A self-directed retirement account is technically no different than any other IRA except it allows the account owner to invest in other types of investments. Both IRA and 401(k) retirement accounts can be self-directed. A self-directed individual retirement account is either a Traditional or a Roth IRA that has been set up to allow the account owner to select a variety of investments for the benefit of the retirement plan. Self-directed retirement accounts may be invested in stocks, bonds and mutual funds, but are not limited strictly to those asset types. A self-directed retirement account may also be invested in a number of other IRS permitted investment types, such as real estate, mortgages, franchises, partnerships, private equity and tax liens. IRS regulations require that either a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner. Most banks, stock brokerages, insurance companies, and financial planners and/or advisors who are affiliated with an independent broker-dealer will not permit the IRAs they manage to be self- directed. They require their clients to select investments from the products they offer for sale. A self-directed retirement account gives more investment choices than the typical situation.
An Individual 401(k) Account is Better Than an IRA
What is a Self-Directed Individual 401(k) Account?
The term self-directed refers to any retirement account where the owner of the account personally directs where the retirement funds are to be invested. Self-directed 401(k) retirement accounts are similar to any other type of 401(k) account. They derive their name from Section 401 of the Internal Revenue Code. These 401(k) qualified retirement plans came into being in 1974 with the passage of the Employee Retirement Income Security act (ERISA), however, individual 401(k) accounts didn’t become permanent until 2002 with the passage of the Economic Growth and Tax Relief Act of 2001 (EGTRRA), commonly known as the Bush Tax Cuts. The Internal Revenue Service (IRS) refers to these types of accounts as one-participant 401(k) plans. Some 401(k) administrators have called these one-participant 401(k) plans by other names, e.g., Individual (k), Solo 401(k), Solo-k, and Uni-k. These are different names for the same plan. I have chosen to use the term Individual K to refer to all one-participant plans. Individual 401(k) plans are designed specifically for businesses that employ only the owner and/or their spouse or their partners. They have no other employees. These plans are perfectly suited for sole practitioners like self-employed consultants, real estate professionals, sales people, private contractors, sole proprietors and any person who does not control the company they work for and who want to start a consulting business on the side. If you are a 1099 independent contractor, it is likely you would be a good candidate for a Self-Directed Individual 401(k). The term 1099 refers to the IRS form that an independent contractor receives from a company stating his/her income that was paid for activity or service that was performed.
Benefits of a Self-Directed Individual 401(k) Account
There are basically two individual 401(k) account options available: the brokerage-directed account and the self-directed account. Brokerage-based plans are established through a stockbroker, a banker or financial planner. These plans limit the investment choices to market-based assets such as individual stocks and mutual funds that are sold by the firm with whom the adviser is affiliated. Self-directed plans, on the other hand, are established with an IRS-approved independent third party administrator who handles administration of the qualified plan and is affiliated with a federally-insured custodian to safeguard your retirement funds until the account owner decides which investments are suitable for his/her plan. A self-directed individual 401(k) plan is the most tax-advantaged plan available among the various retirement plan options
The benefits and advantages of having a Self-directed Individual 401(k) plan are significant.
- The contribution limits to a Self-directed Individual 401(k) are the same as a standard 401(k). Contributions are separated into two parts: (1) employee salary deferral contributions and (2) employer profit sharing contributions. If the employee is under 50 years of age, the 2017 contribution limit is $18,000. If the employee is 50 or older, an additional catch-up contribution of $6,000 is permitted for a total contribution limit of $24,000.
Additionally, the employer can make profit-sharing contributions of 25 percent of the entity’s income up to $36,000 for a maximum contribution of $54,000 if the plan owner is under 50 and $60,000 if the plan owner is 50 or older. The maximum compensation
amount that can be used for calculating your contribution is $270,000 for 2017. The employee salary deferral can be up to 100 percent of your earned income for you and your spouse, up to the maximum annual contribution limits. This is on top of
any Individual Retirement Account (IRA) contributions. The worksheet for determining the 401(k) calculation is found in IRS Publication 560.
- The self-directed plan cannot only invest in standard assets like individual stocks, mutual funds, bonds, and money market certificates, but they can also invest in alternative assets such as real estate, private businesses, precious metals, loans and a host of other IRS permitted investments. There are no brokerage-imposed investment restrictions for self-directed plans.
