We know that you have questions. That is why we have listed below some of the frequently asked questions:
Is a Solo 401k Subject to UBTI or UDFI?
Even though a solo 401k can invest in most things, certain investments can trigger immediate tax concerns. The two main concerns for solo 401ks relate to income from a trade or business that is regularly carried on and income generated from debt-financed property. These are called: (1) unrelated business taxable income (or “UBTI”); and (2) unrelated debt financed income (or “UDFI”).
Unrelated Business Taxable Income
UBTI is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization (the 401k trust), less any deductions associated with carrying on the trade. The business or trade itself needs to be “regularly carried on” in order to trigger UBTI.
So in most situations, UBTI occurs when a solo 401k owns a portion of an actual operating business (service business, manufacturer, retailer, etc). Rental income from real estate is specifically excluded in computing UBTI, but may be subject to UDFI (discussed next). Interest income, dividends, royalties, annuities and other investment income are also typically exempt from UBTI but can be subject to other limitations such as UDFI.
Unrelated Debt-Financed Income
UDFI is another important concern. It is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the tax year. It also includes gains from the disposition of such property. UDFI applies to corporate stock and tangible personal property. But it is most often encountered when investing in real estate.
In practice this means that if your solo 401k acquires a rental home for $200,000 with a $50,000 down payment and obtains a $150,000 loan to finance the property, approximately 75% of the income generated by the property itself would be subject to UDFI. The UDFI calculation uses the percentage of average acquisition indebtedness for a tax year divided by the property’s average adjusted basis for the year (average debt/average basis).
But here’s a big difference between an IRA and a solo 401k. When an IRA buys leveraged real estate it creates UDFI and taxes must be paid pursuant to Internal Revenue Code Section 514 (subject to limitations). But a solo 401k is generally exempt from UDFI.
Do I Have to Be Self Employed to Establish a Solo 401k?
Yes. It can be either on a full time or part time basis. A participant can be employed by an outside company. A person may even participate in an employer’s 401k plan in conjunction with their own solo 401k plan. However, they are still subject to rules governing maximum contributions.
Self-employment can take different forms. It would typically include ownership and operation of a sole proprietorship, Limited Liability Company (“LLC”), Corporation (including C Corps and S Corps) and a Limited Partnership where the business itself intends to generate profit (earned income).
Based on compensation and profits of the business, there are certain contribution limitations. Generally, you are considered eligible by the IRS if the business is being conducted with the intention of generating profits.
How Much Can I Contribute to a Solo 401k?
Solo 401k allow for two types of contributions: (1) employee contributions; and (2) employer contributions. Both types of contributions have certain maximum amounts and other limitations.
- Employee Contributions. These are often called “elective deferrals” or “employee deferrals”. If you are under the age of 50 you can contribute a maximum of $18,000 and if you are over 50 you can contribute an additional $6,000 (total of $24,000). However, these amounts are limited to 100% of compensation or “earned income”.
- Employer Contributions. An employer can contribute up to 25% of compensation which is defined in the plan document. Typically it is based on W2 income. For self-employed individuals, the amount is limited to 20%.
However, total contributions are subject to annual maximums. The maximum contribution for each employee is $53,000 if under the age of 50 and $59,000 if age 50 or older. These amounts are all subject to change each year.
Can I Have Checkbook Control of 401k Funds?
Yes. Our solo 401k plans allow the plan participant to serve as trustee of the solo 401k plan. This allows them to open up a bank account and effectively have “checkbook control”.
Do I Need to Establish an LLC for a Solo 401k?
While many participants may want to establish an LLC, it is not required.
What is the Deadline to Establish and Fund a Solo 401k?
In order to take a deduction for a specific year, a solo 401k plan must be established and adopted by the last day of that tax year. For a calendar tax year that date is December 31st.
For contributions, you generally can apply them to the prior year if all of the following criteria are met:
- They are made by the due date of your tax return for the prior year (which includes extensions).
- The plan treated the contributions as though it had received them on the last day of the previous year.
- You do one of the following: (1) specify in writing to the plan administrator (or trustee) that the contributions are intended to be applied to the prior year; or (2) you deduct the contributions on your tax return for the prior year.
Can I Roll Over My Other Retirement Accounts into a Solo 401k?
