

The IRS came out with a statement recently, and it was a really interesting statement. It came out on December 12th of 2011. Here’s what they came out and said. They said that they were aware that the Department of Labor had issued some rulings, and the IRS said that they were pretty much going to stick their head in the sand about these rulings. Now, what were these rulings? Basically, these rulings said that… By the way, some of you might be wondering, why do we care what the Department of Labor says? The answer is the Department of Labor is the government entity in charge of determining is somebody’s engaged in a prohibited transaction or not. It’s not the IRS.

Getting back to this, the Department of Labor has issued two very important rulings. Once again, I’m biased. I was involved in these rulings whenever they came out. The two rulings were this. One said that if anybody pledges their personal assets as collateral for the benefit of the IRA, basically gives a personal guarantee, that causes a prohibited transaction. Once again, that probably isn’t a news flash to anybody here. If you give a personal guarantee, that’s considered a prohibited transaction.

The other one was a question mark as to whether if somebody agrees to indemnify somebody, is that a prohibited transaction as well? The most recent one came out in October 20th of 2011, where they said that if somebody does agree to indemnify somebody for opening up their IRA… Basically, the fact pattern was a lot of brokerage firms – you know, the fancy-dancy stock brokerage firms – they have language in there saying that somebody has to agree to indemnify them before the stock brokerage firm will open up the account. Once again, it says, “If an individual IRA’s owner agreement agrees to indemnify a broker, that will be considered an impermissible extension of credit.”

So, I’m going to give you guys some homework assignments. If any of you see the word “indemnify” in your account paperwork for an IRA, if you have a self-directed IRA, look at your by direction letters. See if there’s an indemnification requirement. If your self-directed custodian requires you to agree to indemnify them in order to execute the by direction letter, you’ve probably got an issue going on. If you guys have traditional IRAs, and if you look inside your traditional IRA paperwork, and it says that… it has the word “indemnify” or “security for indebtedness,” you probably got an issue going on.

Now, what’s the IRS’s position with this? Well, we got our good friends at the IRS. They’re sticking their heads in the sand. In that exact same announcement they said the IRS for right now is going to ignore that. The IRS is not going to treat these accounts as distributed upon an audit, so the IRS doesn’t want to have anything to do with this. They’re saying they’re waiting from further information from the Department of Labor. They’re waiting for further guidance from the Department of Labor.

Now, here’s the interesting thing though. Whenever somebody is attacked by creditors and the creditors now say, “What assets do you have?” and they list that they have an IRA, and the creditors now say, “Yeah. We’ve heard about those IRAs. They’re all blown up. Here. We can prove your IRA’s blown up. Here’s your account paperwork where you agreed to indemnify it. Mr. And Mrs. Judge at the federal court, Mr. And Mrs. Judge at the state court, they violated this rule. Can we have these assets?”

Now, if the judge looks at it and determines that that rule or that law has been violated, those assets are probably going. The IRS has nothing to do with it. The IRS’s role is strictly to enforce the tax code. Now, in this interesting situation, they’re coming out and saying they’re not going to enforce it until the Department of Labor comes along, so they’ve basically passed the buck, but there’s a lot of people out there looking at this IRS announcement and saying, “Okay. We’re all saved.” Au contraire. IRS is just saying they’re waiting until further guidance from the Department of Labor. The really ironic thing is in a similar situation, it took the Department of Labor, gosh, 10 years to come out with guidance on one issue. It’s going to be interesting to see how fast the Department of Labor comes out with something and what the IRS does. Once again, the IRS is bound by the Department of Labor’s determinations.

Now, other thing about this. This was released on 12/12/11. What do you think the various brokerage firms and, I don’t know, anybody with IRAs, the IRA custodians are doing? Do you think they’ve cleaned up their language? Well, take a look at this. This is a IRA account app from a big brokerage house. Security for indebtedness, all securities, options, credits. Blah, blah, blah, blah, blah, blah. A bunch of legalese and boiler plate, but basically they’re saying if you want to open up an IRA with us, you have to give us a personal guarantee of all our other securities you have with us. The amazing part is… I don’t know how good your screens are here. In fact, let’s try to move this here. This document was generated 1/12, so it was generated after this announcement was issued by the IRS.

