Fulcrum Self-Directed: Better Options for Your Retirment Savings

Tax Credits for a Self-Directed IRA or 401(k)

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If you are an individual (or business) who qualifies to establish a SEP-IRA, SIMPLE IRA or 401(k) qualified plan, such as a multi-participant or Solo 401(k) plans, you can qualify for tax credits for  certain types of self-directed IRAs and a Solo 401(k) plan.

Yes, you read that correctly! The IRS will permit your business to qualify for tax credits for a self-directed  SEP-IRA, SIMPLE IRA or 401(k) plan if you qualify for any of these plans. This benefit, amongst many others, is just another reason for one to consider this type of plan. The Solo 401(k) plan, which many also refer to as a self-directed 401(k) or Uni-K has many benefits that surpass the benefits of an IRA.

We all know the usual benefits of self-direction, and the receipt of tax credits for a self-directed IRA or 401(k) creation can just be added to the list. But, any time the IRS is “giving” us something there are rules to be followed and requirements to be met. And I won’t disappoint you…while the requirements are not burdensome, there are some rules.

So…

How Does a Business Qualify for the Tax Credit?

1)  If you have 100 or fewer employees who received at least $5,000 in compensation;

2)  You had at least one participant who was a non-highly compensated employee; and

3)  In the 3 tax years before the first year you are eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you…a member or a controlled group that includes you, or a predecessor of either.

How do I File for the Tax Credit?

As business owner you will file Form 8881 to request the tax credit.

Amount of the Tax Credit

The amount of the tax credit is 50% of the expenses (e.g., start up costs) up to a maximum of $500 per year.

What Expenses and Services?

1)  Set up and administration of the plan, and

2)  Educate your employees about the plan

What Tax Years are Covered?

A credit can be claimed for each of the first three years of the plan. You may also choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.

Obviously, you can’t deduct the start-up costs and claim the credit for the same expenses…but, you knew that.

For more information feel free to review IRS Publication 560 (Retirement Plans for small Business (SEP, SIMPLE, and Qualified Plans).

As always, the information provided is intended to be educational in nature. It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must consult with your respective professional in all such matters.

Types of Self-Directed Retirement Plans

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When it comes to self-directed retirement plans, any plan can–generally speaking–be self-directed. That is true whether it is a self-directed Traditional IRA, Roth IRA, SEP IRA or SIMPLE IRA. Whether you have a company-sponsored 401(k) plan or an Individual 401(k) plan–also referred to and marketed as a Uni-K, Solo 401(k) or self-directed 401(k)–they can ALL be self-directed.

While any of these plans can be self-directed, the majority of plans that are self-directed are the Traditional and Roth IRA, along with the Solo 401(k).

Self-directed or not, however, you should consider all of the retirement options that are available to you.

Fair Market Value for an IRA

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The primary reporting requirement for an IRA is Form 5498 which identifies the annual FMV (Fair Market Valuation) on the assets held by the IRA. In the case of a regular IRA (non-self-directed), this step is an easy “snapshot” of the account (e.g., stocks, mutual funds) that can be taken quickly and accurately.

In the case of a self-directed IRA LLC, it is the responsibility of the IRA LLC manager (probably you) to report the FMV of  the IRA to the IRA custodian so they, in turn, can report that value to the IRS annually. Historically, with many self-directed custodians, this may be as easy as the IRA LLC account manager simply informing the custodian of the value.

It is important to note that even IF this was the only request that the custodian was making of you, as the Manager of the IRA LLC you must account and operate the plan in full compliance and expectation of the IRS. This would include the annual valuation of the assets of your IRA LLC, regardless of what the custodian asks for.

However, effective in 2015, the FMV process is going to be a bit more detailed as the IRS is imposing stricter FMV reporting requirements on custodians to provide a more meaningful FMV on assets that may be difficult to value.

The IRS has noted:

“New information-reporting requirements are proposed to apply to certain IRA investments with no readily available fair market value. Reportable investments may include:

• Nonpublicly traded stock.

• Partnership or [limited-liability] interests.

