“What happens if I break a prohibited transaction rule, and what do I do if I find out I already did?”
The prohibited transaction penalty depends heavily on which account made the mistake. In an IRA, one prohibited transaction, of any size, can cost you the whole account. In our September live Q&A, Laura Dohanes, CPA, and guest John Bowens of Equity Trust Company compared the damage in an IRA and a Solo 401(k), then took an emailed question: what if you find out you already broke a rule?
Quick answer: In an IRA, one prohibited transaction can disqualify the entire account: it’s treated as distributed on January 1 of that year (taxable, plus a 10% penalty if you’re under 59½, and possibly a 20% accuracy penalty). In a Solo 401(k), the prohibited transaction penalty is generally a 15% excise tax on the amount involved, which stacks each year until you correct it. Found a mistake? “Mess up, fess up”: act fast, usually by distributing the asset. In a Solo 401(k), correcting it stops the excise tax; in an IRA, it limits the damage but doesn’t undo the disqualification.
When something goes wrong in an IRA, the IRS has the power to dismantle the whole structure. If you do one prohibited transaction, regardless of the amount, the entire IRA can be treated as distributed to you. John put the timing precisely: the account is treated as distributed on January 1 of the year the prohibited transaction happened. That means ordinary income tax on the taxable portion, a 10% early-withdrawal penalty if you were under 59½, and potentially a 20% accuracy-related penalty. The more you have in the account, the more you have to protect.
“Self-directed” means you take on the responsibility. You give the instructions and you choose the investments, so if something goes wrong, it’s typically on you, not the custodian. In 20 years John has seen relatively few prohibited transactions, but he has seen them, and custodians sometimes have to force a distribution when a transaction is blatant.
A Solo 401(k) is treated very differently. Instead of losing the whole account, the disqualified person generally owes a 15% excise tax on the amount involved (reported on Form 5330). John’s example: lending $100,000 to your mother is a prohibited transaction. In an IRA, the whole account goes — “the fruit of the poisonous seed.” In a Solo 401(k), it’s a 15% excise tax on the amount involved, which for a loan is the fair-market interest on the $100,000, not the principal. It applies again for each year until you correct the transaction, so it stacks, and it can jump to 100% if it’s never fixed. Painful, but not the whole plan.
Some investors, usually working with tax and legal counsel, want to do a deal that’s genuinely gray, for example investing in privately held stock of a company where they’re an executive. IRAs are treated as separate accounts, so those investors put the gray-area deal in its own IRA. If it turns out to be a prohibited transaction, it doesn’t taint their other IRAs, especially a Roth full of plain private-lending notes.
There’s no exact playbook. There are only a handful of tax-court cases. John cites Swanson, which the taxpayer won, and Rollins; in his read, the cases taxpayers lose involve blatant violations, not the subtle gray areas. Peek is a reminder that even personally guaranteeing a loan can sink an IRA. The rule of thumb: if you mess up, you fess up. The logical step is to distribute the asset involved from the IRA as quickly as possible and report any income it produced, since that income was really yours.
Laura adds what she sees in audits: when a transaction is clearly prohibited, you’re at fault, so the work happens in IRS Appeals, negotiating to mitigate the damage. That’s why so few of these cases reach tax court. A genuinely gray position is different, but only if you documented a strong case before you did the deal.
Official IRS reference: IRS — About Form 5330, Return of Excise Taxes Related to Employee Benefit Plans
The IRA generally stops being an IRA as of January 1 of that year and is treated as distributed, taxable to the extent of pre-tax money or non-qualified Roth earnings, plus a 10% penalty if you’re under 59½.
Generally yes. Instead of losing the whole plan, the disqualified person owes a 15% excise tax on the amount involved, which stacks each year and can reach 100% if it isn’t corrected.
There’s no set playbook. The usual step is to distribute the asset quickly and report the income. In a 401(k), that corrects it; in an IRA, it limits further damage. Work with a CPA or tax attorney.
IRAs are treated as separate accounts, which is why some investors keep riskier deals in their own IRA.
These answers come from our monthly open Q&A. Only newsletter members get the invite (real tax strategy for business owners, twice a week, no fluff).
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Guest: John Bowens, Director & Head of Education and Investor Success at Equity Trust Company, appeared as a guest. Custodians, including Equity Trust Company, do not provide tax, legal or investment advice.
Disclaimer: This article is for educational purposes only and is not tax, legal, or financial advice. Every situation is different. Talk to a qualified professional about your specific facts before making any decisions.
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