Solo 401ks are powerful retirement vehicles. As the name implies, the Solo 401k plan is an IRS approved plan that is designed for self-employed individuals or sole owners of a business entity. They are cost effective and tax efficient retirement solutions with substantial advantages. Let’s take a look at the top 10 advantages of a solo 401k:
1) Ability to Self-Direct
With a Solo 401k, you can act as your own trustee. This eliminates the need for a bank or trust company to serve as a trustee. Effectively all assets of the plan are under the control of you – the plan participant.
As the trustee you can open a Solo 401k trust bank account at any local bank or credit union. This gives you checkbook control and the ability to act quickly and decisively when an investment opportunity arises.
In addition, with a Solo 401k plan there is no need to have a custodian or to form an LLC. This substantially decreases administrative costs as compared to self-directed IRAs.
2) Contributions are Elective
Contributions to a solo 401k plan are entirely discretionary. A participant has the option of contributing to the plan and can reduce or even suspend plan contributions as necessary.
In other words, the IRS has established maximum allowable contributions but are under no requirement to contribute.
3) Generous Contribution Limits
For the plan year 2017, a participant under the age of 50 can make a maximum employee deferral in the amount of $18,000. This is also called an “employee” contribution.
4) Ability to Take Out a Loan
A solo 401k allows participants to borrow up to $50,000 or 50% of their vested account value (whichever is lower). This loan can be made for any purpose with a payback period of up to 5 years.
This offers significant flexibility and provides flexibility against having to take a withdrawal that would be subject to a tax penalty. This flexibility is in contrast to an IRA that offers no participant loan feature.
Also, if the 401k allows for it, there is a specific carve-out that can be included in a plan that will enable a longer payback period as long as it is used for a primary home. So instead of a five-year loan you could have for example a 15-year loan. This gives the plan participant significant flexibility.
5) Profit Sharing Provision
As previously discussed, a participant can make an employee deferral. Also, the participant can contribute up to 25 percent of total compensation to a profit-sharing component of the plan. This is often called an “employer” contribution.
Total combined plan contributions (employer and employee) cannot exceed the lower of $54,000 or 100 percent of compensation (plus any catch-up contributions if over the age of 50).
6) Exemption from UDFI
Like a self-directed IRA, a Solo 401K offers participants the ability to invest in real estate. All income and gains generated by the investment will flow back to the 401(k) plan tax-deferred.
If an IRA uses nonrecourse debt to finance a real estate purchase (only nonrecourse debt is permitted as recourse debt would trigger a prohibited transaction), income or gains generally from the investment would potentially trigger Unrelated Debt Financed Income (UDFI) tax. UDFI is a complex issue but should be a discussion point with your CPA.
When an IRA buys leveraged real estate, it creates Unrelated Debt Financed Income (“UDFI”). This is a form of Unrelated Business Taxable Income (also known as “UBTI or UBIT”) which can create a tax problem. But a Solo 401(k) plan allows leverage without being subject to the UDFI rules. This exemption alone provides significant advantages to the Solo 401(k) Plan versus an IRA when it comes to purchasing real estate.
7) Minimal Tax Filing Requirements
The solo 401k is relatively easy to administer. There are no annual filing requirements unless the solo 401k plan exceeds $250,000 in assets. In this case, the 401k is required to file a short information return with the IRS (Form 5500-EZ). Also, the solo 401k is required to file this same form when the plan is closed and funds are distributed or rolled over to another retirement account.
8) Catch Up Provision
While an IRA only allows a $5,500 contribution limit (with a $1,000 additional “catch up” contribution for those over age 50), the Solo 401k annual contribution limit is $54,000 for 2017 with an additional $6,000 catch-up contribution for those over age 50. Also, if your spouse generates compensation from the business, he or she can also make contributions to the Plan.
9) Roth Contributions
Solo 401ks can include a Roth component. Just like Roth IRA contributions, Roth 401k contributions are made on an after-tax basis. Unlike a pre-tax contribution, there is no upfront tax deduction. However, a distribution of Roth 401k contributions (along with earnings) is tax-free.
Individual taxpayers are disallowed from contributing to a Roth IRA based on income restrictions. These same restrictions do not apply to Roth 401k contributions. A Roth 401k contribution has the same limitation as an employee deferral of $18,000. This is substantially more than the $5,500 limit of a Roth IRA.
One key advantage is rollover flexibility. A solo 401k can accept rollovers from other retirement accounts, such as an IRA, a SEP, or a 401k from a prior employer. However, Roth IRAs cannot be rolled into a solo 401k. Therefore, you can directly rollover other retirement balances for investment or loan purposes.
Advantages of a Solo 401k
Clearly, there are many advantages to solo 401k plans. Self-employed individuals should consider them as a part of their retirement planning arsenal. They are cost effective to set up and tax efficient retirement solutions. The advantages are extensive.