• Real estate, options.

• Other hard-to-value investments.”

So with this new ruling coming into play for 2015, all IRA custodians (especially self-directed IRA custodians) will be required to complete the form with hard-to-value assets. One would expect that IRAs could fall under some regulatory scrutiny. Let’s face it, FMV valuations are of utmost importance to the IRS when an individual is executing a Roth conversion or distributions from the plan (e.g., Required Minimum Distributions (RMDs)). It is totally understandable that the IRS wants to ensure they are receiving their tax receipts on these transactions.

How Could This Change SAVE You Money?

Now, as a side note: There may be an unplanned benefit with more detailed accounting of the FMV as it relates to Roth conversions and distributions. Has anyone thought about the possibility of your hard-t0-value IRA asset losing value? For example, if your self-directed IRA purchased real estate for $100,000 and then, unfortunately, lost $30,000 in fair market value, the correct FMV would be $70,000 on the IRA asset, and not $100,000.

While this seems like common sense, it may surprise you that some IRA custodians will NOT value an IRA for LESS than what it had as a beginning balance.  Quite honestly, they may be concerned that without a full and credible FMV being executed, the value is not actually correct.

They could also be…greedy.

You see many self-directed IRA custodians receive fees from account values. If your IRA has legitimately lost value, their fees may be reduced if they reflected a new FMV that is lower. Understanding and correcting that could actually save you money in custodian fees.

So, What is FMV? (and we will keep it easy)

First, let’s keep a couple of concepts in mind:

  • FMV is not some IRS form that tells you what assets are worth (you know that…asset valuation is typically made by appraisers)
  • FMV values can be significantly different between States and areas of states (e.g., New York City vs. Omaha, NE; New York City vs. Syracuse, NY)
  • FMV and Market Value (MV) are not the same and will not necessarily result in the same value on the same property being evaluated

In more simplistic terms, what is MV and what is FMV?

Market Value — In simple terms, Market Value is the value of an asset (e.g., real estate) on a specified date when a sale occurs between a seller and buyer.  Think of this: if an asset was sold today, what would it sell for? What is the market value as of that date?

Fair Market Value — With FMV, there is an assumption that the asset is not being sold. However, for valuation purposes, what would be the value if there was a hypothetical sale. The IRS gives some clarification on FMV:

“In a profit-sharing, money purchase, or stock bonus plan, the assets’ valuation will determine a participant’s account value, and ultimately, a participant’s distribution. In a defined contribution plan, Revenue Ruling 80–155, 1980–1 C.B. 84 provides that since amounts allocated or distributed to a participant must be ascertainable, plans must value their trust investments at least once a year, on a specified date, and according to a method consistently followed and uniformly applied”

Treasury Regulations state (the following text specifically addresses estate valuation issues, but the same principal applies to the definition of a FMV):

The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property…..is not to be determined by a forced sale price.  Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.

It continues by noting:

Thus, in the case of an item of property…..which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail.

Finally:

For example, in the case of shares of stock or bonds, such unit of property is generally a share of stock or a bond….Property shall not be returned at the value at which it is assessed for local tax purposes unless that value represents the fair market value as of the applicable valuation date. All relevant facts and elements of value as of the applicable valuation date shall be considered in every case.

The bottom line is that with the IRA LLC valuation, a credible value will need to be identified. The question that many people will practically ask is: If an IRA LLC has real estate within the plan, will due diligence dictate that an appraisal be executed on the property OR will a comparative analysis (comp) be acceptable? A more logical answer to that question may undoubtedly hinge on whether any distribution or Roth conversion is being executed for the plan.  Let’s break that down a bit further:

Example: Jo is 40 years of age and is the manager of her IRA LLC. She has a $300,000 (value) IRA LLC in which she has two assets: a $200,000 piece of property and $100,000 (cash). Based on her age, Jo will not be taking any distributions from the plan and she is not executing a Roth conversion to her IRA. Since there are no concerns with either distributions or conversions, would the IRS find it acceptable that Jo secure a comparative analysis (comp) on the property from a licensed and competent realtor or would they require an appraisal. The hopeful thinking by many IRA LLC managers is that, in this example, a comp would suffice in establishing the FMV. Obviously, the property is not being sold (meets FMV standards) and no distributions/conversions are occurring.

