Yes, Roth contributions can be made into your 401(k) plans BUT, and it is a big BUT, the plan must first adopt the ability to permit Roth contributions AND the Roth contributions must be placed into a separate sub-account of the 401(k) plan specifically designated for Roth contributions. The Trustee of the plan (typically you) must also account (through separate records) for all earnings that are generated from the Roth contributions. Keep in mind that the IRS will be really interested in you ensuring and proving that what is Roth IS Roth.
Fulcrum Self-Directed recommends that ALL 401(k) plans are established with sub-accounts, whether they be pre-tax contributory, rollover contributory, Roth contributory and profit share contributory accounts. They are established to protect you.
Yes. For those of you are familiar with IRAs, this is one area where, so to speak, the IRA may be simpler and more beneficial to the account owner. Generally speaking, Roth IRAs do not need to be distributed from the IRA; however, the 401(k), as a qualified employer-sponsored plan must distribute assets at some point in time. Usually, distribution of 401(k) assets occurs when the business is terminated. In simple terms, if a Trustee was still operating their business and plan by the time they reach 70 1/2, they would be required to take RMDS….whether the funds are held in pre-tax, Roth or a combination of accounts.
These distribution rules also require your beneficiaries, usually family members, to be bound to distributions requirements as well. However, there is one possible exception to this rule. While you would always want to refer with a tax professional, with proper planning, the business and the 401(k) could be terminated prior to 70 1/2 with all Roth assets being rolled over to a Roth IRA..
No. One may question why a Roth 401(k) could be rolled over to an IRA but not vice-versa. Good question! While there are some complex factors involved, please note that you cannot currently rollover Roth IRA funds into any 401(k) plan. This is important if you are planning on establishing or converting current funds in an IRA to Roth as it may affect your ability to potentially rollover those assets at a later date.
Yes. Unlike someone who wants to rollover a Roth IRA to a self-directed Roth 401(k), this activity is permissible.
Yes, this has been permissible for any 401(k) plan since 2010, including a self-directed 401(k). However, the key points are that the plan documents for the 401(k) must permit Roth accounts and the ability to convert funds into Roth dollars. If the plan does not permit it, the individual cannot convert. As the Trustee of your self-directed 401(k) plan, you have the ability to ensure that this provision is included in your plan documents.
In addition, all funds converted must be maintained and accounted for in a separately-designated Roth sub-account. Provided the assets have been in the account for at least 5 years and the participant is over the age of 59 1/2, all income and gains from the Roth sub-account will be distributed tax free.
Keep in mind that when executing a Roth conversion, you will be responsible for paying the tax on the conversion of these funds to Uncle Sam 🙂
No, contrary to popular belief, there is nothing as specific as just a Roth 401(k). The 401(k) plan, self-directed or not, can establish through a separately-designated account WITHIN the 401(k) a Roth contributory or conversion account. At the end of the day, it really doesn’t affect you, as you are still permitted to establish the Roth sub-account(s) to your plan.
Yes, as it relates to elective employee deferrals (e.g., your personal contributions into the plan). In short, yes, employee elective deferrals, whether made in a Traditional or Roth manner (of a combination thereof) will have the same elective deferral limitations.
But, it is important to keep in mind that the “same” contribution limits only apply to elective deferrals. Obviously, rollover contributions, pre-tax contributions and the business’ profit share contributions (if any), must be placed within separate accounts for the plan. In short, only your Roth contributions and the gains from those invested funds will be in the Roth contribution account.
Yes, of course. Fulcrum Self-Directed believes that our clients should be able to execute their plan in any manner that the IRS and DOL permit, or don’t specifically preclude. As such, as the Trustee you can elect to have your plan offer Roth contributions and execute Roth conversions. As a participant, and if the plan permits, you can not only make Roth contributions, but can also execute Roth conversions on any permitted plan funds.
