Possibilities & Limitations
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..
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 🙂
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.
“Self-dealing” occurs when you (or any other person who is considered to be disqualified to the plan) benefit in some way by being involved in the transaction. Please note that the IRS does not prohibit you from managing the plan’s investments as it benefits you in retirement; however, you cannot be personally benefiting from those activities or the investments that the plan makes. Always keep in mind that, similar to any trust (which is what a qualified 401(k) plan is), as Trustee you can make any and all decisions related to the plan as long as you follow all IRS and DOL regulations and you do not benefit in any manner from serving in this capacity.
There is a clear, legal distinction between your 401(k) and you individually. While the plan is established for your benefits in retirement, there are strict rules for the manner in which you much operate the plan. You are empowered, as Trustee, to make investment choices, but you must follow the rules associated with the operation of the plan. The plan is the plan, meaning the plan is not you! You are merely the legal Trustee of the plan and its operation.
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.
Here is clear distinction between an IRA and a 401(k). If an IRA leverages (borrows) funds to purchase an investment, there will be taxes (UDFI) due on the profit with the investment which is attributable to leveraged funds. With the 401(k) purchasing real estate (only) with leveraged funds, no such taxes on profits utilizing leveraged funds is applicable. Therefore, UDFI does not apply. This is a tremendous benefit of a 401(k) over an IRA IF the account owner is wishing to leverage investments.
Not in most cases. If a Self-Directed 401(k) buys a piece of property and then sells it at a profit, the gains stay within the Self-Directed 401(k). Now, it is a matter of whether you made the investments with Traditional (pre-tax) funds or Roth funds. If Traditional, then your gains will be tax-deferred. If Roth, your gains will be tax free.
Further, as a reminder, you need to keep all Roth funds segregated and separate from pre-tax funds within the plan.
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.
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.
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.
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).