Feel free to visit with your IRA custodian and inquire if they have been provided final instructions from the IRS on the proper completion and filing of Form 5498.

The “Life” of a 401(k) Plan

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Almost like a person, your 401(k) plan has its own “life” that can best be described as the plan’s establishment, operation and termination. For most individuals who are the Trustee of this type of plan, the plan begins and ends. Between these two dates is the operation of the plan. As you probably know, the establishment, operation and termination of the plan must adhere to various IRS and DOL regulations.

In comparison to a multi-participant 401(k) plan, the individual self-administered 401(k) plan has significantly fewer compliance reporting requirements. These requirements make an individual 401(k) plan ideal for the self-employed individual in that the plan is much easier to administer and operate than the multi-participant plan.

Establishment – The individual, self-directed 401(k) plan, like any 401(k) plan, must be established in compliance with IRS and DOL requirements. The primary tool involved in establishing the plan are the plan’s operating documents (e.g., Adoption Agreement, Basic Plan Document) accompanied with an IRS satisfactory opinion letter confirming that the plan documents meet the IRS’ requirements for a 401(k) plan. These documents must be written to be in operational compliance for the plan and the IRS must approve the plan’s documents.

Further, even with the proper documents in place, the plan and its assets must be appropriately cared for by establishing account(s) to hold and invest the plan’s assets and invest these assets in compliance with tax law. While the account for the 401(k) can be at any financial institution that will accept the plan’s funds, it is the responsibility of the plan’s Trustee to ensure that the assets are properly protected and invested.

Operation – The operation of the plan is of vital importance. While it is exciting to control the investments of the plan, the 401(k) Trustee assumes the responsibility of operating the plan in full compliance with IRS and DOL regulations.

Aspects of the plan that need to be addressed include: 401(k) plan documents, amendment, updating and re-statement of plan documents, plan investments, plan transfers and rollovers, employee and employer contributions, adherence to IRS and DOL Prohibited Transactions, plan tax reporting and plan termination.

Termination – For most individuals, the plan will be terminated at some future date. Like any “living” entity, the plan will be terminated once the business discontinues its business activities. It is important that the Trustee understands this and properly terminates the plan when needed.

Time Required to Fund Your Self-Directed IRA

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Realistically, how long does it take to fund your plan? You are creating a plan and you should have a very realistic and conservative idea on the time required to fund your self-directed IRA.

I always advise folks to expect a 2 – 3 week time frame for this process. The reason for the delay is not the self-directed company. Typically, their work in establishing IRA LLC plan documents can be done within a couple of days up to a week.

As a quick refresher, the IRA LLC structure will permit you (or your designee) to be the manager of the LLC of which the IRA (and the IRA only) is the sole member of the LLC. As manager, you will have checkbook control of your funds and can invest on behalf of the LLC and the sole-member IRA. As always, you must follow all IRS regulations.

Another Self-Directed Company Says This Can be Done in Days!

First, let’s establish some ground rules. Can an IRA that is not going to have funds transferred or rolled over into the plan be established within a week…possibly. However, let’s assume that funds will be transferred or rolled over into the newly-established IRA.

There is a difference between the time needed to prepare the IRA LLC documents and the actual funding of the IRA LLC. What is humorous are companies that say, suggest or even hint that this can happen within a matter of days. I guess if the sun and moon are in perfect alignment, sure, anything can potentially happen…but, even then, it won’t be a matter of days. Why?

If a self-directed company is being totally honest and frank with you, they will tell you that the following reasons (and there can be more) dictate the expediency of establishing and funding your IRA LLC account. With mailing (or even over night options) requirements, do you think all of the following can be done in a “matter of days” (between two custodians)?