Yes, of course…with some exceptions. Generally speaking, there are two types of funds that you cannot rollover into your 401(k) plan. The first being is that Roth IRAs cannot be rolled over into any 401(k), regardless of whether the plan permits Roth contributions and Roth conversions. Secondly, in most cases, you will not be able to rollover funds from a current employer’s 401(k) plan (where you are still an active participant). There are exceptions to this (e.g., in-service distributions being over the age of 59 1/2), so you will always want to review this with us or your tax professional.
It is based on your currently employer’s plan documents. You will want to ask your current employer if you are allowed to execute “in-service transfers” (usually applicable to people over the age of 59 1/2, but that is not necessarily the only exceptions). If they are, any portion that you can rollover through the in-services transfer could be rolled over into your solo 401(k) plan.
Yes, and quite honestly, you probably should do this anyway, even if you are not self-directing. But, yes, you can rollover these funds from “old” employer 401(k) plans into your new self-directed 401(k).
Yes, this can be done as the purchase of stock or a stated return of interest in consideration for the loan to the business. Of course, you will always want to make sure that you are not executing an IRS/DOL Prohibited Transaction by self-dealing or executing a loan to a disqualified individual.
The interesting thing is that the IRS code does not advise on what plans can invest into, only what plans specifically cannot invest to (as it relates to asset classes). The disqualified assets (Prohibited Investments) include:
- Collectible Coins
- Stock in a S-Corporation
- And certain other tangible personal property
You will notice that the aforementioned list of disqualified investment assets fall under “collectibles.”
Understanding what constitutes a prohibited transaction is very important when it comes to making investments within your Self-Directed 401(k). The IRS defines a prohibited transaction as follows:
“Generally a prohibited transaction is any improper use of your 401(k) account or annuity by you, your beneficiary or any disqualified person. Disqualified persons include your fiduciary and members or your family (spouse, ancestor, linear descendant, and any spouse of linear descendant).” IRS Publication 590
IRC 4975 is the section that lays out the rules on prohibited transactions. Prohibited transactions generally involve one of the following: (1) doing business with a disqualified person; (2) benefiting someone other than the 401(k); (3) loaning money to a disqualified person; or (4) investing in a prohibited investment.
Bluntly stated, prohibited transactions are those transactions that violate the basic intent of IRS code as it relates to the operation of the 401(k). Always consider this basic statement: Your activities with the plan must always benefit the plan and not you personally. If one always keeps this premise in mind, it will greatly assist them in the “common sense” approach to operating and administering their plan.
Can your self-directed 401(k) invest into foreign real estate?
Your Self-Directed 401(k) can invest outside of the U.S. States into real estate as it is not a Prohibited Transaction. There are certainly many great investment opportunities in other countries, and as long as a Prohibited Transaction is not otherwise triggered, this is a permissible investment of the plan.
No, that is the reason why you are establishing this type of plan. As long as the plan is established or administered correctly, you will not pay taxes and penalties because you DO NOT take money out of your plan to purchase the real estate! Your 401(k) or IRA LLC will be the entity on record for purchasing the property. As they are either tax-deferred or tax-free entities, no taxes or penalties will be due. Of course, if either plan is making investments with pre-tax funds, taxes will be due on the distribution from your plan…whether the distribution is in cash or through a non-liquid asset.
Think of it this way, if you IRA or 401(k) plan purchased 100 shares of Apple, you do not pay taxes or penalties on that investment. Think of real estate, from an asset in the plan standpoint, as being the same transaction as your stock. The method of doing so is different but the tax ramifications are the same.
Yes. According to IRC 4975, siblings are not included in the definition of a disqualified individual. While most people believe that the IRS may have intended that such individuals be considered to be disqualified, they are not identified. As such, a loan to your brother does not appear that it would be considered a prohibited transaction. As noted, while many believe it is an error that the IRS omitted siblings from the definition, they were, nonetheless, omitted. To the best of anyone’s knowledge, the IRS has never ruled to the contrary.
Absolutely. And this is done frequently, and it is a great investment for your Self-Directed 401(k) because the loan can be secured by the property.