So, what you have here is a case where a lot of custodians are thinking, “You know what? We don’t care. We’re banking on the IRS not doing anything because the IRS says they’re not going to do anything until the Department of Labor comes out, and surely the IRS isn’t going to allow this to happen.” Well, let’s talk about the possibilities of what could happen. Here’s a court case from the Eastern District of Tennessee. It’s a bankruptcy court case. Here’s what kind of the bottom line was on this bankruptcy court case, and let me give you some background.

Background was somebody filed bankruptcy in Tennessee, and they knew that their IRA was an exempt asset. It was protected in bankruptcy. No one could take it away from them in bankruptcy. So, they go into a bankruptcy knowing that their nest egg, their retirement plan, is safe and protected. Now, they go to court. Now, the bankruptcy trustee says, “Oh. You got an IRA? Let me see the account paperwork on that IRA. Oh, yeah. Look right here. You agreed to indemnify them. You agreed to give them security. You agreed to give them a lien on your assets. You agreed to give them a personal guarantee.”

Fill in the blank. The bottom line is the judge looked at the paperwork, and the judge said, “You know what?” Guys, I can’t pronounce certain words here, so if I blow this word, please excuse me. I promise I graduated kindergarten. It says, “As incongruous as it appears, based upon the language of the client relationship agreement signed by the debtor, the mere opening of the Merrill Lynch IRA caused the debtor to participate in a prohibited transaction under 4975.” Once again, the judge says, “As crazy as it appears, based upon the language of the client relationship agreement signed by the debtor, the mere opening of the Merrill Lynch IRA caused the debtor to participate in a prohibited transaction under 4975.”

Now, you guys are all experts. What happens if an IRA engages in a prohibited transaction? It’s blown up. This poor debtor lost his retirement plan. Oh. By the way, one of the things I hear from almost everybody I talked to is they say, “You know what, Tim? It’s interesting that you’re bringing up these arguments. Really fascinating stuff, but you’re just one guy out in Phoenix, and what do you really know? Merrill Lynch has a lot of high-powered attorneys – gosh, a bunch of New York guys in high office towers. These guys know the law. We think you’re a bright guy, but you don’t know the law as well as they do.”

What happened here? The mere opening of the Merrill Lynch IRA caused the debtor to participate in a prohibited transaction under 4975. Now, stop and think about this. This guy lost his IRA. This guy lost his retirement funds. Now, also, since it was determined that the IRA was considered distributed, what else has happened to the guy? He now owes back taxes, penalties, and interest, but he doesn’t even have that IRA to pay the taxes anymore. This guy filed bankruptcy, presumably because he wasn’t doing too well. He lost his nest egg, and now he doesn’t even have a dime of that retirement plan to make payments to the IRS. This is the challenge that a lot of you are facing.

A very high percentage of you have probably signed paperwork that said, “You agree to indemnify the custodian if your investment goes south. You agree to indemnify the custodian if something goes wrong. You give a personal guarantee of your assets in order to open up the account.” If you look over your account paperwork, I can almost guarantee that a lot of you have done that. If you have done that… Oh. By the way, a lot of you are going to come back and say, “But hold it here. The IRS has already said they’re just going to ignore this issue.” You’re right. The IRS is going to ignore this issue right now, but that doesn’t mean the rest of the judicial system is. This is a law, and the rest of the judicial system’s going to keep on rolling. They don’t care what the IRS is going to say.

Actually, to make things even a little bit more confusing, the IRS said they’re going to ignore the issue, provided there has been no execution or other enforcement, pursuant to the agreement, against the assets of the IRA. That’s fancy language for saying they’re going to ignore the issue, so long as that person’s IRA wasn’t taken away due to the bad language. Well, what happened to the guy over in Tennessee? His IRA was taken away.

