Avoid Losing Tax-Deferred Status on Your IRA

Has your father, or another blood relative, ever asked you to trade securities on behalf of his or her individual retirement account?

If so -- and you earned even as little as a $1 commission -- the transaction is considered prohibited under federal tax laws.

That's because a long-ignored glitch in the tax code gives the Internal Revenue Service the authority to recognize the entire account balance as a distribution, rendering the balance, as of the first day of the year, subject to income tax, according to Sy Goldberg, a Jericho, N.Y.-based attorney and national expert in retirement-distribution planning.

While the provision is largely unenforced, the IRS could declare possibly hundreds of thousands of IRA accounts illegal and invalidate their tax-deferred status, a scenario that worries Goldberg. A lot of innocent people could get hurt because they don't know the rule, he says.

Section 4975 of the Internal Revenue Code defines prohibited transactions involving IRAs and employer-sponsored retirement plans. They include those between an IRA owner and disqualified person's spouses, lineal descendants and ancestors. The statute also refers to another code provision that includes siblings among the definition of family members who are disqualified from engaging in a transaction with the IRA owner.

With the size of IRAs increasing through rollovers from retirement plans, there is a good chance that the government will take a greater interest in IRAs and how they're managed, says Donald Myers, a partner with Reed Smith LLP in Washington, D.C.