Yes. As long as your plan permits, you can rollover other retirement plans to a Solo 401k. This allows you the ability to consolidate retirement accounts.
Retirement accounts that are permitted to be rolled over into a Solo 401k include a 401k, 403b, 457 and Thrift Savings Plan from a prior employer. You can also rollover a SEP IRA, SIMPLE IRA, Keogh plans, Defined Benefit Plans, Traditional IRA and Rollover IRA.
A Roth 401k from a prior employer may be eligible to be rolled over into a Solo Roth 401k provided the 401k plan document permits Roth 401k contributions and rollovers. However, IRS rules do not allow a Roth IRA to be rolled over into a Solo Roth 401k.
Can I Set Up a Roth Solo 401k?
Yes you can. Our self-directed solo 401k plans contain specific language in the plan document that includes a built in Roth “sub-account” that can be contributed to without any income restrictions.
You can then contribute your employee deferral portion into the Roth. However, any profit sharing contributions will be made on a pre-tax basis. This amount is then deducted by the business as an employer contribution.
What Are Prohibited Transactions in a Solo 401k?
Prohibited transactions are transactions between the plan and a disqualified person that are prohibited by law. If you are a disqualified person who takes part in a prohibited transaction, you must pay tax. Prohibited transactions generally include the following transactions:
- A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person.
- Any act of a fiduciary by which he or she deals with plan income or assets in his or her own interest.
- The receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets.
- Any of the following acts between the plan and a disqualified person: (1) selling, exchanging, or leasing property; (2) lending money or extending credit; or (3) furnishing goods, services, or facilities.
Exemption. Certain transactions are exempt from being treated as prohibited transactions. For example, a prohibited transaction does not take place if you are a disqualified person and receive any benefit to which you are entitled as a plan participant or beneficiary. However, the benefit must be figured and paid under the same terms as for all other participants and beneficiaries. For other transactions that are exempt, see section 4975 and the related regulations.
Disqualified person. You are a disqualified person if you are any of the following:
- A fiduciary of the plan.
- A person providing services to the plan.
- An employer, any of whose employees are covered by the plan.
- An employee organization, any of whose members are covered by the plan.
- Any direct or indirect owner of 50% or more of any of the following: (1) the combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4); (2) the capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4); the beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
- A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
- A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following: (1) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation; (2) the capital interest or profits interest of a partnership; or (3) the beneficial interest of a trust or estate.
- An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
- A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
- Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.
Does My Solo 401k Have to File Form 5500?
Most solo 401ks do not have an annual 5500 filing requirement. If a solo 401k plan has assets of less than $250,000 at the end of the plan year, then it does not have to file Form 5500-EZ for that plan year. However, all plans must file Form 5500-EZ for the final plan year to show that all plan assets have been distributed.
Can I Take Out a Loan From a Solo 401k?
Yes. Assuming your solo 401k has a loan provision in the plan document, this is allowable. The loan is not a taxable distribution to the employee as long as it meets the following criteria:
- You can borrow up to 50% of your account balance, subject to a maximum amount of $50,000. The loan is subject to repayment within a 5 year period, unless it is used for a primary residence. Loan repayments must be made in even payments, at least on a quarterly basis, over the loan term.
- The $50,000 amount is reduced if you already had an outstanding loan from the plan during the 1 year period just prior to the loan. The amount that is reduced is the highest loan balance during the loan period less the outstanding balance on the date of the new loan.
The loan should be evidenced by a formal loan agreement. In addition, the funds can be used for any purpose. The loan is not an actual debt instrument that is issued by a bank or other financial institution. The participant is merely just borrowing against their own money in the 401k.
If your plan document allows loans, you can also borrow against the amount that is in the designated Roth portion. This would also include rollovers into the account as an in-plan Roth rollover.
How are 401k Contributions Reflected on a W-2?
Your 401k contributions must be reflected on your Form W-2 (if they are an employee deferral). While your payroll company should be familiar with the process, here is a quick overview:
- Box 1 (Wages) – Do not include any pre-tax contributions made under an employee deferral. This would reduce the amount in Box 1 by the salary deferral.
- Box 3 & 5 (Social Security and Medicare wages) – This should be the gross wages subject to employment taxes and does not consider any pre-tax, after-tax and or designated Roth contributions.
