Self-directed 401k for the self-employed

When was the Solo 401k first available?

Employer-sponsored retirement plans have been in existence since the nineteenth century. The IRS has confirmed that the self-directed 401k plan has been available since the creation of the 401k in 1974, resulting from the enactment of the Employee Retirement Income Security Act of 1974 (ERISA). However, solo 401k plans didn’t become popular until 2002 as a result of updated tax law. The solo 401k law change was made under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTTRA). The law change essentially made it more advantageous to contribute to a solo 401k than other self-employed retirement plans such as the SEP IRA and SIMPLE IRA because higher contributions can be made to a solo 401k in addition to including the option to process participant loans (solo 401k loans). 

What is a Solo 401k?

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      Name: When a 401k feature is incorporated into a self-employed plan, the plan is called a solo 401k plan or a cash or deferred arrangement (CODA). Solo 401k plans are afforded favorable tax treatment, including tax deductible contributions, deferral of taxation to the employee, favorable tax treatment on distributions to employees, and tax deferred investment earnings on plan assets.

·         Self-Employed: A solo 401k plan allows eligible self-employed (owner-only) business owners the choice to contribute the net earned income generated from business activity to the solo 401k on a tax-deferred basis or after-tax basis.

·         Written Plan: The solo 401k must be formerly adopted in writing through a plan document that has been reviewed and approved by the IRS. The solo 401k plan document provider is responsible for maintaining the plan document.

·         Fully Vested: Unlike contributions made to full-time employer 401k plans that may not always be fully vested when made, once contributions are made to the solo 401k plan, these contributions are fully vested.

·         Solo 401k Loan: The solo 401k allows the business owner/participant to access his or her solo 401k account balance without incurring tax liability by processing a solo 401k loan.

·         Self-Directed: The solo 401k funds may be self-directed by the business owner. As the name solo 401k plan trustee, the business owner may invest the solo 401k in alternative investments such as real-estate, promissory notes, tax liens, private company shares, and precious metals (e.g., gold coins and gold bars as well as silver coins and bars), in addition to stocks, mutual funds and commodities.

·         Self-Managed: The solo 401k may be self-managed and self-administered by the business owner.  As the name trustee, the business owner has the exclusive authority and discretion to manage and control the assets of the solo 401k plan.

·         Checkbook Control: Solo 401k Investments may be placed by writing a check from the self-directed 401k bank or brokerage account. Alternatively, solo 401k investments may be funded by processing wires.

·         Roth Solo 401k (Designated Roth Account)

Commonly referred to a Roth Solo 401k by those in the industry, the IRS defines a solo 401k that allows for Roth contributions as a designated Roth account. A designated Roth account is not a separate solo 401k plan but rather a separate account within the solo 401k plan. Contributions to a designated Roth account solely consist of employee contributions (salary deferrals): 2013 and 2014: $17,500 or $23,000 if age 50 or over. Because the solo 401k plan is required to keep separate accounting records for all contributions, in plan Roth conversions, gains and losses, a separate bank or brokerage account must be established for the Roth designated account.  To learn more about how to establish a designated Roth account, click here.

Who can take advantage of the self-directed 401k plan? 

·         Business Owners: The solo 401k can be adopted by business owners that do not have any full-time employees other than their spouses.

·         Entity Types: A self-directed solo 401k plan can be setup by an incorporated or non-incorporated business, the requirement is to, at minimum, perform part-time self-employment activity. Therefore, the following entity types may adopt a solo 401k plan. Sole proprietorships, Partnerships, S-Corporations, C-Corporations, and Limited Liability Companies.

Items to consider before moving forward with opening a self-directed 401k plan

·         Am I truly self-employed? While part-time self-employment is generally the main requirement for adopting a solo 401k plan, don’t confuse passive income with earned income, as only the latter meets the statutory requirement. Earned income is net earnings generated from a business in which the business owner’s services materially helped to produce the income. As such, capital gains do not count as they are considered passive income. Also, social security benefits do not qualify as earned income because they are exempt from self-employment tax. 

·         Have I considered my future business plans?  For example, if full-time employees are hired, the solo 401k plan will need to be converted to a full-time employer 401k plan and offered to those employees, resulting in higher annual plan fees and mandatory annual reporting, to name a few.

