The Individual 401(k)
According to the Internal Revenue Code Section 401, it is a “one-participant (Solo)” retirement savings trust.
The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) further expanded on this type of qualified defined contribution plan.
It is a qualified retirement plan that is exclusively for business owners and their spouses; combining the tax-deferred benefits of a typical 401(k) plan without the complex administrative ERISA compliance requirements of a regular 401(k) plan that has more than one employee.
The primary reasons why self-employed persons use this plan are the following:
- A client may setup a new business at the same time they set-up the Individual 401(k).
- They are self-administered, usually with the owner of the business being the Trustee.
- No Third-Party Custodian is required.
- Total bank account control and investment authority in the hands of the Trustee.
- You can contribute more to a 401(k) as the employee and the employer, and roll all contributions to a Roth account.
- The Account Owner can access up to $50,000 through a personal loan from their account to themselves for any personal use.
- Can leverage and finance real estate investments without being subject to UDFI tax.
You can self-direct your 401(k) investments into any of the below, to be held (vested) in the 401(k)’s name:
|Stocks, Bonds, Options||Mutual Funds & ETFs||Private Stock Offerings|
|Hard Loans & Receivables||Limited Liability Companies||Limited Partnerships|
|Tax Certificates||Life Insurance & Annuities||Commercial & Residential Real Estate|
|Mobile Home Rentals||Foreign Real Estate Rentals||Trust Deeds & Mortgages|
|Mortgage Pools||Private Notes & Loans||Raw Land|
You cannot purchase the following investments for the 401(k):
If the 401(k) engages in a prohibited transaction, which is defined as a purchase, sale, lease, exchange, loan, extension of credit, goods or services it will incur a 15% excise tax on the amount involved and an additional 100% penalty if not corrected, according to IRC § 4975. It is imperative to keep at arm’s length from personally benefiting from the 401(k) before the distribution phase.
Per Se: A transaction with a disqualified person, who is the:
- 401(k) account owner, their spouse, children, and parents, as well as
- Companies that are owned 50% or more by disqualified persons, including officers, directors, or highly compensated employees of such companies.
- Extension of Credit: An extension of credit by or between the 401(k) and a disqualified person. The only exception is a 401(k) loan, which must be thoroughly documented with a promissory note and amortization schedule.
- Self-Dealing: A transaction where a disqualified person personally benefits from the 401(k) investments, and comingles the 401(k) assets with their personal funds to pay personal expenses.
401(k) Loan for Personal Expenses
- A plan participant can receive a personal loan from their 401(k) up to $50,000 or 50% of the plan participant’s account balance, whichever is less, for anything the Account Owner wants.
- The loan can be with any non-disqualified person or entity.
- The loan must be properly documented with a promissory note and an amortization schedule.
- The loan must be paid back in full within 5 years, with limited exception, and payments must be made at least quarterly. Otherwise the outstanding balance will be considered a distribution.
- The loan interest rate should be at least the WSJ prime rate.
A 401(k) can invest in a pass-through entity that allows for additional layer of liability protection to make real estate investments. When a 401(k) derives profit from an active full-time business that has not paid business tax on those profits before distributing them to the 401(k), those profits are subject to Unrelated Business Taxable Income. This will happen with any unrelated trade or business that is regularly carried on such as LLCs, Partnerships, or trading stocks on Margin. It’s best to create a C-Corporation to avoid triggering the UBTI on the active business.
Unrelated Debt Financed Income Tax (UDFI) Exemption
Unlike an IRA, the 401(k) can obtain financing and loans to leverage real estate investments tax-free, so there’s no UDFI tax, according to IRC §514 I (9)(C)(ii).
Any loans obtained by the 401(k) must be non-recourse, meaning secured only by the assets in the 401(k). A disqualified person cannot personally guarantee the loan, as that would be considered an Extension of Credit Prohibited Transaction. However any non-disqualified person can guarantee a loan.
- For example, say Tom has $160,000 in his Individual 401(k) account. He would like to purchase a property valued at $400,000. Tom’s Individual 401(k) can obtain a non-recourse loan of $240,000 to purchase the property. If this were a self-directed IRA investment, since the loan consists of 60% of the purchase price, there would be UDFI tax on 60% of the profits, so if he later sold the property for $600,000, he would pay UDFI tax on $200,000 profit, equating to a sizeable tax bill; however, since Tom has an Individual 401(k), there is no UDFI tax.
- You can rollover almost every other type of retirement account, such as an IRA or a 401(k) with a prior employer.
- You should only complete a Direct (Trustee-to-Trustee) Rollover; you should not do a 60-Day Rollover as this will trigger a withholding of 20% of the amount that is to be rolled over.
- You cannot rollover a Roth IRA to a Roth 401(k) account.
- You cannot rollover a 401(k) account with an existing employer, unless you qualify for and your plan allows for an in-service withdrawal
(e.g. you are 59 ½ ).
- Employee Contributions. You as the employee can make Traditional tax-deductible or Roth after-tax contributions up to 100% of your salary with the annual contribution limit being $18,000 ($24,000 if age 50+). You can make all of your contributions Roth funds.
- Employer Contributions. You as the employer can only make traditional tax-deductible contributions up to 25% of employee compensation. You can do an In-plan Roth conversion, pay the taxes on the employer contributions, and convert all contributions to Roth funds.
- The client must open two checking accounts to satisfy the IRS documentation requirements for contributions.
- Traditional funds can be converted to Roth funds using an In-plan Roth rollover.
- You pay the taxes based on your personal income tax bracket, but there is not a 10% early withdrawal penalty.
- It is best to convert the funds when they are in cash. If you convert when the funds are not in cash you must get a fair market value appraisal of the value of the investments before you can convert them to a Roth.
Distributions from your 401(k)
As with all retirement plans, distributions from your Individual 401(k) can be subject to taxes and penalties if they are not qualified retirement plan distributions, according to IRC §72 (t). The rules and requirements for taking a distribution from your Individual 401(k) are complex and proper counsel should be contacted prior to making a distribution.
The rules of distribution vary depending on whether the distribution will come from a Roth 401(k) account or a Traditional 401(k) account, which is why it makes sense to have two separate accounts for accounting purposes.
Required Minimum Distributions mandate that you, as the plan participant, must begin taking distributions from the Traditional AND Roth accounts of your Individual 401(k) at the age of 70 ½. This is unlike a Roth IRA, where there are no Required Minimum Distributions at any age. You would, of course, roll the Roth 401(k) funds over to a Roth IRA to avoid RMDs, and continue to allow your Roth IRA account to grow.
Distributions from a Traditional Account
A traditional distribution is always subject to income tax and the additional 10% early withdrawal penalty unless one of the following applies:
- You become age 59 ½
- You pass away
- You become disabled
- You are age 55 and retired
Distributions from a Roth Account
Roth distributions are never subject to income tax or the 10% early withdrawal penalty. Gains are subject to income tax and the 10% early withdrawal penalty unless the owner is age 55 and retired, or the gains are part of a Qualified Distribution.
A Qualified Distribution must meet a two-part test:
- Be made after age 59 ½, death, or disability; and
- The Roth account has satisfied the 5 year rule - when 5 years have passed since contributions have been made to the Roth account or contributions were made to other Roth 401(k) accounts that been rolled over to the current Individual 401(k) Roth account.