- The self-directed plan typically has a loan feature which permits the plan participant to borrow the lesser of $50,000 or 50 percent of the account balance, whichever is less. These funds can be used for any purpose but must be paid back to the plan over a five-year period at a reasonable interest rate. The rate most often stated is the prime rate plus one percent.
- The self-directed plan typically provides the option to contribute after-tax dollars rather than before-tax dollars. This allows the plan holder to have a Roth sub-account, which means any earnings on the Roth portion of the account would be tax free. Usually, brokerage-directed accounts do not permit the Roth sub-account election.
- The plan owner can establish a limited liability company or other entity and have the self-directed individual 401(k) plan purchase an ownership interest in the entity. This gives the plan owner, as fiduciary for the account, the flexibility to determine which investments are purchased by the entity and owned by the plan. It allows almost total control over the administration of the plan assets. Some term this check writing ability.
- One of the absolute biggest benefits to having a self-directed individual 401(k) is that you can invest in leveraged, income-producing real estate investments. Leveraged (meaning borrowing money to purchase an investment) income-producing real estate investments are the best way to build assets in your retirement account that help you transition from relying on earned income to relying on passive income for your retirement needs. Mutual funds cannot be leveraged so they don’t have the same ability to generate income at retirement. Mutual funds are liquidated during retirement while real estate is not. Real estate continues to appreciate in value during retirement while providing passive income to live on. Unlike self-directed IRAs, self-directed individual 401(k) plans are not subject to Unrelated Debt Financed Income (UDFI) tax. UDFI is a type of Unrelated Business Taxable Income (UBTI) which, if triggered, could subject an IRA account to a 35 percent tax on any income or gain attributable to the debt portion of an investment. Self-directed individual 401(k) plans are exempt from UDFI tax (IRC §514(c)(9).
- When a person retires, the typical approach is to either leave the accumulated retirement earnings in the company’s 401(k) plan, if permitted, or to take the money and put it in an IRA with a stock brokerage company, a bank or an insurance company. A better approach is to create a self-directed individual 401(k) account and transfer the money at retirement into that account. It provides all the same investment alternatives but gives maximum flexibility. A rollover or conversion can be done from any existing 401(k), 403(b), Money Purchase plans, Profit Sharing plans, Keogh plans, Define Benefit Pension plans, Traditional IRAs, SEP IRAs, or SIMPLE IRAs into a Self-directed Individual 401(k) with no tax consequences.
Eligibility Requirements for Setting up a Self-directed Individual 401(k)
To establish a self-directed individual 401(k) there are basically three general requirements: The presence of self employment activity Taxable compensation has been received during the year The absence of full-time employees One example of how an individual 401(k) plan would work would be a person who works for an employer but also does consulting on the side. The consulting income would be considered self-employment income thereby rendering the individual’s business eligible for an individual 401(k) plan. The business can be a sole proprietorship, a partnership, a C-Corporation, an S-Corporation, or a limited liability company (LLC). With the exception of a spouse, the plan must not employ any full-time employees. A full-time employee is defined as one who works at least 1,000 hours per year for his/her employer. If you do not meet the eligibility requirements, consider establishing a SEP-IRA plan.
Permitted Self-Directed Retirement Account Investments
Numerous real estate related products and non-real estate products are permitted. Many accountants, financial planners, bankers and stockbrokers are not familiar with the wide array of investment choices that are available.
|Permitted Self-Directed Retirement Account Investments|
|Real Estate-Related Products||Non-Real Estate Products|
|Agricultural (Farm) Real Estate||Annuities|
|Build-to-Suit Real Estate Developments||Bonds|
|Commercial Real Estate||Commercial Paper|
|Fix-and-Flip Properties||Convertible Notes|
|Hard Money Loans||Equipment Leasing|
|Home Equity Loans||Factoring Accounts Payable|
|Home Mortgages/Take Out Loans||Franchises|
|International Real Estate||Hedge Funds|
|Discounted, Mezzanine & Bridge Loans||Mutual Funds|
|Participating Loans||Personal Property (see exceptions)|
|Privately-Traded Real Estate Investment Trusts||Privately-Held Companies|
|Publicly-Traded Real Estate Investment Trusts||Privately-Traded Stocks|
|Real Estate Leases||Publicly-Traded Stocks|
|Real Estate Options||Rights & Warrants|
|Residential Real Estate||Start Up Companies|
|Tax Deeds & Tax Liens||U.S Treasury Bills/Gold|
Prohibited Investments in a Self-Directed Retirement Account
The IRS prohibits IRAs from acquiring several types of investments. They include the following:
While annuities are permitted, whole life, universal life and variable universal life insurance policies are not permitted. Although the Incidental Benefit rule provides an exception for small amounts of coverage, this rule also applies to life insurance in qualified plans.
