The Best Retirement Plans for Investors: The Battle Between the Solo(k) and IRA

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There has been a lot of buzz in the real estate community about some of the benefits of “QRPs.”

What exactly are QRPs?

Do these benefits really exist?

Or is it another scam of the month that we should all be weary of as real estate investors?

The good news is… QRPs do actually offer a lot of the tax benefits that a traditional IRA does not, and may be one of the best retirement plans for investors. In this article, we will discuss some of the key differences and what you need to know as we approach the end of the 2013 year.

To start off, there are a handful different “types” of QRPs (qualified retirement plans). Some of the most commonly seen are 401(k)s, Simple 401(k)s, Safe-Harbor 401(k)s, and Self-Directed Solo(k)s. Each of these types of qualified retirement plans have different attributes in terms of contribution amounts, limits, and investment options. Of the above, the most commonly used vehicle for real estate investors is the Self-directed Solo(k).

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Is the Solo(k)s the Best Retirement Plan?

There are several key differences to note when comparing the Solo(k) to the traditional IRA. One is the difference in contribution limits. While a traditional IRA generally has an annual contribution limit of up to $5,500 per person per year, the Solo (k) can allow for retirement contributions of $50,000 or more per person per year. Businesses with a spouse on the payroll can also contribute to the Solo(k). This means potentially being able to have retirement contributions of $100,000 or more each year that can reduce your taxes and be used for real estate investing. As you can see, this is significantly higher in dollar amount as compared with an IRA or a Roth IRA. This is a very significant difference especially if you are someone who is looking to maximize your tax deferred investing potential.

Another advantage that a Solo(k) has over the IRA is with respect to tax free Roth money. You may be familiar with the current income limitation that is in place to disallow higher income taxpayers to make contributions to Roth IRAs.  The Solo (k) on the other hand, typically comes built-in with a Roth bucket.

Taxpayers generally can contribute to the Roth bucket of their Solo(k) without any income limitations. Essentially, the Roth Solo K allows businesses owners, regardless of their income level, to contribute and participate in Roth Solo K contributions. Depending on your age, income, and investment preference, the ability for a high income taxpayer to have a Roth Solo(k) growing tax free may be one of the best gifts from the IRS.

On the topic of investment preferences, those of you who have self-directed IRAs may be familiar with its restriction from investing funds in S Corporations. Fortunately for a loophole in the tax law, you can use your Solo (k) money to invest in S Corporations. In addition to the traditionally off-limit S Corporation, Solo (k) funds can also invest in most other types of legal entities such as LLCs, Partnerships, and C Corporations.

On top of the seemingly endless types of investments offered by the ability to self-direct, Solo(k) plans also allow for an almost limitless opportunity to invest in most types of legal entities.

Who Can Have a Solk(k)?

Now that we’ve  talked about some of the benefits of the Solo(k), let’s discuss “who” can have a Solo(k).

The Solo(k) is a retirement plan designed for the small business owner.

How small is small you may be wondering? You qualify if you are a business owner or self-employed individual with no full time employees other than you and your spouse. One thing to note is that employing independent contractors in your business does not disqualify you from establishing a Solo 401k. Sole proprietors, independent contractors, C corporations, S corporations, partnerships and LLCs can qualify for this plan if the above requirement is met.

Two Deadlines for the Solo(k)

If you feel that a Solo(k) is a great investment vehicle for you, then you must be mindful of the two following deadlines:

1. The account itself must be set-up before December 31, 2013 in order for contributions to reduce your 2013 taxes, and

2. If you plan on making employee contributions, the employee deferral must generally also be made by December 31, 2013.   Keep in mind, you may also be able to make employer contributions to further decrease your tax bill for 2013.  The good news is that these contributions may be made as late as September or October of 2014 to still count as a tax deduction for 2013….the main thing is that the account itself must be set-up by December 31, 2013.

Here are a Few Key Take-away Points:

  • There are several different types of QRPs. The most common type used by real estate investors is the Solo(K)
  • Solo(k) can allow the account holder to potentially contribute more towards retirement each year than the traditional IRA
  • Solo (k) has more flexibility for investment choices as compared to an IRA and can allow taxpayers to put money towards a Roth bucket regardless of their income level.
  • Solo(k)s are available to small businesses as defined by the IRS. No legal entity is required to set-up a Solo(k).
  • Be wary of deadlines to open accounts and make contributions. There are ways to take a deduction up front and contribute at a later date if you set-up your plan correctly.

If you do not qualify for the Solo (k), don’t be discouraged. As we discussed earlier, there are a handful of other Qualified Retirement Plans (QRPs)  that offer similar benefits which you may be able to take advantage of. It’s best to speak with a professional about what the best retirement plans are for you.

Retirement investing is one of the most powerful tools when it comes to tax savings. Having the right type of retirement account could be the key to supercharging your wealth building.
Photo Credit: StockMonkeys.com

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

29 Comments

  1. Jason-you don’t need to have minimum income to open a 401k, you do need to be expecting to make active income. Contributions are calculated based on earned income so that income will determine how much you can fund each year.

    • Dmitriy Fomichenko

      Contributions to the Solo 401k plan are not required every year. However, the plan will not be considered qualified if it appears from surrounding facts and circumstances that it was established as a temporary program. A plan will be considered temporary if substantial and recurring contributions are not made.

      A plan will be considered permanent even though contributions are not made every year as long as substantial contributions are being made occasionally.