Yes, your 401(k) plan can apply for a mortgage; however, the mortgage must be a non-recourse type of loan. In simple terms, you (as the Trustee) of the plan nor any disqualified individual can assist the plan in qualifying for the mortgage. No personal guarantees, no extension of credit (e.g., running your credit score), no co-signing, etc.
In a non-recourse loan, the 401(k) must make all payments from the plan. If the plan fails to make payments, the lending institution or individual’s only recourse is the property itself.
While there are many benefits of a 401(k) plan purchasing real estate, keep in mind that:
1) Time Constraints — As Trustee of your plan, you control the investment checkbook. All you need to do is write the check for the investment in the name of the 401(k) plan as the legal Trustee. No more waiting for waiting for another company to process or not even being able to make the investment at all.
2) Time as Your Friend — Let’s face it, a 401(k) plan, in most cases, will not make distributions to the individual until their retirement years. Real estate investing can factor in appreciation over a period of time. This expected appreciation can be short or long term. The 401(k) plan, by its very nature of when distributions will occur will permit, if necessary or desired, to play the “waiting game” on the investment. With other non-qualified sources of funds (e.g., non-retirement funds), you may need access to the funds in a shorter period of time.
3) UDFI — If structured correctly, the 401(k) plan will not be subject to Unrelated Debt Financed Income taxation for real estate investments (only).
Yes and No!
You see, when your 401(k) plan purchases a property it is owned solely by the plan and you cannot benefit in any way, shape or form from that investment. You cannot live in the property, vacation in that property or in any other way benefit from the plan owning the property. That is the answer to the “no” part of the question.
However, related to the “yes” part of the question, upon reaching retirement age (in most cases, 59 1/2 years or older), the property could be distributed from the plan and you would be taxed on the FMV (Fair Market Value) of the property. You would owe taxes due on this distribution; however, if this is something you wish to do and can afford and justify the tax associated with the distribution, you can do this. It is a great way for a plan to purchase your eventual retirement home.
Yes. The plan can purchase real estate, including vacation and foreign property. However as a disqualified person to the plan, you could not benefit from the relationship of the plan owning that property….in simple terms, you could not vacation to that property EVEN IF you paid the going rental rates.
Only and solely by the plan. You cannot personally pay for repairs and renovations, as the plan owns the property, not you. Think of it in common sense terms. The plan owns the property which means that all rental income, sales income, etc. must be returned to the plan. The opposite end of the spectrum is that all expenses associated with the property must be paid from the plan as well.
It is important for the self-directed account owner to keep this in mind when purchasing property. It is wise to anticipate future and unexpected expenses that may arise in ownership of the property.
Yes, the actual transaction of your IRA or 401(k) co-investing with others is not, in and of itself, a prohibited transaction. However, one must be careful to ensure that co-investing does not violate any Prohibited Transaction (e.g., co-investing with a disqualified party). Further, one should ensure that full due diligence to the transaction is carefully reviewed to legally protect the plan and its assets when co-investing with others.
Yes, your IRA or 401(k) can use funds as the down payment with the plan getting a loan for the remaining balance. Of course, only the plan can secure the non-recourse loan and a disqualified individual (e.g., you, the account owner) cannot personally guarantee the loan or assist in securing more favorable aspects (e.g., interest) for the loan. The non-recourse type of loan which means that if your plan fails to make payments, the only recourse the lender has is against the property itself. Finally, UDFI (Unrelated Debt Financed Income) taxes may apply, so you will want to confer with your tax professional about what taxes may be applicable to you.
Any and all income generated by the IRA or 401(k) owned property goes directly back to the plan. By doing so, you retain the tax-deferred or tax-free status of your plan. If you choose to distribute funds from the plan (e.g., for personal use), the distribution must come from the plan and appropriate taxes/penalties are applicable.
