Disqualified Persons and Retirement Accounts: Rules & Restrictions

When it comes to self-directed retirement accounts—whether an IRA, Solo 401(k), or other plan, few topics are more critical (or more misunderstood) than the rules on disqualified persons. These rules are central to the IRS’s enforcement of prohibited transaction laws, and violating them can lead to severe tax consequences, including the immediate disqualification of your retirement account. But do the rules around disqualified persons change depending on the type of retirement account you use? And how do you stay compliant while investing in alternatives like real estate, private equity, or crypto?

This guide breaks down what a disqualified person is, how the rules apply across different plans, and where the distinctions lie depending on the account type.

What Is a Disqualified Person?

In the context of retirement accounts, a disqualified person is someone who is too close to the retirement account owner, financially or familiarly, to be involved in transactions with the plan. The IRS created this designation to prevent self-dealing and abuse of tax-advantaged retirement funds.

Under IRC § 4975(e)(2), disqualified persons include:

• The IRA owner or plan participant
• Their spouse
• Lineal descendants and ascendants (children, parents, grandparents, etc.)
• Spouses of lineal descendants
• Entities (corporations, partnerships, LLCs, trusts, estates) owned 50% or more by disqualified persons
• Fiduciaries (e.g., a trustee or custodian)
• Service providers to the plan

In other words, you cannot use your retirement funds to benefit yourself or close family members either directly or indirectly.

What Is a Prohibited Transaction?

A prohibited transaction occurs when your retirement account engages in a deal with a disqualified person that benefits them personally—rather than serving the best interest of the retirement plan.

Examples include:

• Selling personal property to your IRA
• Buying a rental property and letting your child live in it
• Paying yourself a management fee from an IRA-owned business
• Using retirement funds to invest in a company you control

Prohibited transactions can result in disqualification of the plan, leading to immediate taxation of the account’s entire fair market value and possibly penalties.

Do the Rules Differ for IRAs and 401(k)s?

Here’s where things get interesting: The core definition of disqualified persons is the same across all retirement accounts, but the rules and consequences differ depending on whether you’re using an IRA (Traditional, Roth, SEP, SIMPLE) or a qualified plan like a Solo 401(k).

Let’s look at the key distinctions.

Disqualified Person Rules for IRAs

When using an IRA, including a Self-Directed IRA, the prohibited transaction rules are very strict.

If an IRA owner engages in a prohibited transaction:

• The entire IRA is disqualified as of January 1 of the year the transaction occurred.
• The account is treated as if all assets were distributed at their fair market value.
• This can result in income taxes, early withdrawal penalties, and loss of tax-deferred/tax-free status.

There is no grace period, and the IRS takes a hard line stance. Even minor indirect violations, like investing in an LLC partially owned by your child, can trigger disqualification.

Also, with IRAs, the account holder is not allowed to perform services for an asset held in the IRA (e.g., repairing a rental property), as that constitutes “sweat equity,” a form of indirect benefit.

Disqualified Person Rules for 401(k) Plans

Solo 401(k) plans follow the same definition of disqualified persons under IRC § 4975, but the rules and enforcement differ in key ways:

1. Correction Opportunity
   • If a prohibited transaction occurs in a 401(k) plan, the plan may not be immediately disqualified. The IRS allows certain violations to be corrected under EPCRS (Employee Plans Compliance Resolution System) if the mistake is unintentional.
   • This is a huge advantage over IRAs, which have no such correction mechanism.
2. Loan Option
   • One key exception to the prohibited transaction rules for 401(k) plans is that a plan participant can borrow from the plan, as long as it follows strict rules:
     • Maximum of $50,000 or 50% of account balance
     • Repaid over 5 years
     • Market interest rate
   • IRAs do not allow loans to the account owner under any circumstances.
3. Employer-Sponsored Flexibility
   • A Solo 401(k) is treated as a qualified employer plan, even if the employer is a self-employed individual. This offers more administrative flexibility and potential insulation from certain prohibited transaction risks—provided the plan documents are written correctly and the plan sponsor acts prudently.

Real Estate Example: IRA vs. Solo 401(k)

Let’s say you want to invest in a rental property with your retirement funds. Here’s how disqualified person rules might play out:

Action	Self-Directed IRA	Solo 401(k)
Buying a property your parent owns	Prohibited	Prohibited
Hiring your son to manage property	Prohibited	Prohibited
You do the plumbing yourself	Prohibited (“sweat equity”)	Prohibited
Paying yourself a management fee	Prohibited	Prohibited
Borrowing from your retirement plan to buy the property	Not allowed	Allowed (via plan loan rules)
Mistakenly hiring a disqualified person, but catch the error	Immediate disqualification	May be correctable under EPCRS

Common Misconceptions About Disqualified Persons

Let’s clear up some frequent misunderstandings:

• Cousins, siblings, and in-laws are not disqualified unless they fall into another category (e.g., a service provider).
• You can invest alongside a disqualified person in some cases (e.g., using your IRA to buy 50% of a property your brother owns the other 50% of), but there must be no pre-arranged deal and no shared benefit.
• Having your LLC do the deal does not remove disqualified person status if you or your family control the LLC.
• Just because something isn’t clearly listed in the Code doesn’t mean it’s allowed—the IRS looks at intent and indirect benefit.

To keep your retirement plan safe from disqualification, follow these tips:

• Understand who counts as a disqualified person
• Avoid any personal benefit from retirement plan assets
  Do not provide services or labor to your IRA investments
• Use third-party service providers instead of family
• Review operating agreements carefully if investing in LLCs or partnerships
• Work with professionals who understand self-directed retirement rules
• Keep detailed records of all transactions and documents

When in doubt, it’s better to walk away from a deal than to risk the entire retirement account.

Conclusion: Same Core Rules, Different Consequences

In summary, the definition of disqualified persons remains consistent across retirement plan types, but the impact of prohibited transactions differs. IRAs are zero-tolerance: one prohibited transaction equals total disqualification. 401(k) plans, especially Solo 401(k)s, offer more flexibility and correction options but still require strict adherence to the rules. If you’re investing in alternative assets with a retirement account, it’s essential to understand these distinctions. A well-structured Solo 401(k) may offer more leeway, but no plan is immune from IRS scrutiny.

When in doubt, ask yourself: Would this deal exist without my retirement account? If not, it’s probably a problem.

Protect Your Retirement and Invest with Confidence

Understanding disqualified persons and prohibited transactions is critical to keeping your retirement funds safe and IRS-compliant. With the right guidance and a self-directed account, you can invest in real estate, private equity, or other alternative assets without risking disqualification.

👉 Schedule a Free Consultation to discuss the prohibited transaction rules.
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