·         Have I considered annual filing requirements of a qualified plan (a solo 401k plan arrangements is a “qualified” plan). While annual reporting is limited to a solo 401k plan when compared to 401k plans for full-time employers, different filing requirements come into play at different stages of the solo 401k plan life span. For example, once the total value of all plan assets (e.g., cash, real estate, precious metals, promissory notes, private shares, solo 401k loans, etc.) exceed $250,000, an annual Form 5500-EZ must be filed. A final Form 5500-EZ must also be filed when the solo 401k plan is terminated regardless of asset value. Additional reporting applies on Form 1099-R when in-plan Roth conversions are processed, or distributions commence (e.g., required minimum distributions for those aged 70 ½ or older).  Depending on the type of entity sponsoring the solo 401k plan, annual reporting applies when contributions and rollover deposits are processed.

·         Have I considered fees associated with adopting a qualified plan (start-up, annual service fee, etc…)? Because a solo 401k falls under the qualified plan category, it must be formally adopted in writing and continue to be operated in writing. As a result, plan adoption fees apply as well as annual plan document fees.

Solo 401k plan document comparison

Insurance Companies: Their solo 401k plan generally only allows for investing in annuities and mutual funds.

Brokerage Firms: Their solo 401k plan generally only allows for investing in stocks and mutual funds.

Banks: Their solo 401k plan generally only allows for investing in certificates of deposit.

Trust Companies: Their solo 401k plan generally only allows for investing in stocks and mutual funds.

Solo 401k Service Providers: Their self-directed solo 401k plan is the most liberal in that it allows for investing in alternative investments such as precious metals, real estate, promissory notes, tax liens, private placements, stocks and mutual funds and annuities. Their solo 401k plan also permits solo 401k loans and designated Roth accounts. Lastly, their solo 401k plan allows for checkbook control.

Regulators of solo 401k plans

The IRS and the DOL regulate solo 401k plans.

Solo 401k Loan Rules

Unlike the IRA rules, which do not permit the participant to borrow form his or her IRA, the self-directed 401k rules allow for solo 401k loans. The maximum the self-employed owner may borrow from his or her solo 401k is 50% of the 401k balance not to exceed $50,000. More than one solo 401k participant loan may be taken but the maximum loan amount applies in combination to all the loans. The loan payback period is 5 years, or up to 30 years if the proceeds are used for the purpose of purchasing the self-employee’s principal residence. See (IRC Section 72(p)(2)(B)(ii); Reg. § 1.72(p)-1, Q&A-5,-6, -7, and -8)

Disallowed Solo 401k investments

Instead of spelling out allowable self-directed solo 401k investments, the internal revenue code (IRC) lists disallowed investments, which include the following:  collectibles (e.g., works of art and stamps), alcoholic beverage, rugs and antiques.

Allowed Solo 401k investments

Promissory Notes: whether secured or unsecured; however, an interest rate that benefits the solo 401k plan must collected.

Real Estate: all types of real estate are permitted, from fixer uppers to rentals.

Precious Metals (coins & bullion): including coins and bullion; however, the following requirements under 408(m) apply:

A) any coin which is—

(i) a gold coin described in paragraph (7), (8), (9), or (10) of section 5112(a) of title 31, United States Code,

(ii) a silver coin described in section 5112(e) of title 31, United States Code,

(iii)a platinum coin described in section 5112(k) of title 31, United States Code, or

(iv)a coin issued under the laws of any State, or

(B) any gold, silver, platinum, or palladium bullion of a fineness equal to or exceeding the minimum fineness that a contract market (as described in section 7 of the Commodity Exchange Act, 7 U.S.C. 7) requires for metals which may be delivered in satisfaction of a regulated futures contract, if such bullion is in the physical possession of a trustee described under subsection (a) of this section.

Private Company including LLC: the solo 401k is listed as the member and the solo 401k trustee may not be an employee of the LLC.

Contribute to multiple 401k plans

Individuals who work for a full-time employer may participate in that company’s retirement plan (e.g., 401k, 457b, 403b, etc.) in addition to setting up as self-directed solo 401k for their self-employed business. To learn more about contributing to multiple retirement plans click here.

Solo 401k Contributions

The business owner acts in both capacities in a solo 401k plan: employee and employer. The business owner can make both contribution types: employee and employer.