Your IRA LLC account will have its own banking account for the IRA LLC. Similarly, your 401(k) plan will be established with checkbook control as well. As such, you will simply write a check from either account as signor of the account…..as the LLC account manager for your IRA LLC or as Trustee of your 401(k). The property or asset will always be titled in the name of the plan or entity that holds the asset. For example, a property purchased by the IRA LLC will be titled in the name of the LLC, while a property purchased by a 401(k) plan will be titled in the name of the 401(k) plan or a 401(k) LLC (if established for the 401(k)).
Likely because your current broker won’t let you invest in real estate or other non-traditional assets through their custodian. Remember, just because the IRS and DOL permit investments into non-traditional assets (e.g., real estate), does not mean that IRA and 401(k) custodians must permit it. By establishing your IRA or 401(k) through Fulcrum Self-Directed, your plan and its documents will permit such investment opportunities.
Remember any limitation to invest in otherwise-permitted assets by the IRS and DOL is tied back to your current custodian limiting your freedom and flexibility to make such investments.
No, and there is no reason to even expand on this. Such a transaction would clearly be a Prohibited Transaction per IRC 4975 and you must not even consider this type of transaction. There are many cases where individuals have done this type of transaction…..much to their chagrin.
Absolutely. While probably no more than 3% of retirement accounts are invested into non-traditional investments such as real estate, that is changing. It is important to remember that when an IRA LLC or 401(k) or 401(k) LLC invests into the property, the property is titled in the name of the retirement plan (and, possibly, LLC), never in your personal name.
More and more individuals are becoming more and more frustrated with the options offered by their current custodians. Further, even if you enjoy your current investment options, most people would agree that it makes sense to a single retirement plan where they can combine their retirement plan accounts (if possible) and have one account where they can invest into both traditional AND non-traditional investments.
Within the broad category or Real Estate there are many options for investment:
- Residential Rentals
- Commercial Properties
- Mobile Homes
- Raw Land
- Real Estate in Foreign Countries
- Trust Deeds / Mortgages, and Mortgage Pools
With limited and noted exceptions, yes. One major exception is that a Roth IRA cannot be rolled over into a 401(k) plan, EVEN if the 401(k) permits Roth contributions and Roth conversions. However, many people unfortunately believe that an IRA can only be transferred/rolled over into another IRA…even when they qualify for the self-directed 401(k) plan.
Please note that there is also a restriction on the number of rollovers one can execute from an IRA in any given 12 month period of time. While this rule will become effective in 2015, it is important to keep in mind that while practically any IRA can be rolled over into a 401(k), there will be numerical limitations on the number of rollovers you can execute in one year, regardless of how many IRA accounts you have.
Many people and advisors equate a Self-Directed IRA and a Self-Directed 401(k) as being the same. They are not — they have similarities in that both can be established to achieve checkbook control, but the manner and avenues to get to that point are quite different. One major difference that an individual should know about is that a self-directed IRA requires a custodian, while self-directed 401(k) DOES NOT. The trustee of the Self-Directed 401(k) plan calls all the shots. For example, the self-directed 401(k) plan established for John Smith will be established as the “John Smith 401(k) PSP,” with John Smith, most likely, being the designated Trustee for the plan. John Smith, should he desire, can also designate a third party to serve as the Trustee of the plan.
Similar to the ‘ole Tom Cruise movie “A Few Good Men”, the question that is asked is “can you handle the truth?”
Well, bluntly speaking, the primary reason the investment community has no interest in losing control of the control they have over you and their ability to earn commissions. I mean, honestly, why would they want to. Think of it from another angle, if you were speaking to a real estate agent, they would probably always encourage you to purchase investment property vs. investing into mutual funds. Why? Because they would earn a commission. So, why would we expect our financial planners (if they are receiving commissions) to recommend that we invest in assets outside of their control?
Bottom line: why not have a plan where you can do both?!
- Traditional IRAs
- Sep IRAs
- Roth IRAs
- Coverdell Education Savings (ESA)
- Qualified Annuities
- Profit Sharing Plans
- Money Purchase Plans
- Government Eligible Deferred Compensation Plans
It is a step further towards putting you in full control of your 401(k). You don’t have to go to your financial institution to get approval of the investment and get a check written. You truly have a self-directed 401(k) because you have checkbook control. You are the legal Trustee of your plan and control its operation and investments.