1)  Mailing/Over Night Processing — Applications, forms, transfer requests for funds, receipt of transferred funds

2)  IRA Custodian Opening Account — They don’t just instantly open an account even when they receive your application

3)  “Transferring” IRA Custodian Processing Transfer Funds Back to Self-Directed IRA Custodian — This is not immediate

4)  “Holding” Times — After receipt of transferred funds, most custodians will have a minimum 3-day hold on releasing funds to your IRA LLC

Whew!  As you can see, any suggestion that this process can be fully executed within a matter of days is folly. It just ain’t going to happen…even if you pay for wires and over night mailings. And, this doesn’t take into consideration if you make an error.

I even saw a company that said that they will assist you in the “transfer” of funds. Now, what they may have meant is that they will assist you in completing a “transfer” form for your signature. But, please note, a self-directed company cannot and will not be involved in requesting the transfer of funds. Why? Because they are NOT the custodian and ONLY the IRA custodian can request funds in transfer. Even a suggestion that the self-directed company can, magically, assist you in making sure the transfer of funds is executed expeditiously is…incorrect.

Be excited about establishing your self-directed IRA! You are entering into an exciting venture, and one that can be of great benefit to you. Just expect a bit more time than just a “matter of days” for your self-directed IRA and its IRA LLC to be established and funded.

How Long to Establish a Self-Directed IRA LLC — The Truth!

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There are some self-directed IRA companies that give a somewhat misleading picture of how long it takes for an IRA LLC to be established and funded.  An IRA LLC provides you the ability to have “checkbook control” of your IRA funds, and permits the IRA account owner (or their designee) to serve as manager of a special purpose LLC. The sole member of the LLC is the IRA plan. This arrangement, if structured and operated correctly, is a mechanism in which to secure true control of your IRA account.

No more being limited to investing in the traditional world of stocks, bonds and mutual funds. You will now have the ability to invest in any asset not specifically prohibited by IRS Prohibited Transactions. As the IRA LLC manager, you will have this capability to invest on behalf of the IRA plan.

Enough on that…how long does it (really) take to establish and fund the IRA account? How long to prepare the IRA LLC documents, wait for funding of the IRA, and then the amount of time before you fund your IRA LLC at your local bank?

Typically 2 – 3 weeks!

While the self-directed IRA company will be preparing the IRA plan documents during the following steps, it is fair to say that their responsibilities to you will be done well within and before the time your IRA account actually funds.  Let’s break down a realistic time frame on the entire process.

Step 1 — Contract with a Self-Directed Company

Step 2 — Mail IRA Application (even if you do it online, the custodian will still require the signed application forms to be mailed/over nighted) to them 

Step 3 — Establish IRA Account


Step 4 — IRA Custodian Requests Funds in Transfer

Step 5 — Transferring Custodian Processes Transfer Request

Step 6 — Self-Directed Custodian in Receipt of IRA Transfer Check

Step 7 — Self-Directed IRA Custodian Mails Funding Check for IRA LLC

Step 8 — Open Your IRA LLC Account

Okay, that was a bit dry, but it is provided for some basic education on the process, and to show that the overall process of establishing and funding your IRA LLC is not an over night process.

Bottom line: While document preparation for the plan will not be a timely endeavor, waiting (typical time associated with mailing forms) on the account to be established and funded are the steps that truly delay the process.

During these steps of establishment and funding, FSD will be preparing your plan documents. This will include:

1) securing the LLC Articles of Organization (from the State in which the LLC is domiciled)

2) securing the IRS EIN for the IRA LLC, and

3) preparing the special-purpose LLC Operating Agreement.

The special-purpose Operating Agreement is, quite honestly, the most important document for the plan as it identifies how the LLC must operate to comply with IRS regulations.

When a company says that they can establish and fund your IRA LLC within a matter of days…keep this blog post in mind. While the process can be sped up with over night transmissions of various applications, forms and documents, realistically you should be thinking about a 2 – 3 week process in establishing and funding your account. This information should be useful to you so that you know when you can realistically purchase an investment (e.g., real estate) using your IRA LLC funds.

As always, the information provided is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.

 

Solo 401(k) Loans and Prohibited Transactions?