Type 1 Contribution: Employee contributions also known as elective deferrals up to 100% of net earnings from self-employment income up to the annual contribution limit: 

·         2013 and 2014: $17,500 or $23,000 if age 50 or over; and

Type 2 Contribution: Employer profit sharing contributions up to

·         25% of earned income after deducting one-half of self-employment tax.

Total Contributions: Total contributions to a solo 401k plan cannot exceed $51,000 for 2013 and $52,000 for 2014, plus an additional catch-up amount of $5,500 if age 50 or older.

IMPORTANT:  The annual solo 401k contribution limits as affected by the type of entity sponsoring the solo 401k plan.

• If the entity type is a Sole Proprietor, the starting figure for calculating the annual solo 401k contribution is line 31 of Schedule C.
• If the entity type is a C-Corporation, the starting figure for calculating the annual solo 401k contribution is W-2 income.
• If the entity type is an S-Corporation, the starting figure for calculating the annual solo 401k contribution is W-2 income.
• If the entity type is a Partnership, the starting figure for calculating the annual solo 401k contribution is K-1 (Form 1065) line 14.

Solo 401k Contribution Deadlines

The self-directed 401k contribution deadlines are based on the type of entity sponsoring the solo 401k.

• If the entity type is a Sole Proprietorship, the annual solo 401k contribution deadline is April 15, or October 15 if tax return extension is filed.
• If the entity type is an LLC taxed as an S-Corporation, the annual solo 401k contribution deadline is March 15, or September 15 if tax return extension is filed.
• If the entity type is an LLC taxed as a Partnership, the annual solo 401k contribution deadline is April 15, or October 15 if tax return extension is filed.
• If the entity type is a Partnership, the annual solo 401k contribution deadline is March 15, or October 15 if tax return extension is filed.
• If the entity type is an S or C-Corporation, the annual solo 401k contribution deadline is March 15, or September 15 if tax return extension is filed.

Self-directed 401k Adoption Deadline

The solo 401k plan must be adopted by December 31 (i.e., the solo 401k plan documents must be signed) in order to make the annual solo 401k contribution by the business’s tax return due date plus extensions.

FDIC Coverage for solo 401k

The Federal Deposit Insurance Reform Act of 2005 increased the coverage limit for solo 401k plans. Insurance coverage increased from $100,000 to $250,000. The FDIC reviews the insurance limits every 5 years and, to date, has not increased the coverage limit from $250,000.

Solo 401k IRS Levy

IRS tax levies on self-directed 401k plans do not violate the Internal Revenue Code’s anti-alienation provisions. See Treas. Reg. 1.401(a)-13(b)(2).  However, the IRS has published in Field Service Advice Memorandum (FSA) 199930039 that an employer has the option to wait until the participant becomes eligible for a distribution to comply with the levy. Therefore, a self-directed solo 401k distribution triggering event such as normal retirement age (age 59 ½) or plan termination would subject the solo 401k plan to honoring the IRS levy.

Qualified Domestic Relations Orders

Solo 401k plans are subject to QDROs. A QDRO is a court order that requires payment of all or some of the solo 401k assets to an alternate payee such as a spouse, former spouse or child.

Creditors and Solo 401k Plans

Solo 401k plan documents must provide that the plan’s benefits may not be assigned or alienated. See Internal Revenue Code (IRC) Sec. 401(a)(13). The following or similar language is contained in solo 401k plan documents: “No benefit or interest available hereunder will be subject to assignment or alienation, either voluntarily or involuntarily.”

Solo 401k Plans and Bankruptcy Protection

Resulting from enactment of Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), both qualified plans and non ERISA plans are protected from creditors. 

Solo 401k Prohibited Transaction Rules

Prohibited transactions result when the solo 401k business owner or any other disqualified person (e.g., the business owner’s spouse, parent, children, and any person providing services to the solo 401k plan, to name a few) uses the solo 401k plan assets for his or her personal benefit, sells or exchanges assets to or form the solo 401k plan, lends money to the solo 401k plan, performs work on assets of the solo 401k plan (for example, the disqualified person performs repairs on a real estate home owned by the solo 401k plan).  Click here to learn more about the self-directed solo 401k prohibited transaction rules.