The Solo 401(k) plan, also known as an individual 401(k) or self-employed 401(k) plan, is an IRS-approved retirement plan which is suited for business owners who do not have any full-time employees, other than themselves and perhaps their spouse. The Solo 401(k) plan is not a new type of plan; It is a traditional 401(k) plan covering only one employee. However, not all Solo 401(k) plans are the same.
When it comes to deciding what type of Solo 401(k) plan is best for your business, it is important to look at all the options the plan provides to make sure it will satisfy your retirement planning, tax, and investment goals.
Most financial institutions, such as Charles Schwab or E-Trade, offer Solo 401(k) Plans, often called individual 401(k) Plans. However, these plan documents, which are often free of charge, will restrict your plan investment options and typically only allow you to buy traditional equities or mutual funds, financial products that generate commissions and fees for the institution. For example, a 401(k) retirement plan established using E-Trade plan documents would not allow you to make any alternative asset investments, such as real estate.
The reason behind this is simple – traditional financial institutions and banks make money when you buy stocks and mutual funds, not when you buy real estate. That being said, if the only investments you want to do with your Solo 401(k) plan are stocks or mutual funds, then selecting a financial institutional would likely be a wise and cost-effective choice. However, if you were considering making alternative asset investments, such as real estate, in your Solo 401(k), you would likely want to consider the self-directed Solo 401(k) Plan.
In general, the determination of which of the features addressed below are available in a Solo 401(k) Plan depend on the plan documents. Below is a summary of the most popular features available in a Solo 401(k) plan, which may help you decide between a financial institution-directed Solo 401(k) or an open architecture self-directed Solo 401(k) plan.
High Annual Tax-Deductible Contributions: For all Solo 401(k) Plans, under the 2015 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,000. That amount can be made pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $53,000, an increase of $1,000 from 2014. For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,000. That amount can be made pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $59,000, an increase of $1,500 from 2014.
Tax-Free Loan: Most financial institution and bank adopted Solo 401(k) Plan documents offer no loan feature, while the majority of self-directed Solo 401(k) plan documents offer a loan feature. Thanks to the 2001 Economic Growth Tax Relief and Reconciliation Act (“EGTRRA”), a Solo 401(k) plan is able to offer a plan participant the ability to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose, including paying credit card bills, mortgage payments, personal or business investments, a car, vacation, or anything else. The loan has to be paid back over a five-year period at least quarterly at a minimum interest rate, which as of June, 1 2015 is 3.25%, the Prime interest rate as per the Wall Street Journal (you have the option of selecting a higher interest rate)
Investment Diversification: The most notable benefit of establishing a self-directed Solo 401(k) Plan is that it offers a wide array of investment opportunities, such as real estate, precious metals, hard money loans, private business investments, tax liens, and much more. One lesson of the 2008 financial crisis has been the importance of having some investment diversification in your retirement portfolio.
While I am a tax attorney and not a financial advisor, I think it is safe to say that when one diversifies their retirement assets into other asset classes, any potential investment risk is spread around. The more places one invests their retirement assets, the less chance that the overall retirement portfolio will take a big hit when any single asset class slumps. Furthermore, many alternative assets have an underlying physical value. For example, when you buy stocks and bonds, you ultimately own pieces of paper. Buying real estate or IRS approved precious metals or coins gives you an intrinsically valuable asset that has a use above and beyond its investment value. Of course, one should discuss any investment opportunity with a financial advisor or attorney, but establishing a self-directed Solo 401(k) plan does at least offer an individual investor that ability to make traditional as well as alternative assets with their retirement funds.
Roth Contributions & In-Plan Conversions: Most financial institution adopted Solo 401(k) Plans do not allow for Roth (after-tax) contributions or in-plan Roth conversions for fear of complicating plan recordkeeping. The concern is that offering a Roth feature would cause added complexity for purposes of managing pre-tax and Roth account funds in the plan. However, almost all self-directed Solo 401(k) plan documents offer a built in Roth sub-account which can be contributed to without any income restrictions.
For 2015, a plan participant can make a Roth 401(k) plan employee deferral contribution of up to $18,000, or $24,000 if over the age of 50. Any employer profit sharing contributions made can then be converted to Roth. Most self-directed Solo 401(k) plan document providers recommend that the plan participant open two separate plan bank accounts, one for the pre-tax funds and one for the Roth funds. In addition, the majority of Solo 401(k) plans that offer Roth contributions will also provide for in-plan Roth conversions, which allows a plan participant to convert pre-tax 401(k) funds to Roth without any plan-triggering event. However, the Solo 401(k) Plan participant must pay income tax on the amount converted.
“EZ” Administration: One of the primary reasons the Solo 401(k) Plan has become the most popular plan for the self-employed is that they are so easy to operate. There is generally no annual filing requirement unless your solo 401(k) Plan exceeds $250,000 in assets, in which case you will need to file a short information return with the IRS (Form 5500-EZ).
No Tax On Real Estate Financing: Since a financial institution or bank established Solo 401(k) Plan does not allow for real estate investments, you would not be able to benefit from the ability to use non-recourse financing tax-free when making real estate investments with Solo 401(k) retirement funds. A non-recourse loan is a loan that is not personally guaranteed by the borrower and is secured by the underlying asset. A non-recourse loan is the only type of loan that can be used to purchase real estate with retirement funds as using a traditional recourse mortgage would trigger the IRS prohibited transaction rules. In general, a 401(k) plan that uses a non-recourse loan to purchase real estate will not be required to pay any tax on the leverage used. This is in contrast to an IRA that would be subject to the Unrelated Debt Financed Income (“UDFI”) rules – a type of Unrelated Business Taxable Income (also known as “UBTI or UBIT”) on which taxes must be paid. The UBTI tax is approximately 40% for 2015. But, with a Solo 401(k) plan, you can use leverage without being subject to the UDFI rules and UBTI tax. This exemption provides significant tax and investment advantages for using a Solo 401(k) Plan versus an IRA to purchase real estate.
The Solo 401(k) plan is designed explicitly for small, owner only business. Whatever type of Solo 401(k) plan you elect to establish, a Solo 401(k) plan offers self-employed individuals and small business owners with no third-party employees significantly greater retirement benefits than an IRA or even a SEP IRA.