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The ability to take a participant loan from any 401(k) plan, including a Solo 401(k), is an awesome feature to a 401(k) plan that permits such loans. Of course, there are rules to be followed with regard to securing the loan and repaying the loan in compliance with IRS regulations.  These rules include:

  • A loan limit of $50,000 or 50% of their account balance, whichever is less;
  • A loan repayment schedule of 5 years (or less) with an amortized loan schedule;
  • An on-going loan repayment schedule which is repaid on, at minimum, a quarterly basis;
  • No pre-payment penalties; and,
  • An interest rate that is consistent with current loan interest rates.  At minimum, the loan can be reasonable if it is the prime rate (at the time the loan is taken out) + 1%.

So, while the ability to take a loan from the plan has many significant benefits (link back to article on Solo 401(k) loans), one interesting benefit is one that very few people think of. It is a benefit that, when you initially think about it you may believe you can’t do…but you can. What is this benefit that you believe you can’t make?

Using your loan proceeds to make an investment or execute a transaction that would otherwise be treated as a Prohibited Transaction (IRC Section 4975) if it was done within the plan.

Now, let that soak in for a second. If there was always an investment that you wanted to make, or a transaction you wanted to enter into, but you couldn’t enter into the transaction because it would be a prohibited transaction, you can! This is also with the understanding that the transaction was entered into after the participant took a participant loan, and the amount kept within the permissible loan proceeds you can take from the plan with your participant loan.

You already understand this concept.  Let’s use a couple of examples:

1)  Purchase of a Car — Let’s say you qualify for the maximum loan from the plan….$50,000. And, you wanted to use these funds to purchase a vehicle that you would personally own and use. This would certainly be permissible, and you probably understand that. Your mind would most likely be wired that way.

2)  Giving Money to Your Mother — If you have done any research on self-directed plans and 401(k) loans, you understand that your mother would be a disqualified person to your plan. Your mind may initially think that you couldn’t take a loan out of your plan and turn around and give that money to your mother…I mean, she is a disqualified person, right?

But, remember, the loan is a loan and not an investment of the plan. Where you could not loan your mother money as an investment from the plan as she would be a disqualified individual, you could take the loan and do whatever you wish with the proceeds. Again, remember, it is a loan to you, the participant, and NOT an investment from the plan. You can, in effect, do whatever you wish with those funds.

It is interesting that in using these two examples, most everyone would agree that in example #1 there would not be any problem…but, if you did not give example #2 much thought, your first blush reaction might be that it could be a problem. But, the simple fact is that as long as the funds are received by the participant as a legitimate participant loan AND the participant fully complies with the repayment schedule and criterion, the participant can do whatever they wish with the funds.

Just an interesting way of looking at Solo 401(k) loans and some of the freedom you have with this tool. Just remember to follow the rules.

As always, the information is intended to be educational in nature. It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must always consult with your respective professional in all such matters.

 

What is a Traditional IRA?

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An individual retirement arrangement is commonly referred to as an Individual Retirement Account (IRA) and is a trust or custodial account established within the boundaries of the United States. It is for the exclusive benefit of the individual and their beneficiaries. The IRS notes that the account is created by a written document and must meet all of the following requirements:

  • The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.
  • The trustee or custodian generally cannot accept contributions of more than the deductible amount for the year. However, rollover contributions and employer contributions to a simplified employee pension (SEP) can be more than this amount.
  • Contributions, except for rollover contributions, must be in cash.
  • You must have a nonforfeitable right to the amount at all times.
  • Money in your account cannot be used to buy a life insurance policy.
  • Assets in your account cannot be combined with other property, except in a common trust fund or common investment fund.
  • You must start receiving distributions by April 1 of the year following the year in which you reach age 70½.

Related to self-direction, the IRA is held through a custodian, and it is the custodian who identifies what investments are available to the IRA account owner. It is as simple as if the custodian is a bank, you may only have options like CDs. If at a brokerage firm, you will have stocks, bonds and mutual funds. If, however, the IRA is held through an IRS-approved IRA custodian which permits alternative assets, then your IRA will be able to invest in any non-traditional assets permitted. Typically, a self-directed IRA custodian will permit the IRA to invest in any asset not specifically prohibited by IRS Prohibited Transaction regulations.