  2. I know the first answer to this will be my financial planner, but if I don’t feel that he is up to speed on this, are there companies that specialize in this type of planning?

    • Hi Geoff:

      Two great places to start your planning would be your CPA (they can tell you if you qualify and if not what are potential ways to qualify if any). Also great IRA custodian companies can assist with this if you are looking to self-direct into real estate or other alternative assets. There are a lot of great custodians out there for example uDirect IRA Services.

  3. Great article Amanda, and certainly a great tool!

    I know you indicated a custodian isn’t required (as opposed to a self-directed IRA), but what about updates in the law? I am being told by one of the companies that set up Solo 401Ks that they “stay abreast of the changes in the law that sometimes require changes to the wording in the plan in order to keep its “qualified” status.”

    They offer that I can pay them a fee for these changes when they occur (hundreds of dollars each time), or to pay $29/month and then whatever changes come about, I don’t have to pay anything extra for them to provide the updated wording. Of course if no changes come about for a couple of years I’ve still paid them the monthly fee, so I’m trying to get an idea of which way would be better (less expensive).

    • Hi Dawn:

      Great question. This depends on your personal situation. The way I advise clients is that if you are someone who likes to stay updated on tax changes and if you already have a good understanding of self-directed investing rules, then it may be ok to be your own custodian. Alternatively, if your CPA is someone who is very well-versed in this area and they do not need to charge you significant fees to consult with you on these matters, then self-custodian may be ok. Otherwise, the fee you pay an IRA company to be your custodian is very well worth the cost because they may be able to help protect you and your retirement funds from making costly mistakes.

    • Dmitriy Fomichenko

      Dawn,

      Regardless whether the plan has a custodian or you as a trustee manage and direct plan assets and investments, plan documents must be updated in order for the plan to maintain its qualified status. The updates include interim amendments and plan restatements.

      In the past the restatement cycles have been somewhat disorganized. The IRS has now created a systematic six-year cycle. Pre-approved plans must be restated every six years to incorporate the interim amendments and any discretionary amendments that have been adopted since the last restatement. At the end of this six-year period, there will be a two- year window in which to update the plan document.

  4. Great post! We are owners of 5 apartment buildings and one piece of mining land that is all bundled under an LLC that my wife is managing member of. While we have on site managers, and in some cases, a firm that handles tenants and accounting, she is actively engaged in decisions on a daily basis and works 40-50 hours per week on the various properties. What would she need to do to meet the definition of active income?

    • Bill:

      If your goal is to have active income in order to open and contribute to a SoloK then it could make sense for the LLC to pay your wife some management fees. Management fee income is considered active income for retirement contribution purposes. Keep in mind however that typically active income is subject to higher overall taxes than rental income so be careful in terms of how much management income is shifted to be active. This may be something you can still do before year-end but I highly recommend you get together with your CPA to have them calculate the overall tax impact for you to see if this strategy makes sense.

  5. I just set up my new solo 401k last week–easy as pie with Charles Schwab and it’s free. I can’t invest in real estate through that plan but that’s o.k. because I really want to start beefing up my stock portfolio. I have a rental property held in a custodial IRA with Equity Trust, which is pretty expensive. My goal now is to be 50-50 between stocks and real estate.

  6. Thank you for the article…great info!
    I have been putting off starting up a self-directed IRA and now I’m glad that I have because the Solo(k) seems like a better option.

    Considering that the Solo(k) provides a substantial increase in contribution limit, are there other products out there that provide even higher contribution limits while allowing similar investment flexibility?

    I want to make sure that I’m starting the right retirement account, one that offers the ability to invest in real estate and allows the largest contributions.

    • Mike-potentially there could be other retirement accounts that may generate larger contributions for example defined benefit plans. Contributions for these types of plans are based on actuarial calculations based on age and income so generally for “more mature” taxpayers these can potentially provide much higher contribution limits. For example we are looking at a 70 year old client potentially putting in over $200k for his plan. Check with your CPA to have them run the #s for you for comparison.

  7. Good info, but you didn’t address the huge advantage of being able to roll old employer 401k’s, IRAs, and pension plan payouts (lump sum distributions) into a solo 401K. This is the real beauty of it for the huge percentage of investors that have significant dollars in these old accounts from past jobs.

    One can establish a very small and simple business such as being a distributor for a nutritional product, thus enabling them to roll potentially hundreds of thousands (or more) of dollars into a soloK.

    This is a far better option than using a SDIRA or SDIRA/LLC for these rollover moneys. The soloK doesn’t require an LLC to be set up in order to have checkbook control, there is no addtional UDFI tax when the plan borrows (as there is with an IRA), and you can borrow up to $50k to use for any purpose, among other advantages.

  8. If you have or feel you may have employees at some point can you work around that?
    Can I set up a separate entity that has a management or consulting role that only employs me and my wife and legitimately set up this type of plan?

    • Hi Shaun

      The fact that you anticipate having employees in future years does not disqualify for you the account. You can still set up and contribute to it for this year and maximize your contributions as long as the other requirements are met.

      Now once you do have other full time employees in future years you just may need to change your plan into a regular 401k before you make future contributions. You can always keep your SoloK open but you just may not be able to fund it. Lastly, yes you may have other entities or income that allow you to still contribute to a soloK of your own even if you have employees in your company. That gets a bit tricky and needs more advanced planning as there are controlled group rules that you need to plan around.

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