Certain Types of Derivative Trading
Derivatives include options and futures contracts on securities or commodities. Any type of trade or position that has unlimited or undefined risk, such as selling naked calls, is prohibited by the IRS. The reasoning behind this limitation is that the level of risk is inappropriate inside a retirement account that is designed to provide financial security during retirement.
Collectibles and Antiques
Furniture, wine or other alcoholic beverages, fine art, stamps, precious stones, porcelain and pottery, rugs, silver and dinnerware, jewelry, comic books, baseball cards, and other collectibles cannot be owned in the name of the IRA. That would also include priceless family heirlooms.
Your Personal Residence
You cannot hold any property that you personally use inside your IRA. This goes for both real and personal property. For instance, your primary residence, a second home, or a vacation home is prohibited. The Secretary of the Treasury has the right to define what type of tangible personal property may and may not be held in an IRA.
Certain Types of Coins
In general, you cannot hold any type of coin made from gold, platinum, or other precious metal inside an IRA. The IRS does have a list of exceptions, including: American Eagle coins that have never been circulated, Proofs of American Eagle coins, American buffalo coins, Canadian Maple Leaf coins, and Australian Gold Philharmonic coins. To be allowed in an IRA, the coin’s actual currency value must exceed its value as a collector’s item.
Prohibited Transaction Rule Basics
A prohibited transaction is any improper transaction between an IRA and a disqualified person, as defined in IRS Publication 590. Disqualified persons include the IRA owner and certain family members. For example, since your IRA is restricted from buying or selling investments that you personally own, a prohibited transaction would occur if you use your IRA to buy real estate that you already own in your personal name.
Most retirement plan investors have never heard of prohibited transaction rules because they invest primarily in publicly-traded mutual funds and stocks. These rules are important when you have a self-directed retirement account because you are now in charge of the types of investments that are purchased by that account and with whom you intend to transact with. Prohibited transaction rules do not specify what your IRA may invest in, but rather they restrict who your IRA may transact with. The question becomes, who is on the other side of the transaction with your IRA? The consequence of a prohibited transaction between an IRA and the IRA owner can be very serious. It can disqualify the entire IRA and result in a distribution of the total amount in the IRA to the IRA owner personally. The distribution will be subject to all applicable taxes and penalties upon withdrawal. Prohibited transaction rules are the same for Roth IRAs as they are for Traditional IRAs. There are two different categories of prohibited transactions under the rules: per se prohibited transactions and self-dealing prohibited transactions.
Who is a Disqualified Person to my IRA?
A disqualified person to your IRA includes the IRA owner and the lineal ascendants and descendants of the IRA owner, such as: the IRA owner, the IRA owner’s spouse, parents, grandparents, children, spouses of children. Also included as disqualified persons are companies in which the IRA owner or other disqualified person has more than 50% control. Why are these individuals and entities considered disqualified persons? The self-directed IRA account owner is a disqualified person because he or she is a fiduciary to the IRA and makes the investment decisions on behalf of the IRA and, as such, has the ability to enter into a transaction with the intent to avoid or unfairly minimize taxes IRC §4975 (e)(2)(A). Certain close famiy members of the IRA owner are disqualified for the same reason. A corporation, partnership, LLC,, trust or estate which is owned 50 percent or more by disqualified persons could also wield undue influence over the IRA. The 50 percent controlling interest includes:
- 50 percent or more of the voting authority of all classes of stock, or
- 50 percent or more of the capital interests or profits of the entity, or
- 50 percent or more of the beneficial interest of a trust or unincorporated business. IRC §4975 (e)(2)(G).
For example, if an IRA owner and his spouse owned 60 percent of an LLC, then that LLC would be a disqualified person as to the IRA. If the IRA owner and all other disqualified persons own 49 percent or less of the company and other unrelated third parties own the other 51 percent of the company, then the company is not disqualified person to the IRA. A company’s officers, directors, and 10 percent or more shareholders are only disqualified to an IRA when the IRA owner or other disqualified family member owns 50 percent or more of the company. Not all family members are disqualified persons. Brothers, sisters, cousins, aunts, uncles, nieces and nephews are not disqualified persons nor are friends, co-workers neighbors or other third parties. The following diagrams will help you determine whether or not a per se prohibited transaction has occurred.