According to the IRS’s own announcement, they’re going to ignore the issue until someone loses their IRA. They’re going to crack down on the person. By the way, is that probably one of the stupid policies you’ve ever heard on the face of the Earth? They’re going to ignore the issue until someone loses their IRA, and then they’re going to kick the guy who’s lying down? It’s absolute insanity.

This is the challenge that’s facing your retirement accounts right now. This is the challenge that’s facing your retirement plan accounts right now. Most IRA applications fail the Department of Labor requirements. They run afoul of this language that the Department of Labor says causes a prohibited transaction.

Let me give you an example. Back in May or June of last year, I had a client who wanted to roll over a million dollar IRA. I was going to get paid rather handsomely if I could help them roll over that million dollar IRA. I could not find a custodian, a brokerage firm, or whoever that I could in good faith roll that money to without there being some violation of those Department of Labor rules.

Very, very, very few custodians have language that does not run afoul of these Department of Labor requirements. Once again, just the mere act of signing that account paperwork, if it runs afoul of the Department of Labor requirements, it causes the IRA to be fully taxable and fully distributed. Joanne at the very beginning says, “What’s it mean to be fully distributed?” Well, once again, you’ve got a fully taxable event, and you owe back taxes, penalties, and interest on the money that you never paid taxes because you didn’t know anything is wrong. After all, what did you do wrong? Absolutely nothing. You were just believing that your brokerage firm, that your custodian, knew what they’re doing. Come to find out, they really didn’t have a clue.

Once again, the IRS, on something as big as this issue is just sticking their head in the sand. You would think they’d be more proactive and say, “Hey. Guys, we understand we’ve got a big issue. No one has anything to worry about. We’re going to take care of it,” but they’re not. They’re sticking their head in the sand. Once again, one bankruptcy court has already decided that the Merrill Lynch IRA is no longer an IRA and thus not exempt. If I lived in Tennessee and if I had a Merrill Lynch account or if I ever had a Merrill Lynch account, I’d be awfully afraid right now.

That kind of brings up a point. I said if I had or ever had a Merrill Lynch account. Stop and think about this. Once your IRA is blown up, it’s blown up. It can’t be an IRA again without taking further steps. So, that means if I blew up my IRA in 2003, and then in 2007 I moved it to a custodian that doesn’t have this problem, I didn’t fix the problem just by moving it to a custodian that doesn’t have the problem. It blew up in 2003, and it stayed blown up in 2007 whenever I transferred it to the other custodian.

The real bad thing is I’ve probably doubled down on my penalties and the error I committed whenever I transferred it to the new custodian in 2007 because the tax code says if you make a contribution to an IRA and that contribution exceeds the contribution limits of a whopping 5,000 bucks or so, you’re going to be hit with a penalty tax of 6% a year. If I blew up a $100,000 IRA in 2003, and then I moved it over to another IRA in 2007, I made an excess contribution of $95,000 in 2007. Now I owe 6% penalty tax on that each and every year that stays that way. Let’s just keep it simple. 6% times 90,000. That’s $5,400 a year in extra penalties that I’m racking up.

Okay. Now that I might have your attention, let’s just get down to the basics. How do you fix this? How do you fix this disaster? Well, there’s really three ways to go about fixing this thing. Number one, you can stick your head in the sand. Quite honestly, this is probably the option most people are going to be taking. You can stick your head in the sand and hope you don’t have an event that involves creditors, hope you don’t have an event that involves bankruptcy. If you do have an event that involved creditors and bankruptcy, you just got to hope that the imposing council isn’t bright; isn’t aware of the situation. Plan A, stick your head in the sand. Just ignore it. Just hope it goes away.

Plan B. We’re going to be talking about this in a lot more detail. You set up a 401k plan. You move the assets from an IRA to a 401k plan. A couple points here. One, this isn’t going to apply to all of you. This only applies to people that have a valid business, so you would have to have a valid business. It can be a sole proprietorship. It can be an LLC. It can be whatever, but you move the assets to the 401k plan. Now, some of you might be saying, “Well, gosh. How is that going to fix the problem? If it’s blown up, I thought you said if I move it over to an IRA, I’m making an excess contribution?”