- Box 12 (Codes) – Make sure to enter the appropriate code to show elective deferrals and designated Roth contributions. The codes differ depending on the type of contribution.
- Box 13 – This box should be checked if you are an active participant in a retirement plan.
- Box 14 (Other) – You can enter the amount of employer matching and nonelective contributions that are made to the plan and any voluntary after-tax contributions (not including Roth contributions).
Can a Real Estate Investor Have a Solo 401k?
It depends. In order to contribute to a solo 401k, a person must have earned income. If someone just owns multiple rental properties then they would not qualify because rental properties are not considered earned income.
However, profits earned as a flipper or property manager is generally defined as earned income. Accordingly, this would qualify for contribution to a 401k plan.
We work with real estate clients to structure their operations to try to qualify for a solo 401k.
What Can a Solo 401k Invest In?
A solo 401k can make traditional investments, such as stocks, bonds, certificates of deposit and mutual funds. However, it also offers self-employed business owners the ability to invest in alternative assets like real estate. In addition, a solo plan allows for investment in almost any type of asset class without requiring the consent or approval of a custodian. The IRS only designates a few investment types that are prohibited.
The following are some examples of investments that a solo 401k is allowed to make:
- Real estate (including residential and commercial)
- Loan origination, including hard money loans
- Foreclosures, short sales, etc
- Real estate crowdfunding
- Most foreign currencies
- Secondary mortgage or mortgage pools
- Raw land
- Trust deeds
- Private operating businesses (be careful with UBTI)
- Tax liens
- LLC or other partnership interests
- Gold, silver or other precious metals (some restrictions apply)
- Private company C-Corp stock
- Stocks, mutual funds, bonds and other debt instruments
Unrelated Business Taxable Income (“UBTI”) should always be considered before making any investment.
Can a Solo 401k Invest in Real Estate?
Yes it can. Take a look at the investments that a solo 401k can make.
Can I be the Trustee of My Own Solo 401k?
Yes. One of the significant benefits of a solo 401k is that it does not require the participant to hire a bank or trust company to serve as trustee or custodian. The plan participant is allowed to serve as trustee. Accordingly, the plan assets are under the authority of the solo 401k participant.
Another benefit is that this allows a solo 401k to eliminate the expense and delays associated with an IRA custodian. You can act quickly when the right investment comes along.
Is a Solo 401k Required to Have a Separate EIN (Tax ID#)?
Yes. The solo 401k is classified as a retirement trust, which is an entity that is separate from your operating business. You probably already have an EIN for your business, but you will need an EIN for the 401k trust itself. When you open a bank or brokerage account for the 401k the institutions will need this EIN.
Can I Still Have a Solo 401k Even if I Have Employees?
It depends. Many people assume that they can only have a solo 401k if they have no employees. If a spouse is employed by the business, then he or she can also be included in a solo 401k plan. A business owner and spouse would be considered “owner-employees” rather than just “employees”.
The solo 401k plan would be restricted from employing any full-time employees. A full time employee is defined as an employee who works at least 1,000 hours per year. So a company can employee unlimited part time employees who work less than 1,000 hours a year and still be allowed to utilize a solo 401k.
Since there are no employees who would have qualified to receive benefits, the business doesn’t need to perform any nondiscrimination testing for the plan. Should the company hire full time employees, this advantage would go away. At that point, the solo 401k would then have to convert to another retirement plan, which would typically be a safe harbor 401k.
Are Solo 401ks Subject to Required Minimum Distributions (RMDs)?
Yes they are…but there are certain governing rules.
Each plan participant must receive his or her benefits (or start to receive periodic distributions of benefits) by the required beginning date. The participant would begin to receive distributions from the plan by April 1st of the first year after the later of the following:
- The calendar year in which he or she reaches the age of 70½; or
- The calendar year in which he or she retires from the company.
Depending on the plan documents, the participant may be required to start receiving distributions by April 1st of the year after the participant reaches age 70½ even if he or she has not retired from the company.
However, the rules for a participant who is a 5% owner of the employer maintaining the plan are a little different. The participant would be required to begin receiving distributions by April 1st of the first year after the calendar year in which the participant reaches the age of 70½.