Income and Assets · Retirement income

Prohibited transactions and their tax effects

Verification 2026 Verified
tax year · reviewed 2026-08-19 · Draft for I. Ohu review

Two entirely different consequences hide behind one phrase. For an employer plan, a prohibited transaction triggers an excise tax that recurs annually and then escalates. For an individual retirement account, there is no excise tax at all — the account simply stops being an IRA, backdated to the first day of the year, and is treated as having distributed everything in it. The second is far worse, and it is the one most clients are exposed to.

The rule

Six categories, direct or indirect. A prohibited transaction means any direct or indirect sale, exchange or leasing of property between a plan and a disqualified person; lending of money or other extension of credit between them; furnishing of goods, services or facilities between them; transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; an act by a disqualified person who is a fiduciary dealing with plan income or assets in his own interest or for his own account; and receipt of consideration for his own personal account by a fiduciary from a party dealing with the plan (IRC § 4975(c)(1)(A)–(F)).

Who is disqualified is wider than “the owner”. The term reaches a fiduciary; a person providing services to the plan; an employer whose employees are covered; an employee organization whose members are covered; a substantial owner of such an employer or organization; a member of the family of most of those; an entity substantially owned by them; and officers, directors and highly compensated employees (IRC § 4975(e)(2)(A)–(H)). Family is defined in § 4975(e)(6), and the ownership thresholds are in the table below.

The plan-side tax has two tiers. A tax of 15 percent of the amount involved is imposed for each year or part of a year in the taxable period, paid by any disqualified person who participated other than a fiduciary acting only as such (IRC § 4975(a)). If the transaction is not corrected within the taxable period, a further tax of 100 percent of the amount involved is imposed (IRC § 4975(b)).

For an IRA the rule is different in kind. If, during any taxable year of the individual for whose benefit the account is established, that individual or their beneficiary engages in any transaction prohibited by § 4975 with respect to the account, the account ceases to be an individual retirement account as of the first day of that taxable year (IRC § 408(e)(2)(A)). It is then treated as distributing all its assets at their fair market value on that first day (IRC § 408(e)(2)(B)).

And the excise tax then falls away. The individual and their beneficiaries are exempt from the § 4975 tax with respect to any transaction concerning the account where the account ceases to be an IRA under § 408(e)(2)(A) or where § 408(e)(4) applies (IRC § 4975(c)(3)). So the two consequences are alternatives, not cumulative — and the one that applies to an IRA owner is the harsher.

Each plan is treated separately. For § 408(e)(2) purposes each individual retirement plan of the individual is treated as a separate contract (IRC § 408(e)(2)(A)(iii)), so a prohibited transaction in one account does not destroy the others.

Pledging is narrower, and deliberately so. Where the individual uses the account or any portion of it as security for a loan, only the portion so used is treated as distributed (IRC § 408(e)(4)). That is a partial consequence rather than the total disqualification a prohibited transaction brings — a distinction that decides how much damage an act does.

Borrowing against an annuity is different again. Where the owner of an individual retirement annuity borrows any money under or by use of the contract, the contract ceases to be an individual retirement annuity (IRC § 408(e)(3)).

Current figures

Item	2026
The six categories	six, each reaching any direct or indirect dealing — sale, exchange or lease of property; lending or extension of credit; furnishing of goods, services or facilities; transfer to or use by or for the benefit of a disqualified person of plan income or assets; a fiduciary dealing with plan income or assets in his own interest; and a fiduciary receiving consideration for his own account from a party dealing with the plan^TY2026
Disqualified persons	a fiduciary; a service provider to the plan; an employer or employee organization whose people are covered; a 50 percent owner of such an employer or organization; a member of the family of most of those; an entity 50 percent owned by them; and officers, directors and highly compensated employees^TY2026
Excise tax on a plan transaction	15 percent of the amount involved for each year or part of a year in the taxable period, and a further 100 percent of the amount involved if the transaction is not corrected within that period — both paid by the disqualified person who participated^TY2026
Consequence for an IRA	the account ceases to be an individual retirement account as of the first day of the taxable year, and is treated as distributing all its assets at their fair market value on that day — with the owner and beneficiaries then exempt from the IRC § 4975 excise taxes^TY2026
Pledging as security	using an individual retirement account or any portion of it as security for a loan treats the portion so used as distributed — a partial consequence, not the total disqualification that a prohibited transaction brings^TY2026
Additional tax on early distributions	10 percent of the portion of the distribution includible in gross income, subject to the exceptions in IRC § 72(t)(2)^TY2026

How it works in practice

The exposure arises almost entirely with self-directed accounts holding real property, private businesses or loans. A conventionally invested IRA holding listed securities has essentially no way to engage a disqualified person; an IRA that owns a rental property has several, and they are not obvious ones.