Traditional IRA Contributions — What differentiates a Traditional IRA from, for example, a Roth IRA, is the tax treatment of contributions made to the plan. You see, IRS rules on Prohibited Transactions, transfers, rollovers, contribution amounts, etc. are the exact same for both. However, with Traditional IRA contributions, the benefit to the account owner is that the contributions can be tax-deductible; therefore, the contribution is not considered to be taxable income to the IRA account owner. Any and all gains from investments are tax-deferred and no taxes are due on the Traditional IRA until such time when distributions from the plan are taken.

Why Choose a Self-Directed 401(k) vs. a Self-Directed SEP-IRA

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Fulcrum Self-Directed establishes self-directed IRA and 401(k) plans so clients have the greatest freedom and flexibility legally provided under IRS rules, and the IRA LLC Manager or 401(k) Trustee has checkbook control of their retirement funds.  In establishing these plans, there are no biased or selfish interests other than assisting the client in establishing the self-directed plan that best suits their interests.  One of these cases of bias may be when comparing the self-directed 401(k) to the self-directed SEP IRA.

Self-Directed 401(k) vs. Self-Directed SEP IRA

While both of these plans can certainly be self-directed, a comparison of the two really goes back comparing the 401(k) to an IRA.  The  SEP, as a Simplified Employee Pension plan, is still an IRA and must still comply with many of the requirements set forth for IRA plans.  While the contributory limits are definitely potentially higher than that of the Traditional or Roth IRA, it is still an IRA when compared to the 401(k).

Keeping this in mind, what are the benefits of the 401(k) vs. the SEP IRA?  You will find that the benefits can be substantial:

1)  401(k) Plans can be Established for the Self-Employed — Self-employed individuals with no common law employees can establish a 401(k) plan for their business.  An individual can probably more easily establish a SEP IRA with less hassle and potentially have the same level of contributory benefits.  On the surface then, why still establish a self-directed 401(k)?

Simply speaking, even if contribution limits were identical, the SEP is still an IRA and will not have of the same benefits afforded through the 401(k).

Rollover Funds Cannot be from an IRA or Other Non-401(k) Plan — Yes, you heard that correct and that is not an uncommon belief.  Many individuals believe that in order to fund a 401(k) plan, ONLY funds from a previous employers’ 401(k) plan can be rolled over into the plan.  While self-employed, they may have a Traditional IRA funds and, as such, believe that since it is an IRA funds, those funds can only fund a self-directed IRA.  What plans are eligible to rollover to a 401(k):  Traditional IRAs, SEP IRAs, SIMPLE IRAs (under certain conditions), 401(k) plans, 403(b) plans, 457 plans, Keogh plans and Money Purchase plans.

3)  Guidance from Professionals — Simply stated, many individuals have been guided and advised that a SEP is easier to establish and less burdensome to operate.   Many times these comments are well intended, but may not be factually correct or in the best interests of the individual.  While the SEP may have some limited benefits over the 401(k), as a general rule, the  benefits of a 401(k) will probably be better suited for the self-employed individual.

Solo 401(k) and SEP IRA

So, with some of the aforementioned reasons why a self-employed individual may incorrectly believe that they cannot establish a SOLO-K plan, let’s provide some general reasons why someone should consider establishing the Individual 401(k) plan.

1)  Maximum Contribution Limits — While on the surface most people don’t see much difference in the contribution limits between a Solo 401K and SEP IRA, there are significant differences.  Keep in mind that the 401(k) permits you to make employee elective deferrals AND employer profit share contributions, whereas the SEP only permits only the profit share contribution.  In most cases, you will be able to defer more in contributions with the 401(k) vs. the SEP.

