Solo 401k Plans v Self Directed IRAs

12 Replies

Hello BP Community,

I am looking to do my first property flip, but am needing to get a little creative on the financing side due to minimal cash on hand. Although my liquidity is limited, I do have a decent amount of capital sitting in retirement accounts. Consequently I have been looking at a Self Directed IRA as a means to fund my flip. Just as I was thinking this is the route to go, I read about the Solo 401(k) plan and found that it is exempt from UDFI (and consequently UBTI) resulting from the financing of the asset. A few questions regarding the Self Directed IRA and Solo 401(k):

-Am I eligible for a Solo 401(k) if I do not yet have any self-employment income? I am currently employed full-time, and have not yet begun generating income from real estate.

-I have read conflicting accounts on whether the proceeds from the sale of real estate in a Self Directed IRA and/or Solo 401(k) are subject to UBTI. To be clear, is sale of real estate considered 'business income' or 'investment income'? Based on what I've read, business income IS subject to UBTI and investment income IS NOT subject to UBTI. Not sure if this is accurate or not...

Any clarification you could provide on these topics would be greatly appreciated!

-Conner

@Conner Parsons

Without qualifying self-employment, you are not eligible for a Solo 401(k) plan.  

A self-directed IRA could invest in a flip project but it would not be "your" project. The IRA would own the property, pay for all expenses and receive all income. A self-directed IRA is not money for you to use to invest in real estate. Rather, it is a means to invest the tax-sheltered IRA into real estate instead of into conventional assets such as stocks, funds, etc. Your role is limited to general administration of the IRA such as signing contracts, paying bills and receiving income from investments into the IRA. You may not personally benefit from the IRA income (other than growing your retirement savings) nor may you add value to the IRA through the provision of goods or services.

An IRA would be subject to UDFI taxation if it used debt-financing.

If the IRA is flipping properties on a regular or repeated basis, then it is acting like a business and subject to UBIT taxation. This tax is designed to protect taxpaying businesses from unfair competition by tax-exempt entities. This tax only applies to active trade or business activities, not to passive income such as rentals, interest on hard money loans, etc.

I would not recommend leveraged flips in an IRA. It will be complicated and the returns would likely be diminished to the point of not being the best investment for the IRA.

Using the IRA for hard money lending to other investors, or to acquire properties you intend to have the IRA hold over time as rentals would be more productive approaches.

@Conner Parsons

A Solo 401k plan requires self-employment activity to adopt the plan. You will need to be self-employed (or own a business with no full time non-owner employees) before you can create a Solo 401k plan.

IRAs are subject to UBIT for investments into an active trade or business and are also subject to UDFI for debt-leveraged investments.

Solo 401ks are subject to UBIT for investments into an active trade or business but are generally not subject to UDFI for debt-leveraged real estate investments.

Conner,

if you are personally considering making investments - you can't use your retirement funds for that (IRS rules don't allow that). If you set-up self-directed IRA or 401k - your retirement plan can make investment on it's own, without your personal involvement (again, not allowed by the IRS rules). You must understand the UBIT impact if you consider flipping in your IRA. 

Dmitriy Fomichenko, Broker
(949) 228-9393

@Brian Eastman @Justin Windham @Dmitriy Fomichenko

Thanks for the replies. Sounds like if I plan on using retirement funds, I need to a) establish self-employment income and b) invest passively in rentals or with a third party.. I really like the fact that you can borrow from the solo 401k too. What (if any) restrictions are there on the  uses for funds borrowed from a solo 401k?

I've recently set up my solo 401k to use as either a personal loan to myself which I pay back over 5 years at 1 point above market rate (got to pick that myself). Biggest limit there that you'll need to keep in mind for what you're doing is that a solo 401k allows you to borrow 1/2 of your account up to a max limit of 50k. Not much if you're doing big deals but I'm working individual mobile homes so it was more ideal than the SDIRA which is up to any amount but only for 60 days. Check in the fileplace a document I uploaded called 'comparison of self directed 401k and ira.' I put it together myself comparing the two because I kept getting the information confused but I think its correct for the most part.

@Conner Parsons

You do not need to become self-employed, only if you wish to use the Solo 401(k) option. A checkbook IRA is also very flexible as an investment tool. Only become self-employed if that makes sense for its own reasons.

With a Solo 401(k) you can borrow the lesser of $50K or 50% of your plan value, for a term of 5 years.  So long as you make regular amortized payments on the note and repay the plan, you can use the money for any purpose. It is your money at that point.

@Connor Parsons

To learn about what is considered self-employment activity for participating in a solo 401k plan, please see the following. 

https://www.irs.gov/businesses/small-businesses-se...

