The December 14 edition of USA Today included a letter headlined, “Stay Away From 401(k)”. Jim Hitt, CEO of American IRA, shares his knowledge on this subject to let everyone know that a self-directed 401(k) is actually like a self-directed IRA on steroids!
Lots has been written about the tremendous benefits of the self-directed IRA. IRAs have terrific upsides for the investor, including tax deferral (for traditional IRAs), asset protection of up to $1 million under federal law, and higher in some states, and the flexibility to invest in a wide variety of assets not typically available in an employer’s 401(k) plan.
There’s one drawback to self-directed IRAs, though: They can’t contribute enough. At best, they can contribute $5,000 to an IRA, plus another $1,000 in catch-up contributions for those over age 50.
If they like the idea of taking control of their retirement assets with a self-directed IRA, though, then they’ll love the idea of doing the same thing with a 401(k).
Solo 401(k) Basics
About a decade ago, the financial industry responded to a lot of popular demand from sole proprietors and owner-operators of very small businesses – often with just one owner and employee, or managed solely by the owner and his or her spouse, and introduced the Solo 401(k). This plan had all the same advantages of traditional 401(k) plans, but stripped down some of the administrative requirements to make them realistic for very small companies.
If they are a small business owner with some free cash flow, they can invest far more in a Solo 401(k) – self-directed or otherwise – than they can in an IRA. Specifically the 2012 pre-tax contribution limit for Solo 401(k) plans is $17,000, plus another $5,500 for contributors over age 50, compared with a maximum of $5,000 ($6,000 for those over age 50) for IRA investors. Furthermore, there is no income threshold to meet when it comes to contributing to a Solo 401(k). They can contribute to a Solo 401(k) no matter how much income they earn. And if they are the only employee, there are no “top hat” concerns they need to worry about that would restrict their contributions if some of their employees didn’t contribute. Their contribution ensures they have a participation rate of 100 percent!
Depending on the circumstances, and whether they are an owner-employee of their own corporation or whether they are technically self-employed, they may be able to contribute even more in a Solo 401(k) than to a SEP-IRA, because of the way self-employment taxes are calculated.
Self-Directed Solo 401(k)s
Because they own the company, they can also set up the plan the way they see fit – and draw up the plan rules to suit their own style of investing and their own expertise. Many small-business owners don’t realize that by using a self-directed Solo 401(k), they can avail themselves of the same flexibility and investment choices as they can get in a self-directed IRA.
This means that they can use their Solo 401(k) to invest in any of these investment options on a pre-tax basis:
- Real estate, including raw land and foreign real estate
- Privately held small business
- Farms and ranches
- Gold and silver
- Tax liens
- Private equity
- Private lending
… and much more! In fact, they are only limited by a few restrictions on what they can invest in: They can’t invest in collectibles, alcoholic beverages, gems and jewelry, and anything in which they, their ascendants and descendants and their spouses and their financial and accounting advisory team have a direct interest.
Benefits of Solo 401(k) Plans
Many planners are surprised to learn that IRA accounts are subject to a little-understood tax called UBIT – or ‘unrelated business income tax.’ This may apply, for example, if an IRA receives money from an ownership interest in a partnership: The IRA itself is still exempt from income tax and capital gains tax. But the IRS considers the income from the partnership itself to be taxable, and will come after their IRA to collect.
Another factor that could lead to UBIT in an IRA is ownership of assets which they purchased with debt. If they sell at a profit, the IRS will assess a portion of that gain as unrelated debt-finance d income, or UDFI.
Their Solo 401(k) is not subject to UBIT taxes attributable to UDFI on leveraged real estate. So if they plan to borrow money to buy real estate for their retirement account, they may want to consider using a Solo 401(k) plan.
The law allows them to borrow from their Solo 401(k) for any purpose, provided the plan is set up at the outset to allow loans. This could be a valuable source of short-to-medium term capital for small businesses and their owners – and they can borrow from their 401(k) regardless of their credit history or rating. They can also complete the transaction and have the cash in hand within days – and not have to tangle with bank loan officers for weeks. However, they must pay back any money they borrowed within five years, plus interest, or they will become subject to income taxes and penalties on the outstanding loan balance.
As of 2012, the maximum salary deferral contribution to a Solo 401(k) is $17,000, plus an additional $5,500 per year if they are over age 50. This is a substantially larger limit than those available in IRAs, without all the income restrictions. If they are looking to shelter a substantial amount of money from taxes, while still realizing the benefits of charting their own investment course, they may consider a Solo 401(k) plan.
The higher contribution limit can make a big difference when they need to make a repair or capital investment in a property or asset they own in a Solo 401(k). Suppose part of their roof started leaking in a rental property in their IRA and they needed to spend $10,000 to get it fixed. That means they would either need to have $10,000 in cash lying around within their IRA (or roll it over from another account), or their IRA would have to borrow the cash to make up the difference between the cost of the repair and what they could contribute for that year. If they couldn’t find a non-recourse loan, they would be out of luck until at least January of the following year, when they could make another contribution – provided they met the income threshold.
In a Solo 401(k) plan, however, if they didn’t have the liquidity in the plan to begin with, they could easily cover the expense with this year’s allowable cash contributions, which are more than 3 times larger than the allowable IRA contributions – and not subject to an income test.
Designated Roth Accounts
If they choose, they can elect to have a portion of their employee deferral go to their Solo 401(k). These designated Roth accounts are treated like a Roth IRA for tax purposes, as well: They don’t get an up-front tax deduction on contributions. But provided the money remains in the 401(k) designated Roth account for five years or more, it grows tax free, forever. There is no income limit to contribute to a Solo 401(k) designated Roth account.