To keep things simple for now, let’s assume John (age 45)  is a self-employed individual operating as an S-Corp and has wages of $100,000.  Let’s also assume that John is interested in contributing as much as possible…whether he was using a SEP or a 401(k).  In this scenario, John could have elective employee deferrals of $17,500 and the employer profit share contribution could be $25,000….or a total of $42,500.  In contrast, the SEP’s total contributions would be $25,000….which do you think is better?!

Then, take in mind also that the 401(k) permits “catch-up contributions” of $5,500 if you are over the age of 50.  SEP plans do not have these catch up contributions provisions.

2)  Anyone Say Loan? (401(k) Loan Provisions) — When I visit with clients, my job is never to advise them on whether they should ever take a loan from their 401(k) plan, rather educate them on the ability of a 401(k) plan to exercise such loan(s).  Of course, strict adherence to all IRS 401(k) loan regulations regarding the loan must be followed.  But, the point in this conversation is that IF an individual ever wants the benefit of taking loans from the plan, they are out of luck with the SEP (being part of the IRA family) as it does not permit loan provisions.

3)  No Custodian Relationship Required — Yes, you heard that correctly.  401(k) plans are not required to have a custodian-relationship for the plan where the SEP (as an IRA) absolutely must have a custodian in place.  In addition to more freedom, less intervention from an outside custodian and, more notably, less fees to operate has to be attractive.  Even IF an IRA custodian’s fees are not much, there are still fees that are going to be charged for that account.  These fees do add up.

4)  Don’t want an LLC? — Well, then you don’t need one…with the 401(k).  You see, the 401(k) is a “trust” and, as Trustee of the Trust, the trustee can make investment decisions without the need of an LLC.  As such assets are held in the name of the plan.   With what is commonly marketed as the “IRA LLC” (for any type of IRA including the SEP), you are going to need an LLC for the IRA to be able to make non-traditional assets.  Now, keep this in mind, in some states these LLC fees can be  extremely excessive.  In California the LLC filing fee is not excessive; however, the State charges LLCs $900 (I believe that is the current fee) JUST to operate the LLC on an annual basis….geesh.  In States like Massachusetts and Maryland, not only are there high LLC establishment fees, but also high annual fees (e.g., annual filing fee)….to the tune of $500 establishment/$500 annual fee. This is extremely expensive.

Now, can your 401(k) plan have an LLC that, so to speak, acts like the “investment arm” of the plan.  Yes.   And, there may be reasons why the Trustee of the plan would desire to have an LLC for the 401(k)’s investments.  But, for this conversation, the point is that the 401(k) does not require the LLC, where the IRA family (inclusive of the SEP), generally, will require the use of the IRA LLC.

5)  Roth Contributions — This is a wonderful benefit to the 401(k)…the ability to make both pre-tax and after-tax (Roth) contributions…all within one plan.  You do not have this option with any IRA, meaning the ability to do both pre-tax and Roth contributions all within one plan.    You can make both pre-tax and Roth contributions to a 401(k) plan, whereas with a SEP the only contribution to this profit sharing plan is a contribution made in a pre-tax manner.

6)  Account Flexibility to Invest in Both Traditional & Non-Traditional Assets — Can an IRA invest in both traditional and non-traditional assets…yes.   But, this option is not necessarily easy for many and, quite honestly, when they find out some of the hassles associated with their IRA investing in traditional assets from a self-directed IRA….they will elect to use their self-directed IRA for non-traditional asset investing (only).  However, in contrast to the IRA (and especially if structured in a certain manner) think about how flexible and advantageous to have your 401(k) be one account….one account to invest in both traditional and non-traditional assets.  No need for two different accounts to accomplish your overall goal of having just one account to manage….how nice is that?!

Now saying that, your plan can certainly be established at a bank.   However, you might be interested in having one account that can be hosted with highly rated financial service companies who do not charge fees for the establishment of your 401(k) account AND  you have the ability to have full control of your account (i.e., controlling the retirement “checkbook”).  So, literally, the ability to invest in both traditional assets from that same account.