Legally speaking, a self-directed 401(k) is no different than any other 401(k). Having a self-directed 401(k) simply means that you are allowed to direct the investments of the 401(k). Many financial institutions claim that they allow you to self-direct your 401(k) investments but then turn around and restrict what you can invest in. A truly self-directed 401(k) allows you to make the decisions without restriction. And, think of the benefits associated with having a plan where you can literally make traditional and non-traditional investments from one account….now, that is truly self-directed.
Well, you can fund the plan in different ways. Many people will initially fund the plan with rollovers from other plans. But, don’s lose sight of the fact that this is a plan for your self-employed business, so you will always be able to make employee elective and, potentially, profit share contributions once the plan has been established. Of course, you need to follow all IRS and DOL rules related to funding amounts and segregating funds within the plan based on the origin of the funds (e.g., profit share sub-account, rollover sub-account, pre-tax contributory sub-account, Roth contributory sub-account).
Most passive investments that your self-directed 401(k) might invest in are exempt from UBTI. Some examples of exempt type of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
When a tax exempt organization such as an 401(k) plan undertakes any development activities in connection with selling real estate, beyond passively placing the property for sale either directly or through a broker, the issue arises under Internal Revenue Code 512(b)(5)(A) whether the real estate is “property held primarily for sale to customers on the ordinary course of the trade or business.” An organization that engages in the sale of property to customers in the ordinary course of the trade or business is characterized as acting as a “dealer”.
Fundamental to considering whether an exempt organization (i.e. a 401(k) Plan) is a “dealer” of real property is whether the property itself is held “primarily” for resale to customers in the ordinary course of a trade or business. In Malat v. Riddell, 393 U.S. 569 (1966), the U.S. Supreme Court interpreted the meaning of the phrase “held primarily for sale to customers in the ordinary course of trade or business” under Internal Revenue Code Section 1221(1). The IRS has often applied the principles derived under Internal Revenue Code Section 1221 to rulings interpreting the language of Internal Revenue Code Section 512(b)(5). The Court interpreted the word “primarily” to mean “of first importance” or “principally.” By this standard, ordinary income would not result unless a sales purpose is dominant. Both the courts and the IRS concluded that a taxpayer may make “reasonable expenditures and efforts” (such as subdividing land, construction of streets, the provision of drainage, and furnishing of access to such a necessity as water, as part of the “liquidation” of an investment asset without being treated as engaged in a trade or business.
The UBTI generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.”
Trade or Business: In defining “unrelated trade or business,” the regulations start with the concept of “trade or business” as used by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.” Although Internal Revenue Code Section 162 is a natural starting point, the case law under that provision does little to clarify the issues. Because expenses incurred by individuals in profit-oriented activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212 , it is rarely necessary to decide whether an activity conducted for profit is a trade or business. The few cases on the issue under Internal Revenue Code Section 162 generally limit the term “trade or business” to profit-oriented endeavors involving regular activity by the taxpayer.
Regularly Carried On: The UBIT only applies to income of an unrelated trade or business that is “regularly carried on” by an organization (Solo 401(k) Plan investment). Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses. The requirement thus is met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.” Short-term activities are exempted if comparable commercial activities of private enterprises are usually conducted on a year-round basis (e.g., a sandwich stand operated by an exempt organization at a state fair), but a seasonal activity is considered regularly carried on if its commercial counterparts also operate seasonally (e.g., a horse racing track). Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if conducted without the promotional efforts typical of commercial endeavors. Moreover, if an enterprise is conducted primarily for beneficiaries of an organization’s exempt activities (e.g., a student bookstore), casual sales to outsiders are ordinarily not a “regular” trade or business.