Well, with the IRS’s current stance, they’re saying they’re treating these IRAs as if there hasn’t been a taxable event. Right now, what they’re doing is they’re giving you a window of opportunity to move these damaged IRAs over to something else. The best thing out there is a 401k. Now, what about the 401ks and if they have the bad language, if they have the bad paperwork? Well, 401ks are completely different from IRAs in many different reasons. One of those is if an IRA engages in a prohibited transaction, the IRA is considered completely and fully distributed. If the 401k engages in a prohibited transaction, basically, you owe a penalty tax of 15% on the amount involved, and the IRS has come out and said the amount involved would be the interest on the extension of credit. Since there’s no interest on this particular extension of credit, presumably, there’s no penalty.

This is the amazing thing. If you had signed the exact same paperwork on behalf of your 401k plan, if you had agreed to indemnify a custodian on behalf of your 401k plan, there never would have been a problem just because of the differences in the laws between 401ks and IRAs. With a 401k,K no problem. With an IRA, massive problem. This is why, as I said at the beginning of… I almost said the episode… at the beginning of the webinar today. Yeah. You would think it’s an episode. It’s a long going thing. That’s why I said I don’t even mess with IRAs anymore. It’s way too dangerous. It’s way too much liability. Strictly go to 401ks. Strictly 401ks.

Third alternative. What you could do is send a love letter to the IRS and say, “Hey, IRS. I didn’t know any better. Please take mercy upon my soul. I had no clue that this could happen. Will you please forgive me?” Now, the challenge is just by doing that, the IRS themselves, they’re going to charge you a user fee. They’re going to charge you at least… Well, it’s not at least. They’re going to charge you $3,000 if your IRA exceeds $100,000. The user fees go between $500 and $3,000. It’s $500 if the account… I think if it’s less than 50,000. If it’s between $50,000 and $10,000, I think the user fee’s $1,000. If it’s over $100,000, they’re going to charge you $3,000.

What course of action should you take? Well, I arranged the courses of action kind of in degrees of certainty. The worst thing you can do – but, unfortunately, probably the most common thing which everyone’s going to do – is stick your head in the sand. Not do a single thing. Second best thing is start moving the assets over to a 401k. Once again, there’s only a window of opportunity right now based upon the IRS’s… They’re sticking their head in the sand… of time to move assets to the 401k. There’s still going to be some question marks there, quite honestly. Safest thing you could do is send off to the IRS and say, “IRS, I didn’t mean to do this. Will you please forgive me?” Safest is Plan C. Next safest, Plan B. Worse thing you can possibly do, Plan A. All right. Let’s go into the 401ks.

Joanne: Hey, Tim?

Tim: Yes, ma’am.

Joanne: Before you go into the 401ks, which I’m really anxious to hear about because I’ve been hearing about solo 401ks for a while… the three solutions that you just went over, that last one where you write a note to the IRS – I mean, is that all you have to do? Just say, “Please forgive me,” or do you still have to move that money over into another account?

Tim: Oh. Fantastic point. Yeah. Thanks for bringing that up. I tend to skip over things at times. There’s a certain procedure of that, “Pplease forgive me.” I’m giving it a 50,000 foot overview. There’s a formal process you have to go through, and as part of that formal process, you have to show that you had no clue that signing that language was bad, which I think everybody could agree on. Then you have to show that you never did anything bad with your IRA in the meantime, which I think most people could show also. Then you have to show that you did in fact move the assets over to a valid retirement account. A 401k could be that valid retirement account as well.

Joanne: Okay. You know, you went over that really quick. I know people are going to have questions about that, but I just want everybody to know that we are going to actually, at the conference, April 14th… Tim was going to be there in person, but he can’t show up in person. He is going to show up by webinar or through Skype. We can go over… Is that one of the things we can go over, Tim, the specific step-by-step procedures that people have to do to protect the money in their retirement account?