7)  UDFI — UDF what?  Unrelated Debt Financed Income.  In simple terms for this post, if structured correctly, your 401(k) plan can leverage investments into real estate (only) without paying taxes on gains realized from the use of leveraged funds.  This is a huge benefit of the 401(k) compared to any IRA.  The IRA, including the SEP, will pay taxes on gains realized from leveraged investments.  For many serious real estate investors who actively utilize leverage, this reason alone is enough to establish the 401(k) (again, provided they qualify for the plan).  Of course, it should be noted that any non-Roth 401(k) investment will pay taxes upon distribution from the plan.

Want more?!  Generally speaking, better asset protection with a 401(k) vs. an IRA, and the possibility of having lesser penalties associated with, should they occur, Prohibited Transaction dealings within the 401(k) (vs. the IRA).

SEP-IRA

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The SEP-IRA is a nice plan but very few people self-direct this type of plan.  I am sure that it is because most people are enticed by many of the benefits of the 401(k) plan….a Solo 401(k) or multi-participant 401(k).  Remember that the SEP-IRA is…still an IRA.  Therefore, while it has some wonderful features, it is part of the IRA family and is limited to some of the same limitations (e.g., no loan provisions) as an other IRA.

Simplified Employee Pension (SEP-IRA)— Believe it or not, many people believe that the SEP-IRA actually has the moniker of a “Self-Employed Pension” because so many self-employed individuals utilize this type of plan.  However, the correct terminology for the SEP-IRA is a Simplified Employee Pension.  It fits the name as the SEP-IRA is intended to be simpler in establishment, operation and administration than the 401(k) plan.   And, there is some truth in that, especially for a multi-participant 401(k) plan.

The IRS identifies characteristics of a SEP-IRA to include:

  • Available to any size business
  • Easily established by adopting Form 5305-SEP, a SEP prototype or an individually designed plan document
    • If Form 5305-SEP is used, cannot have any other retirement plan (except another SEP)
  • No filing requirement for the employer
  • Only the employer contributes
    • To traditional IRAs (SEP-IRAs) set up for each eligible employee
    • Employee is always 100% vested in (or, has ownership of) all SEP-IRA money

Why Might an Employer Elect a SEP-IRA?

Probably the SEP-IRAs most friendly feature is the relative ease of establishment and administration.  While the plan requires a written document to establish, many traditional SEP-IRA custodians have these documents in place for their clients.  The SEP-IRA has nearly the same contributions maximum limits of the 401(k).  SEPs have many of the characteristics of qualified plans but are much simpler to establish and administer.  There are no annual reports that must be filed by the employer for the plan.

The SEP-IRA can be established for any business…self-employed or with participants.  Contributions are based on a percentage (up to 25%) of the participant’s income  up to a maximum of $52,000.  The contributions go directly into a separate IRA account for the participant.  All contributions are made by the employer and the participant is able to choose their investments offered by the plan.

Individuals may ask why they shouldn’t set up a self-directed SEP-IRA if, generally speaking, it may be easier to establish such a plan. compared to others (e.g. 401(k)).  And, keeping in mind that a self-employed individual would only be responsible for compliance to the plan for themselves, and not other participants.

SEP-IRA Disadvantages?

Well, for a self-employed individual, the establishment, operation and reporting requirements for a Solo 401(k) are minimal.   And, one still has the benefits of a 401(k) plan over the SEP-IRA.  But, beyond the benefits of the Solo 401(k), are there disadvantages of the SEP-IRA?

Yes.

First, the business owner will need to make equitable contributions for almost all employees of the business.  And, it doesn’t matter if the employer is concerned about employee turnover…all employees are 100% vested immediately.  That can certainly rankle an employer if they have continual turnover in employee retention.  A 401(k) plan, in contrast, can legally limit (to  a degree) when employees enter the plan and can establish a vesting schedule for employees.  This is not the case with the SEP-IRA.

Sec0nd, the SEP-IRA does not have participant loans (not permitted) as a 401(k) would have and the SEP-IRA has some further limitations to in-service withdrawals.

These are just two potential disadvantages of many.  So, is the SEP-IRA bad, of course not.  You just need to determine if it is the SEP or the 401(k) that best suits your needs.

As always, the information provided is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional.