Once your Solo 401K is established, you can roll your other IRA-type accounts into it. You then have the exceptional flexibility of a Solo 401K with all of your retirement savings.
However, there are certain safeguards that you must observe in the way that you manage and invest funds from a Solo 401K. In particular, you cannot make investments that directly or indirectly benefit you or the people whom the IRS calls "disqualified persons."
Neither can you use your personal or company credit to benefit the Solo 401K trust in any manner.
Author: Mike Armour
Even though the tutorial examines legal and tax issues faced by small business owners, it should not be construed as legal, accounting, or tax advice. Always seek competent professional counsel in addressing issues and questions raised in this tutorial.
A Guide to Solo 401Ks
Additional Advantages of a Solo 401K Program
Are there other significant benefits associated with a Solo 401K?
One of the most attractive features of a Solo 401K is your ability to borrow money from it. The plan can loan you as much as $50,000 for any purpose whatsoever. Loans can be in any amount, up to that maximum. And you can have as many as three concurrent loans.
You must sign a binding loan agreement with the trust, just as you would with a bank. The maximum term for repayment must be no more than five years and you must make scheduled, amortized payments rather than structuring the loan with a balloon at the end. You must also pay an interest rate that is at least one point above the prevailing prime rate at the time the loan was originated. If you fail to comply with these requirements, the IRS can treat your loan as a disbursement and tax you accordingly.
Another benefit which is often quite high is your freedom as the custodian to make investment decisions with no need of outside approval. I have bought several houses as investments in my Solo 401K. I could quite literally find a good buying opportunity in the morning, have a signed contract by noon, begin the title transfer that afternoon, and complete the entire transaction in three to five days. And because I was paying cash, without having to qualify for a loan, I could often negotiate a better purchase price.
Since contribution limits to a SEP are nearly as high as those for a Solo 401K, why go to the extra effort of having a Solo 401K?
In terms of the amount of money which you can shelter as part of a retirement plan, SEPs and Solo 401Ks are on similar footing. But you cannot borrow money from a SEP. And because the SEP has an institutional custodian, you don't have the range of investment options which a Solo 401K provides.
In addition, if your goal is to make the maximum possible contribution to your retirement program, a Solo 401K allows you to do that with a significantly lower income than a SEP requires. SEPs are funded entirely by employer contributions. The maximum contribution in a SEP is 25% of your compensation, or $51,000, whichever is less. Since you are not contributing directly to the SEP as an employee, you need a salary of $204,000 to maximize your contribution.
Now let's look at the numbers for a Solo 401K. The maximum combined contribution (employee and employer) is $52,000, with the employer eligible to contribute up to 25% of your compensation. If you are maximizing your employee contribution ($17,500), then the most that the company can contribute is $34,500. To qualify for an employer contribution at this level, your salary must be $138,000 after your $17,500 salary reduction. You have been able to maximize your contribution with about $50,000 less in salary.
SEPs and Solo 401Ks also have different consequences for the employee on April 15. Since there is no employee contribution with a SEP, the company gets the entire tax benefit from contributions to a SEP program. With no salary reduction agreement, the employee must report his or her entire compensation as 1040 income.
With a Solo 401K, by contrast, the company has a tax deduction for its portion of the contribution and the employee pays lower taxes due to the salary reduction. This is identical to the way that a regular 401K works. But in this case, as both an employee and the owner of the business, you receive both sides of the tax benefits.
What other retirement funds can I roll into a Solo 401K?
With the exception of Roth IRAs, any IRA-type program can be rolled into a Solo 401K tax-free. This allows you to reposition any existing retirement programs so that all of your retirement money can benefit from the investment flexibility of a Solo 401K. By pooling my 503B, a SIMPLE, a SEP, and a traditional IRA with my Solo 401K, I immediately availed myself of enough money to start buying houses and making mortgage loans and hard-money loans. It also instantly gave me enough funds in the Solo 401K that I could borrow from it, if need be.
What do I do with my Roth IRA, since I can't roll it into the Solo 401k?
To preclude the co-mingling of pre-tax and after-tax IRA contributions, the IRS does not permit Roth accounts to be rolled into a Solo 401K. The company which set up my Solo 401K, however, also created a means for me to invest my Roth money with the same freedom with which I invest funds from the Solo 401K.
Because the Roth funds are not in the Solo 401K, I cannot serve as their custodian. So my service provider connected me with an affiliated company which provides custodial services for Roth IRAs, then delegates to the account owner full control over how the money is invested. Let me show you how this could work for you.
In this case, the custodian does not hold the Roth funds. Instead, an LLC is set up with you designated as the manager. A checking account is then opened for this LLC and the Roth funds are deposited into it. A small balance is left with the custodian (mine requires a minimum of $300) to cover any administrative expenses. Then, for a nominal fee, the custodian files the required annual reports to the Federal government, based on numbers which you supply.
This gives you full checkbook control of your Roth funds. What I then did was to create still another LLC which was jointly owned by the Roth LLC and my 401K trust. Its purpose is to serve as the investment mechanism for buying real estate, making secured loans, etc. When an investment is to be made, the Roth LLC and the 401K trust pool their money in this jointly-owned LLC, and it secures the properties or makes investments in its own name. It then distributes earnings back to the two ownership entities based on their proportional investment in a given enterprise.
Are there any special considerations to keep in mind when making Solo 401K investments?
The one thing you must guard against carefully is any co-mingling of your personal funds or your company funds with the Solo 401K. This means that you as a person and the 401K trust cannot generally enter joint ventures together where you personally control the operational management of the venture, either directly or indirectly.
It also means that you cannot use your credit to benefit the trust, or vice-versa. If the trust owns a piece of real estate and wants to borrow money against it, you cannot personally guarantee the loan. If the trust has a credit card, you cannot be personally liable for seeing that payments are made. Neither can your company.
In addition, you cannot donate labor to a business or real estate venture which the trust owns. For example, if my Solo 401K buys a house as an investment, I can't do the painting and repair work to make it ready for sale or for rent. This is one of the trickiest areas of regulation when it comes to Solo 401K investments, especially if you invest in commercial enterprises or real estate.
Before you move into these types of arenas, be sure that you have knowledgeable counsel to whom you can turn for legal advice on any involvement on your part that might be subject to question. Currently there is not much case law involving this aspect of Solo 401K management, so you are wisest to err on the side of caution rather than risk becoming a court test case for the IRS.
My only regret is that I did not know about Solo 401Ks sooner. The diversity of investments which they permit give you great flexibility to respond to changing conditions in the economy. If the sector in which you've invested starts under-performing, you can quickly shift to another sector with more promising trends.
Before I had a Solo 401K, and with my retirement investments scattered across four different programs, I was largely restricted to the stock market as an investment vehicle. And when it went sour, my only real choice was to convert my investments to cash, go to the sidelines, and wait out the downturn.
Those days are behind me with a Solo 401K. I hope you find the same benefit from this marvelous tool for building your retirement nest egg.