Before it can be determined whether an activity is seasonal or intermittent, the relevant activity must be identified and quantified, a step that is often troublesome. The type of income that generally could subject a self-directed 401(k) plan to UBTI is income generated from the following sources:
- Business income generated via a passthrough entity, such as an LLC or partnership
- Income earned from a convenient store operated through a passthrough entity
- Income earned through an active business owned by an LLC in which the IRA is an investor
- Income from a real estate investment held through a passthrough entity that is treated as a business (inventory) instead of as an investment
Examples could include:
- In Brown v. Comr, 143 F.2d 468 (5th Cir. 1944), the exempt taxpayer owned 500 acres of unimproved land used for grazing purposes within its tax-exempt mission. Taxpayer decided to sell the land and listed it with a real estate broker. The exempt organization instructed the broker to subdivide the land into lots and develop it for sale. The broker had the land plotted and laid into subdivisions with several lots. Streets were cleared, graded and shelled; storm sewers were put in at street intersections; gas and electric lines were constructed; and a water well was dug. Each year 20 to 30 properties were sold. The court held that the taxpayer was holding lots for sale to customers in the regular course of business. The court identified the sole question for its determination as whether the taxpayer was in the business of subdividing real estate. The fact that the taxpayer did not buy additional land did not prevent the court from finding that the sales activities resulted in an active trade or business.
- In Farley v. Comr., 7 T.C. 198 (1946), the taxpayer sold 25 lots out of a tract of land previously used in his nursery business but now more desirable as residential property. Because the taxpayer made no active efforts to sell and did not develop the property, the court described the sale as “in the nature of the gradual and passive liquidation of an asset.” Therefore, the income derived from the sales represented capital gains income, rather than ordinary income from the regular course of business as in the Brown case.
- Dispositions of several thousand acres of land by a school over a period of twenty-five years does not constitute sale of land held primarily for sale to customers in the ordinary course of business and thus gains are excludable under Internal Revenue Code Section 512(b)(5) (Priv. Ltr. Rul. 9619069 (Feb. 13, 1996)).
- Developing or subdividing land and selling a large number of homes or tracts of land from that development in a given period.
- Buying a property/home rehabbing it and then selling it immediately thereafter when this was your sole intent (note: The activity must manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations). It is unclear whether the purchase and sale of one or two homes in a given year that were held for investment purposes would trigger UBTI.
Like an IRA, the tax advantage of a Solo 401K Plan is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.
What is Unrelated Business Taxable Income?
UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. The UBTI rules only apply to exempt organizations such as charities, IRAs, and 401(k) Plans. Congress enacted the UBTI rules in the 1950s in order to prevent charities from competing with for-profit businesses since charities do not pay tax giving them an unfair advantage over for- profit businesses. With the enactment of ERISA in 1974, IRAs and 401(k), who are considered tax-exempt parties pursuant to Internal Revenue Code Sections 408 and 401 respectively, became subject to the UBTI rules. As a result, if an IRA or 401(k) invests in an active business through an LLC or partnership, the income generated by the IRA or 401(k) from the active business investment will be subject to the UBTI rules.
In other words, a 401(k) Plan that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity. For example, if a self-directed 401(k) Plan invests in an LLC that operates an active business such as a restaurant or gas station, the income or gains generated from the investment will generally be subject to the UBTI tax. However, if the self-directed 401(k) Plan invested in an active business through a C corporation, there would be no UBTI since the C Corporation acts as a blocker blocking the income from flowing through to the self-directed 401(k) Plan. This is why you can invest IRA and 401(k) funds into a public company, such as IBM without triggering the UBTI tax. Remember that if an IRA or 401(k) Plan makes a passive investment, such as rental income, dividends, and royalties, such income would not be subject to the UBTI rules.
UDFI and The Solo 401(k) Plan
However, unlike a Self-Directed IRA LLC, in the case of a Solo 401(k) Plan, UBTI does not apply to unrelated debt-financed income (UDFI). The UDFI rules apply when a 401(k) Plan uses leverage to acquire property such as real estate. Pursuant to Internal Revenue Code Section 514(c)(9), a 401(k) Qualified Plan is not subject to the UDFI rules and, thus, the UBTI tax if nonrecourse leverage is used to acquire property such as real estate. With the UBTI tax rates at approximately 35%, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.
