Self-directed IRA crypto: the prohibited-transaction cost

The phrase the code does not use

“Self-directed IRA” is a marketing phrase. The statute that defines an IRA, section 408, does not use it [2]. Neither does the IRS page on prohibited transactions, nor the chapter of Publication 590-A that covers them [4] [3]. There is one kind of IRA in the code.

What people call self-directed is an ordinary IRA whose trustee lets the owner pick assets outside the usual list. The trustee is still the trustee, and the rules below are the same rules.

The IRS does describe the situation without naming it. Publication 590-A says the risk of a prohibited transaction may be higher when an IRA holds nonpublicly traded assets, or assets the owner directly controls [3]. That sentence is the whole crypto angle in one line. A coin in a wallet whose keys the owner holds is the plainest case of an asset the owner directly controls.

I read the four documents the way I read any receipt. What is prohibited, who is caught, and what does it cost?

What section 4975 prohibits

Section 4975 is a tax section. It defines a prohibited transaction as any direct or indirect dealing of six kinds between a plan and a disqualified person [1]. An IRA counts as a plan here. The section’s definitions list an individual retirement account described in section 408 [1].

The first three kinds are plain dealings: a sale, exchange, or lease of property; a loan or other credit; and goods, services, or facilities furnished between the plan and a disqualified person [1]. The fourth is wider. It is a transfer to a disqualified person of the plan’s income or assets, or their use by or for that person’s benefit [1].

The last two catch a fiduciary in particular. One is a fiduciary dealing with the plan’s assets in his own interest or for his own account [1]. The other is a fiduciary taking anything for his own account from a party dealing with the plan [1]. The IRS page puts the list in plainer words: borrowing from the IRA, selling property to it, using it as security for a loan, and buying property for personal use with IRA funds [4].

Who is a disqualified person

The statute’s list of disqualified persons is long, because it was written for employer plans too. For an IRA, two entries matter: a fiduciary, and a member of the fiduciary’s family [1]. Family means a spouse, ancestor, lineal descendant, and any spouse of a lineal descendant [1]. The IRS page says the same: the IRA owner’s fiduciary and members of his or her family [4].

So the question becomes who the fiduciary is. The statute answers by function, not title. A fiduciary is anyone with discretionary control over managing the plan, or any control over managing or disposing of its assets [1]. It also covers anyone paid to give the plan investment advice, or with discretion in running it [1].

For the owner, the label does not decide anything. The IRS page defines a prohibited transaction in an IRA as any improper use of the account by the IRA owner, the beneficiary, or any disqualified person [4]. The owner is named before the list begins. Publication 590-A uses the same words and the same fiduciary test, applied to “your IRA” [3].

What it costs

There are two costs, and they fall on different people. The first is the tax the section is named for. Section 4975 taxes the disqualified person who takes part at 15 percent of the amount involved, for each year in the taxable period [1]. If the transaction is not corrected in that period, a second tax of 100 percent of the amount involved follows [1].

The second cost is the one that matters for an owner, and it is not in section 4975. It is in section 408(e)(2). If the individual the account was set up for, or the beneficiary, engages in any transaction prohibited by section 4975, the account ceases to be an IRA as of the first day of that taxable year [2]. The account is then treated as having paid out all its assets at fair market value on that first day [2].

Publication 590-A spells out what that means on a return. The account stops being an IRA on the first day of the year and is treated as paying everything to the owner at fair market value on that day [3]. Any excess of those values over basis is a taxable gain, and the distribution may owe additional taxes or penalties [3]. If the owner has more than one IRA, each is a separate account, and only the one in the transaction loses its status [3].

One more line from the publication closes the loop between the two costs. If the IRA stops being an IRA because of the owner’s or beneficiary’s prohibited transaction, the owner does not owe the excise taxes [3]. The owner’s penalty is the deemed distribution. The excise tax is for other disqualified persons.

Where crypto fits

None of the four documents mentions crypto, bitcoin, or a wallet. The statute prohibits transactions, not assets. Nothing above turns on what the IRA holds. What changes with crypto is how easy the prohibited shapes are to make.

A coin can be moved to a wallet the owner holds the keys to. Publication 590-A’s warning about assets the owner directly controls is the IRS’s own framing of that fact [3]. The statute’s fourth kind, use of the plan’s assets by or for a disqualified person, is the one a wallet raises [1]. A sale of the owner’s own coins into the account is the first kind [1].

The crypto IRA guide describes the custodial structure this rests on: cash in, coins bought inside, and the keys held by the custodian rather than the owner. This note adds nothing to that. It only lays the statute beside it, so the reason for the structure is on the page with the structure.

The receipt

Four documents, one rule. Section 4975 lists six prohibited transactions, defines the fiduciary by control over the assets, and taxes the disqualified person 15 percent and then 100 percent [1]. Section 408(e)(2) ends the account’s IRA status on the first day of the year the owner engages in one [2]. Publication 590-A and the IRS topic page say the same in plain words and add the warning about assets the owner directly controls [3] [4].

The word “self-directed” is nowhere in any of them. The owner is named in the consequence, the beneficiary beside the owner, and the asset is not named at all. That is what the sources say, and it is all this note says.