What Companies are Prohibited to my IRA?
The rationale behind the 50 percent controlling interest provision is that if non-disqualified owners are in majority control of the company, they would only decide to sell at a legitimate purchase price and would not allow shares to be sold below its fair market value to the IRA. Suppose there is an LLC with ownership interests owned 33 percent by you, 33 percent by your brother, and 33 percent owned by your aunt and it owns rental property. Can your IRA buy the property from the LLC? The answer is yes, because you own less than 50 percent and the other two owners are not disqualified persons. IRC §4975 (e)(2)(G). Now suppose that you want to sell your 33 percent ownership in the LLC mentioned above to your self-directed Roth IRA, can yo do this? The answer is no, because the shares you are selling are owned by you personally and you are a disqualified person to your IRA, since you are the owner. If your Roth IRA is investing in the company, it must purchase its shares from the other two owners, i.e., the brother or the aunt, who are not disqualified persons.
Self-Dealing Prohibited Transactions
Self-dealing is the second type of prohibited transaction. Self-dealing occurs when an IRA owner or other disqualified person benefits personally from the IRA’s investments rather than the IRA benefiting from its investments. IRC §4975 (c)(1)(D), (E), and (F). A self-dealing prohibited transaction is also referred to as a conflict of interest prohibited transaction. The IRS, in IRC §4975 (c)(1), has stated that an IRA is engaged in self-dealing prohibited transactions when a direct or indirect:
(d) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; or
(e) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account, or
(f) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Paragraph (D) applies to all disqualified persons while paragraphs (E) and (F) apply only to the IRA owner, who is the fiduciary of the IRA. Self-dealing prohibited transactions are based on subjective factors that can be difficult to determine, but they are best analyzed under the language of paragraph (D), which gives the broadest interpretation. “For example, let’s say you’re a real estate agent, and you act as the agent and purchase an investment property with your self-directed IRA. As part of the purchase, you receive the buyer’s agent commission. Since you were the buyer’s agent on the transaction, this commission, unfortunately, constitutes a self dealing prohibited transaction because the IRA owner personally benefited from the IRA’s transaction by receiving the commission. As a result, if you are serving as the real estate agent for your own IRA, then you would need to waive your commission or would need to hire a non-disqualified person to serve as the agent for the self directed IRA’s purchase of the investment property.
“There is an argument that a broker commission may be ‘reasonable compensation’ under IRC §4975 (d)(10), and exempt from the prohibited transaction rules. However, the reasonable compensation exemption for real estate commissions received by a disqualified person, has not been tested in Court nor has it been specifically endorsed by the IRS or DOL. As a result, IRA owners should not rely on it and should avoid commissions or compensation to disqualified persons.”
“Another common example is a rental property owned by your IRA. While you may lease the property to non-disqualified persons, you may not personally stay at or use the property Use of property violates the self dealing rules as you end up personally benefiting from your retirement account’s investments by getting a free stay. If you paid rent at the same rate that other tenants paid, then you wouldn’t be personally benefiting and wouldn’t have a self dealing prohibited transaction. Instead, you would have a per se prohibited transaction because the rent payment would be a payment to the IRA from a disqualified person. Therefore, using the assets of your retirement account for personal use (or use by another disqualified person) will create a prohibited transaction whether you pay for them (per se prohibited transaction) or whether you receive them for free (self dealing prohibited transaction).”1
The Consequences of a Prohibited Transaction
The consequences of a prohibited transaction differ, depending on whether the disqualified person is the IRA owner or another party. The most common type of prohibited transaction is between an IRA owner and his/her IRA. If an IRA owner engages in a prohibited transaction with his, or her, own IRA, the entire IRA is disqualified. Disqualification results in distribution of the entire account, based on the fair market value of all assets in the account as of January 1 of the year in which the prohibited transaction occurred. IRC §4975 (c)(3), IRC §408 (e)(2)(A). Distribution of an IRA resulted in possible taxes on the amount distributed, early withdrawal penalties, if the person is under 59 1/2 years of age, and revocation of the favorable tax treatment for IRA investments that occurred after the prohibited transaction.