Exceptions to the UBTI Rules
There are some important exceptions from UBTI: those exclusions generally exclude the majority of income generating investment activities from the UBTI rules – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
What is an Unrelated Business?
For a Solo 401(k), any business regularly carried on or by a partnership or corporation of which it is a member/partner is an unrelated business. For example, the operation of a shoe factory by a pension trusts, the operation of a financial consulting business for high net worth individuals by a university, or the operation of an computer rental business by a hospital would likely be treated as an unrelated business and subject to UBTI.
UBTI & Real Estate Investments
Although there is little formal guidance on UBTI implications for Solo 401(k) Plans investing in real estate, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers. In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.
How Do I Avoid UBTI?
In general, if you make passive investments with your Solo 401(k) Plan, such as stocks, mutual funds, precious metals, foreign currency, rental real estate, etc the passive income generated by the investment will generally not be subject to the UBTI tax. Only if your Solo 401(k) Plan will be making investments into an active business, such as a retail store, restaurant, software company using a passthrough entity such as an LLC or partnership will your Solo 401(k) Plan likely be subject to the UBTI tax.
No. A solo 401k loan is permitted at any time and for any purpose using the accumulated balance of the solo 401k as collateral for the loan. A Solo 401K participant can borrow up to either $50,000 or 50% of their account value – whichever is less. This loan has to be repaid over an amortization schedule of 5 years or less with payment frequency no less than quarterly. The interest rate must be set at a reasonable rate of interest – generally interpreted as prime rate + 1%. As of 9/1/13 prime rate is 3.25%, which means participant loans are to be set at the very reasonable Interest rate of 4.25%. The Interest rate is fixed based on the prime rate at the time of the loan application.
No. The most significant cost benefit of the self-directed 401(k) is that it does not require the participant to hire a bank or trust company to serve as trustee. This flexibility of the plan and its plan documents permits the self-employed business owner to wear both hats….one as the participant and one as the Trustee of the plan.
This means that all assets of the 401(k) trust are under the sole authority of the self-directed 401(k) Trustee. This permits you to eliminate the expense and delays associated with an either an IRA or 401(k) custodian, enabling you to act quickly when the right investment opportunity presents itself….and, save by having no custodian fees.
One of the benefits of a Self-Directed 401(k) is that the business owner can make both employee elective deferral contributions and employer profit share contributions. To state it more simply, contributions can be made by both the participant and the business. Employer profit share contributions can be made even if the self-employed individual is a sole proprietor.
Employee Elective Deferrals (your contributions)
For 2014, the participant in a plan (whether sole proprietorship or incorporated entity) can contribute up to $17,500 per year. These contributions can be made in either a pre-tax or Roth (after-tax) basis….and, even a combination of the two. If the participant is over the age of 50, an additional $5,500 can be contributed (up to $23,000) as part of what the IRS calls a “catch-up” provision. This level of contribution can be up to 100% of the individual’s self-employment income.
Important note: While you can participate (e.g., you are a participant in your self-employed side business and a 401((k) participant in a W-2 employer’s plan) in more than one 401(k) plan as a participant, you must coordinate your employee elective deferral contributions….in simple terms you must still abide to the $17,500/$23,000 employee elective deferral.
Profit Sharing (Employer Contributions)
Through the role of employer, an additional contribution can be made to the plan in an amount up to 25% of the participant’s self employment compensation IF the business is an incorporated entity or 20% of the individual’s compensation if they are a sole proprietorship.
What is Your Total Potential Limit
If you qualified for the maximum contributions to your plan, the potential maximum contributions to your plan can reach $52,000 per year (for 2014) or $57,500 for persons over age 50.
You Say Your Spouse if Also Employed in Your Business?