Tim: Absolutely. In fact, Joanne, I’m going to do one better than that. Yes. I’m going to show up via wonderful technology, Skype. Hopefully we can do questions and answers and go through people’s situations, but also here’s my commitment. Guys, as my way of apologizing to Joanne for not showing up there, what I’m going to do is I’m going to create an interactive CD. It’s going to have a number of different presentations on it in regards to self-directed retirement plans. Also, I didn’t even think of it before, but I will add on what are the actual steps. Whenever you write your love letter to the IRS, what are the actual steps of writing that love letter to the IRS? What are the requirements of that? I’ll even go through step-by-step on that, and we’ll have that on the interactive CD as well.

Joanne: Oh, great. Okay. All right. Let’s go on to the 401ks.

Tim: Got it. No other questions? Feel free to ask questions if you want to.

Joanne: We do have a lot of questions, but I don’t know if we’ll be able to answer them tonight. You’ve already answered a couple of them through the presentation, so let’s go ahead and let you finish the presentation. The questions you can always handle at the seminar.

Tim: More than happy to handle them at the seminar. Okay. Let’s go onto 401ks then. Joanne, if we have any questions, dear, stop me if you have any that you want to ask.

Joanne: Okay. Great.

Tim: Okay. What are these personal 401ks? I think they’re the best thing since sliced bread out there. I wish I’d have realized how easy they were to work with years ago, but, alas, it took me a while. Personal 401k. First requirement on these personal 401ks: You have to have a valid business. You have to have a valid business in order to set up and create one of these 401k plans.

If you have a sole proprietorship, that’s a valid business. If you have an LLC that’s transacting business, that’s a business. If you have a partnership, a corporation, a C corporation, and S corporation, that’s a business. If you work for IBM during the day, a company during the day, but then you have your own home-based business that you work for at night, that’s a business. You can be a participant in the big company’s 401k and you can set up your own 401k plan as well. First requirement is that you have a valid business in order to set up the 401k. Now, what are some other neat things about these 401ks?

Joanne: Hey, Tim.

Tim: Yes, ma’am.

Joanne: I’m sorry to interrupt you. I do have a question about that. If you have a SEP IRA, does that mean that you have the qualifications to have a 401k?

Tim: That was an excellent point actually. Yeah. If you qualify to set up a SEP, you qualify to set up a 401k.

Joanne: Great.

Tim: I have never thought of it in those terms, but that’s just a very easy way of figuring out if you qualify or not.

Joanne: Well, that’s good news because both my husband and I, we both have SEP IRAs.

Tim: Well, that’s another fantastic part about the 401k. You said both your husband and you have SEP IRAs, and this is a big question I get hit by with a lot of people. They say, “Hey, Tim. Husband and wife. We both have IRAs. Can we combine those IRA assets to do some joint assets?” That is a very, very gray area. I typically tell people, “Don’t do it,” because the first letter of IRA stands for “individual.” So, it’s just a gray area about combining assets with IRAs – family assets with IRAs. The better way is a 401k. These things were designed to combine people’s assets and make the assets together, so now you guys could roll your SEPs into the exact same 401k plan, wipe out two sets of annual fees, wipe out two fees for setting up separate self-directed IRAs, and you just do it all through your 401k.

Joanne: Great.

Tim: Once again, with these 401ks, you get some pretty darn big tax deductions. You know, if you work your cards right, you could actually move 50,000 bucks a year into a Roth account of the 401k as well. I’m constantly hearing people talking about, “Boy, I wish I could put more money into my Roth. I wish I could put more money into my Roth.” Well, with this personal 401k, it’s the way you could do it. You could put up to $50,000 for each participant into the Roth accounts. Then once it’s inside there, it grows tax free, so you got your tax-free growth inside of that 401k plan.

Here’s the other big one. The 401ks, even if they signed this bad account language, which few 401ks have this bad language, they’ve got asset protection. They’re protected. I think every single state in the land says assets inside of a qualified retirement plan, a 401k plan, are exempt from the claims of creditors. I know bankruptcy 401k assets are exempt from the claims of creditors. They’re a fantastic solution. You get these massive tax deductions, if you want them. You can get tax-free growth, and you can get asset protection on the account as well.

This slide just says that so many people have been led to the belief that only large companies can set up the 401. Au contraire. Even if you got a business where you’re sitting on the beach drinking whatever that beer people drink on the beach is… Oh. Coronas… Corona, you’re allowed to set up a 401k, even if you’re a sole proprietor. No challenge whatsoever.

Other big benefit of 401ks. I can’t overemphasize this. Real estate agents – I have seen so many real estate agents that in the boom years, whenever they were knocking it out of the ballpark, they put a lot of money inside their retirement plans. Now, whenever things aren’t booming so good, they would love to be able to have access to some of that money, but they don’t want to pay the taxes and the penalties for taking that money out. You could roll over your SEP account. You could roll over your IRA account, as long as it’s not a Roth IRA. You can roll over your IRAs into the 401k plan. Now you’ve rolled those accounts over into the 401k plan.

One of the big benefits of the 401k plan is you’re allowed to borrow out the lesser of 50% of your account balance or $50,000. If you only had $50,000 inside the account, you could borrow up to $25,000 from the account. If you had over $100,000, you could borrow out $50,000. You’re actually allowed to make loans from the 401k to yourself, and so long as you pay those loans back in the right time frame, you get that money out tax free. That’s another big benefit of the 401ks. You’ve got that nice safety net available.

Next, the prohibited transactions. I already talked about this. If an IRA commits a prohibited transaction, it’s the death sentence. It’s fully distributed. If a 401k commits a prohibited transaction, it’s not a death sentence. It gets massive clemency. It keeps on rolling. Many times, it’s not going to be faced with any fines or penalties. Other one, I know a lot of people have a lot of money. Well, gosh. I mean, most of the people listening probably have self-directed IRAs. You can transfer the assets from your self-directed IRA into the 401k.

You have a piece of real estate inside your IRA – not a problem. We can transfer that real estate from your IRA to the 401k. You got a tax lien certificate? Not a problem. We can assign it from your IRA to the 401k. You got a hard money loan? Not a problem. We can transfer it. Heaven forbid you just have plain old cash? That’s makes it even simpler. We just wire the money directly into the 401k account. By the way, the 401k – you have the checkbook control with the 401k, just like what you do with your IRA. You have that checkbook control also.

Kind of summing up the 401ks versus the IRAs… oh. This is a big one I didn’t even mention. I don’t know how I couldn’t have mentioned this. With an IRA, there’s something called debt financed income. That means that if you engage in a leveraged transaction with your IRA on real estate and you make a profit on that leveraged transaction, your IRA, even your Roth IRA, has to pay taxes on the profits generated.

With the 401k, so long as you structure the deal right, if you go out and do massive leveraging… Let’s say it’s 100%. Let’s say it’s, well, whatever. It’s 100% financing on the piece of real estate, but you sell it, and you make – I don’t know, $200,000 profit. Not a dime of that is going to be subject to taxes. So, you’re allowed to invest in real estate using leverage, and whenever you ultimately sell off that investment, you don’t have to pay taxes on the profits. Whereas with the IRA, you would. That’s a massive benefit with the 401k.

A loan, IRA, no. You’re not allowed to do loans. 401k, yes. We’ll approve you. Prohibited transaction, is it the death sentence? Yes, with the IRA. 401ks, no. Easy reporting? Yes with the IRA, because basically, your custodian does everything. Here’s a mind blower. The 401k, so long as you don’t commit any bad stuff with the 401k, but for the most part, if the assets of the 401k are less than $250,000, there’s no reporting involved whatsoever. Can you roll over assets into an IRA? Yes. Can you roll over IRA assets into a 401k? This is yes, but what I meant was can you roll over a Roth IRA into a 401k? You can’t roll a Roth IRA in, but you can roll traditional IRA money into a 401k. That kind of sums up the IRAs versus 401ks.

Speaker 1: That’s it for today, as we dream of a tax system that works just for you. But until then, you have Tim Berry. See you next Tuesday for another episode of Tax Hacker Tuesday.

Matt Theriault

Real estate investor and educator.