Following are the similarities and differences between the solo 401k and the self-directed IRA.

The Self-Directed IRA and Solo 401k Similarities

  • Both were created by congress for individuals to save for retirement;
  • Both may be invested in alternative investments such as real estate, precious metals tax liens, promissory notes, private company shares, and stocks and mutual funds, to name a few;
  • Both allow for Roth contributions;
  • Both are subject to prohibited transaction rules;
  • Both are subject to federal taxes at time of distribution;
  • Both allow for checkbook control for placing alternative investments;
  • Both may be invested in annuities;
  • Both are protected from creditors;
  • Both allow for nondeductible contributions; and
  • Both are prohibited from investing in assets listed under I.R.C. 408(m).

The Self-Directed IRA and Solo 401k Differences

  • In order to open a solo 401k, self-employment, whether on a part-time or full-time basis, is required;
  • To open a self-directed IRA, self-employment income is not required;
  • In order to gain IRA checkbook control over the self-directed IRA funds, a limited liability company (IRA LLC) must be utilized;
  • The solo 401k allows for checkbook control from the onset;
  • The solo 401k allows for personal loan known as a solo 401k loan;
  • It is prohibited to borrow from your IRA;
  • The Solo 401k may be invested in life insurance;
  • The self-directed IRA may not be invested in life insurance;
  • The solo 401k allow for high contribution amounts (for 2017, the solo 401k contribution limit is $54,000, whereas the self-directed IRA contribution limit is $5,500);
  • The solo 401k business owner can serve as trustee of the solo 401k;
  • The self-directed IRA participant/owner may not serve as trustee or custodian of her IRA; instead, a trust company or bank institution is required;
  • When distributions commence from the solo 401k a mandatory 20% of federal taxes must be withheld from each distribution and submitted electronically to the IRS by the 15th of the month following the date of each distribution;
  • Rollovers and/or transfers from IRAs or qualified plans (e.g., former employer 401k) to a solo 401k are not reported on Form 5498, but rather on Form 5500-EZ, but only if the air market value of the solo 401k exceeds $250K as of the end of the plan year (generally 12/31);
  • When funds are rolled over or transferred from an IRA or 401k to a self-directed IRA, the amount deposited into the self-directed IRA is reported on Form 5498 by the receiving self-directed IRA custodian by May of the year following the rollover/transfer.
  • Rollovers (provided the 60 day rollover window is satisfied) from an IRA to a Solo 401k or self-directed IRA are reported on lines 15a and 15b of Form 1040;
  • Pre-tax IRA contributions on reported on line 32 of Form 1040;
  • Pre-tax solo 401k contributions are reported on line 28 of Form 1040;
  • Roth solo 401k funds are subject to RMDs;
  • A Roth 401k may be transferred to a Roth IRA (Note that from a planning perspective, it may be advantageous to transfer Roth Solo 401k funds to a Roth IRA before turning age 70 ½ in order to escape the Roth RMD requirement applicable to Roth 401k contributions including Roth Solo 401k contributions and earnings.);
  • Roth IRA funds are not subject to requirement minimum distributions (RMDs);
  • The fair market value (FMV) of assets held in a self-directed IRA is reported on form 5498;
  • The fair market value of assets held in a solo 401k are reported on Form 5500-EZ;
  • At termination, the solo 401k is required to file a final Form 5500-EZ and 1099-R; and
  • At termination, the self-directed IRA is only required to file a form 1099-R.

Thanks @George Blower . Good info.

Is the loan from the solo 401(k) able to be drawn down and paid back repeatedly, similar to a line of credit, or must funds be distributed in one lump draw and paid back over time, similar to a term note?

@George Blower

Also, would I have to wait until I file taxes as either part-time or full-time self-employed in order to open the solo 401(k) or could I open the solo 401(k) as soon as I can establish income from my self-employed work?

Conner, 

The loan from the 401k must be repaid over a period of 5 years using amortized payments. You can chose monthly or quarterly payment schedule. The interest rate is typically set at Prime + 1%. If you wish to take another draw that would mean that you need another loan. If your plan documents allow for multiple loans - then you should be able to have more than one loan.

Regarding your Solo 401k eligibility question - income or tax filing are not the requirements. You are required to have legitimate self-employment activity in order to establish the plan. And you would have to show profit in order to make contributions. 

Dmitriy Fomichenko, Broker
(949) 228-9393

@Conner Parsons

Good question. The rules state you simply need to be pursuing self-employment activity in order to open a solo 401k; therefore, yes you could open a solo 401k even before your business makes a profit. However, from a long-term perspective you generally need to continue performing self-employment activity in order to continue with the solo 401k plan.

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