Test the counterparty against § 4975(e)(2) before the transaction, and remember that family members are in the definition. An IRA buying property from the owner’s son, lending to a company the owner half controls, or paying the owner’s spouse to manage the property are all within the six categories, whatever the price or the commercial merits. Section 4975(c)(1) reaches indirect dealings too, so routing a transaction through an intermediary does not help.

Watch for the categories that do not involve money changing hands. Subparagraph (D) reaches the use by or for the benefit of a disqualified person of plan assets — so the owner staying a weekend at an IRA-owned holiday property, or storing goods in an IRA-owned warehouse, is within it. Nothing was bought or sold and the account is still destroyed.

Where a client is already exposed, quantify the damage before advising. For an IRA the deemed distribution is measured at first-day fair market value, so a transaction in December is valued at the previous 1 January — which may be more or less than the current value, and is a figure the custodian can supply. The distribution is includible under § 408(d)(1), and § 72(t) will apply to the includible portion unless an exception reaches it. There is no correction procedure that undoes § 408(e)(2).

A weekend at the IRA's cottage

Nadia’s self-directed IRA owns a holiday cottage let commercially all year. In August she and her husband stay there for a long weekend, paying nothing.

The account is destroyed. IRC § 4975(c)(1)(D) reaches the transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan, and she is a disqualified person as the account owner. No sale, no payment, no bargain — the use alone is enough.

The consequence is IRC § 408(e)(2)(A): the account ceased to be an individual retirement account on 1 January, not in August, and § 408(e)(2)(B) treats it as having distributed everything at its 1 January value. She has a distribution of the whole account, includible under § 408(d)(1), with the additional tax under § 72(t) on the includible portion if she is under 59½ and no exception applies. Paying a market rent would not have cured it — the category does not turn on consideration.

The loan that was not a distribution

Rafael pledges $30,000 of his $200,000 IRA as security for a personal bank loan.

This is the narrower rule. IRC § 408(e)(4) provides that where the individual uses the account or any portion thereof as security for a loan, the portion so used is treated as distributed. So he has a $30,000 deemed distribution — includible, and exposed to § 72(t) — while the remaining $170,000 survives as an IRA.

Contrast the same client borrowing directly from the IRA. That is an extension of credit between a plan and a disqualified person within IRC § 4975(c)(1)(B), and IRC § 408(e)(2) then destroys the whole account from the first day of the year. The two acts look similar to a client and differ by an order of magnitude.

Paying a family member to manage

Bea’s self-directed IRA owns three rental units. She engages her daughter, a licensed property manager, at a documented market rate to run them, and the IRA pays the fees.

Both limbs of the definition are met. Her daughter is a member of Bea’s family and so a disqualified person under IRC § 4975(e)(2)(F), and the arrangement is the furnishing of services between a plan and a disqualified person within IRC § 4975(c)(1)(C).

That the rate is market and the arrangement documented does not matter. The categories are structural rather than valuation-based — the statute asks who dealt with the plan, not whether the deal was fair. An unrelated manager at the same rate would have been unobjectionable, and the account would have survived.

