What happens if you make a prohibited transaction?
The consequences of a prohibited transaction depend entirely on who triggered it — this article walks through the two very different outcomes, the year the damage is assessed, and what correction looks like.
Steps / Explanation
A prohibited transaction is a specific set of dealings between an IRA and a disqualified person, defined under Internal Revenue Code (IRC) Section 4975. For the definitions and the six categories of prohibited transaction, see "Prohibited transactions — what they are and why they matter" and "Disqualified persons — who counts and why". This article assumes you know what a prohibited transaction (PT) is and focuses on what happens next.
The outcome depends on who engaged in the prohibited transaction:
If it was you (the account holder) or a beneficiary, the consequences are severe and fall on the IRA itself.
If it was any other disqualified person, the consequences are an excise tax paid by that disqualified person, and the IRA's tax-advantaged status is generally not affected.
Understanding which side you are on matters, because the facts that trigger each path are different and the remedies are different.
If the account holder or a beneficiary triggers the prohibited transaction
This is the harsher of the two outcomes. Under IRC §408(e)(2):
The IRA loses its tax-advantaged status as of January 1 of the year the prohibited transaction occurred — not the date of the transaction itself.
The entire account balance is treated as distributed at its fair market value (FMV) on that January 1.
The full deemed distribution is taxable as ordinary income in that year, and it is reported on IRS Form 1099-R.
If the account holder is under age 59½ when the deemed distribution occurs, the 10% additional early-withdrawal tax applies on top of the ordinary income tax. See "Early withdrawal — penalties and exceptions" for how that additional tax works.
There is no unwind. The account is no longer an IRA and the tax-advantaged character of prior years' growth is erased on a forward basis.
A useful way to think about it: the IRS treats the IRA as if you took the whole account out as a lump-sum distribution on January 1 of that year — regardless of how small the actual prohibited transaction was. A single improper transaction can put the entire account into ordinary income in a single tax year.
If another disqualified person triggers the prohibited transaction
Under IRC §4975(a) and (b), the consequences fall on the disqualified person who engaged in the transaction, not on the IRA:
An excise tax of 15% is imposed on the "amount involved" in the prohibited transaction. This tax is assessed for each year or part of a year during which the transaction remains uncorrected.
If the transaction is not corrected within the taxable period (the IRS's defined correction window, generally ending when a deficiency notice is mailed or the tax is assessed), an additional tax of 100% of the amount involved applies.
These excise taxes are paid by the disqualified person — not by the IRA — and are reported on IRS Form 5330.
In this second scenario, the IRA's tax-advantaged status is generally preserved if the transaction is corrected. The corrective step is what keeps the 100% tax from applying.
What "correction" means
The IRS defines correction as undoing the transaction to the extent possible and placing the IRA in a financial position no worse than it would have been if the disqualified person had acted under the highest fiduciary standard. In practice, that usually means unwinding the transaction (for example, the disqualified person buys the asset back from the IRA) and making the IRA whole for any losses, interest, or opportunity costs.
Correction only reduces the 100% additional tax — it does not eliminate the underlying 15% excise tax for the years the transaction was in place. Correction is also only available for the "other disqualified person" path. The account-holder path has no equivalent remedy because the account has already been deemed distributed.
Audit and reporting risk
The IRS finds prohibited transactions through several pathways. The most common are:
Form 5498 and Form 1099-R reporting. Digital Trust, the custodian for your account, files these annually, and unusual patterns (for example, large swings in reported fair market value, or distributions without supporting documentation) can prompt IRS review.
Audit of the account holder's personal return. If an IRA-owned asset appears on the account holder's personal tax return (as a deduction, a basis, or otherwise), the IRS can trace the relationship.
Third-party reporting on the investment itself. For example, an IRA-owned real estate asset where the operating entity files returns showing rent paid to a disqualified person.
Self-reporting is also an option. IRS Form 5329 can be used by an individual to report an excise-tax liability or to request a waiver of tax penalties in certain circumstances. We recommend consulting a tax advisor or attorney for guidance specific to your situation.
Common questions
If the prohibited transaction was small, is the whole IRA really disqualified?
When the account holder or beneficiary is the one who triggered the prohibited transaction, yes — IRC §408(e)(2) treats the entire IRA as distributed. The size of the underlying transaction does not scale the consequence.
Can I correct a prohibited transaction I made myself?
No. The correction process is available only when a disqualified person other than the account holder or beneficiary engaged in the prohibited transaction. When the account holder is the one who acted, the IRA is already deemed distributed as of January 1 of that year.
Does the 10% early-withdrawal tax apply if the deemed distribution hits me before age 59½?
Yes. A deemed distribution from a disqualified IRA is treated the same as any other early distribution for the purposes of IRC §72(t). The 10% additional tax applies unless an exception — such as disability, death, or one of the other exceptions listed in "Early withdrawal — penalties and exceptions" — is met.
Who reports the excise tax to the IRS — me or the custodian?
The excise tax under IRC §4975 is reported by the disqualified person who engaged in the transaction, on IRS Form 5330. The custodian does not file Form 5330 on the account holder's behalf. Digital Trust's reporting, as custodian for your account, is limited to the custodial reporting it is required to do (Form 5498 annually, Form 1099-R for distributions).
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