If your spouse is a legitimate participant in the business, not only can the spouse rollover their funds into the plan, but the spouse can also make contributions to the plan based on the compensation they receive. Now, if the participants qualify for the maximum contributions, the couples’ annual total contribution can be $104,000 for 2014 or $115,000 if both spouses over age 50.
Let’s use an easy illustration which demonstrates one’s ability to maximize contributions. John Doe , age 40, is self-employed and operates his business as an S-Corp. The business pays John $100,000 per year in compensation.
For 2014, the maximum deductible contribution John can make to his self-directed 401(k) account would be $42,500. This is broken down into employee elective deferrals of $17,500 and a business profit share contribution of $25,000 (25% of $100,000).
Let’s use the same numbers for the sole proprietor. For 2014, the maximum deductible contribution John can make to his self-directed 401(k) account would be $37,500. This is broken down into employee elective deferrals of $17,500 and a business profit share contribution of $20,000 (20% of $100,000).
Your self-directed 401(k) can invest in practically any asset. Specifically, the individual is prohibited from investing into collectibles but otherwise can invest into any asset class they desire…and, provided, the plan documents for the 401(k) permit.
The following assets are common examples of the types of investments that a 401(k) plan may consider:
- Residential or commercial real estate
- Raw land
- Foreclosure property
- Mortgage pools
- Private loans
- Tax liens
- Private businesses
- Limited Liability Companies
- Limited Liability Partnerships
- Private placements
- Stocks, Bonds, Mutual Funds
- Most currencies
Qualifying for a self-directed 401(k) plan is not difficult to qualify for, BUT it also does not permit one to establish the 401(k) plan just because they feel it is in their best interests. The IRS has identified conditions that must be met to qualify for any individual 401(k) plan, self-directed or not.
Further, keep in mind that to be considered self-employed and eligible to your self-directed 401(k) plan you must:
- Have the presence of self-employment activity, and presence of self employment activity.
- Not have any full-time employees.
Must Your 401(k) Generate Income?
This is always an interesting question as, in and of itself, a business is not required to earn income to justify the establishment of a 401(k) plan, self-directed or not. There can certainly be conditions where there is legitimate self-employment where, possibly, income (or much income) is realized. Does that mean that the person is not self-employed? Of course not.
However, the lack of income (and contributions) can be a slippery slope if a plan were to be audited. Why? While the general consensus is that the IRS’ main concern is that an individual is operating a legitimate business that is being operated to generate income/profit, there could be misunderstandings on this topic.
As an example, if you started a new business and rolled over $500,000 into your new 401(k) plan from another plan. Now, if you were operating your business for five years, you generated income and you never made a contribution, would the IRS question your ability to legitimately sponsor your plan? Possibly. It could be viewed that the plan was established more to rollover the other funds vs. operating your 401(k) plan with the intent of benefiting your retirement by making contributions to the plan from your self-employment activities. Again, it can be a slippery slope.
NO Common Law Employees!!
This is another consideration which can certainly cause compliance mistakes within a plan, and it is is a very simple happenstance that many can intentionally or unintentionally violate.
When you are establishing your plan, it is an individual plan! For it to be considered an individual plan, it cannot have any common law employees other than, potentially, a spouse that works for the business as well. The documents for the 401(k) plan are written to only permit one participant. Further, even IF the plan documents are amended to permit additional participants, annual non-discriminating testing on the plan must be executed and an annual Form 5500 for the plan must occur.
Unfortunately, a self-employed business owner may unintentionally hire what the IRS may consider a common law employee and still consider themselves self-employed. This unintended violation can create significant problems for the plan’s compliance and qualification requirements. The IRS has identified what defines a “common law” employee but, generally speaking, any employee hired as noted below will not be considered a common-law employee if:
- the employee is under the age of 21;
- the employee works less than 1000 hour per year; and,
- the employee is a non-resident employee.
Keep in mind that your business can employ individuals if they are under the age of 21, work less than 1,000 hours per year and are independent contractors retained by your business.