Traps

For an IRA there is no excise tax — IRC § 4975(c)(3) exempts the owner and beneficiaries where § 408(e)(2)(A) or § 408(e)(4) applies. The consequence is destruction of the account instead.
Disqualification is backdated to the first day of the taxable year (IRC § 408(e)(2)(A)), so a December act is valued the previous January.
The whole account is deemed distributed, not the amount involved in the transaction.
Family members are disqualified persons (IRC § 4975(e)(2)(F)) — the definition is not confined to the owner.
Indirect dealings count (IRC § 4975(c)(1)), so an intermediary does not cure anything.
Use alone is a prohibited transaction (IRC § 4975(c)(1)(D)); no purchase or payment is needed.
A fair price is no defence. The categories are structural, not valuation tests.
Pledging is partial, borrowing is total. IRC § 408(e)(4) reaches only the portion used as security; a loan from the account is within § 4975(c)(1)(B) and destroys it.
An individual retirement annuity has its own rule — borrowing under the contract ends it (IRC § 408(e)(3)).
Each IRA is a separate contract for this purpose (IRC § 408(e)(2)(A)(iii)), so other accounts survive.
The plan-side first-tier tax recurs annually and is followed by a far larger second tier if the transaction is not corrected (IRC § 4975(a), (b)).

How this has changed

Section 4975 is among the more stable provisions in this outline. The six categories, the definition of a disqualified person, the two-tier rate structure and the § 408(e)(2) consequence have all been in place for decades, and the first-tier rate has been raised only once since enactment. Older material is therefore unusually reliable here, which is not true of most of the retirement topics around it.

What has changed is the exposure rather than the rule. Self-directed accounts holding real property, private company interests and promissory notes were once rare and are now widely marketed, so a provision written for plan fiduciaries now most often bites individual account owners who have never heard of it. Nothing in the section moved; the population it reaches did.

One drafting point is worth carrying forward because it is easy to read past. Section 4975(c)(3) exempts the IRA owner from the excise tax, which reads like relief and is not — it is the statute allocating a single, harsher consequence rather than stacking two. A source that lists the two excise tiers as the consequence of an IRA prohibited transaction has the mechanism backwards.

Exam focus

Know that the IRA consequence is disqualification under § 408(e)(2), not the § 4975 excise tax, and be able to say that § 4975(c)(3) is what allocates it that way.

Know that disqualification is as of the first day of the taxable year and that the whole account is deemed distributed at that day’s fair market value.

Know the six categories well enough to spot the one that needs no consideration — use by or for the benefit of a disqualified person.

Distinguish pledging from borrowing: § 408(e)(4) reaches only the portion pledged, while a loan from the account is a prohibited transaction destroying the whole thing.

Check yourself

1. An IRA owner sells a piece of land to their own IRA at an independently appraised market price. What is the consequence?

Answer: the account is destroyed. IRC § 4975(c)(1)(A) makes any direct or indirect sale or exchange of property between a plan and a disqualified person a prohibited transaction, and the owner is a disqualified person. The price is irrelevant — the category is structural. IRC § 408(e)(2)(A) then provides that the account ceases to be an IRA as of the first day of that taxable year, and § 408(e)(2)(B) treats all its assets as distributed at their first-day fair market value.

2. Does the 15 percent excise tax apply to an IRA owner who engages in a prohibited transaction with their own account?

Answer: no. IRC § 4975(c)(3) exempts the individual for whose benefit the account is established, and their beneficiaries, from the § 4975 tax with respect to any such transaction where the account ceases to be an IRA under § 408(e)(2)(A) or where § 408(e)(4) applies. The consequence is disqualification of the account instead — a single, harsher outcome rather than both.

3. A taxpayer pledges a quarter of their IRA as collateral for a personal loan. How much is treated as distributed?

Answer: the quarter pledged. IRC § 408(e)(4) provides that where the individual uses the account or any portion of it as security for a loan, the portion so used is treated as distributed. The rest of the account remains an IRA — unlike a prohibited transaction, which under § 408(e)(2) destroys the whole account from the first day of the year.

4. An IRA owns a commercial building. The owner’s brother rents a unit at full market rent. Is there a problem?

Answer: yes. IRC § 4975(e)(2)(F) makes a member of the family of a disqualified person a disqualified person, and § 4975(e)(6) defines family. Leasing property between a plan and a disqualified person is within § 4975(c)(1)(A). Market rent is no answer, because the category asks who dealt with the plan rather than whether the terms were fair, and § 408(e)(2) then disqualifies the account from the first day of the year.

Change log

2026-08-19Initial draft. Sets out the six IRC § 4975(c)(1) categories, the IRC § 4975(e)(2) definition of a disqualified person, the two-tier excise tax, and the very different IRC § 408(e)(2) consequence for an IRA together with the narrower IRC § 408(e)(4) pledge rule.