One of the biggest mistakes I see retirees make is to transfer their company 401(k) to an Individual Retirement Account with the same financial planner or stock broker who likely achieved abysmal returns for them while they had their 401(k) with their employer. When you retire, don’t lock yourself into a relationship that restricts the types of products you can invest in and limits your ability to earn above-average returns. And don’t transfer your retirement funds into an account that limits your ability to grow your income-producing assets.
When you retire from your present company, you have a great opportunity to take control of your retirement account and start making important changes that will secure your financial future. The approach I would suggest you consider forming a limited liability company and creating a self-directed solo 401(k) account to roll your retirement account into rather than blindly rolling it over into a traditional IRA. The government calls these accounts one-participant 401(k)s.
There are several important reasons for rolling your account from an existing 401(k) to a self-directed solo 401(k) rather than transferring it to a traditional IRA. First, you have the opportunity to self-direct your account. What that means for you is that you can now begin making investment decisions on your own. When you had your company 401(k) account, you were obligated to make investments through the financial adviser your company selected regardless of how good or how poorly he or she managed your account. Self-direction means that you are no longer required to use that financial adviser nor are you obligated to continue to put all your retirement funds with them. Instead of having to select investments like mutual funds or bonds that are publicly traded, you can now choose alternative investments like income-producing real estate.
Second, by rolling your account from one 401(k) to a solo 401(k), you continue to be able to make significant contributions to your retirement account. Not only can you continue to make major contributions to your account, but your spouse can also make significant contributions. If you roll your retirement funds into an IRA, you are only permitted to make annual contributions of $6,500, which includes the standard $5,500 contribution plus a $1,000 catch-up contribution for being over age 50. The 2015 annual elective deferral (contribution) limit for employees who participate in a 401(k), 403(b), and most 457 plans is $18,000 plus an additional $6,000 catch-up contribution for employees aged 50 or over. That’s $24,000 a year instead of $6,500 a year for an IRA. That’s not only $24,000 a year for you but also $24,000 a year for your spouse. Not only can you make employee contributions of $24,000 a year, but your employer, which is your new LLC, can also make profit sharing contributions of an additional $29,000 up to a maximum allocation of $53,000 for you and your spouse.
Third, you can now begin to invest in leveraged investments. Mutual funds and other publicly-traded investments don’t give you the opportunity to leverage your investment. When you buy a mutual fund, you purchase one dollar of stock for each dollar you invest. There is no leverage. However, if you purchased income-producing real estate, for every dollar you invest you can buy four dollars of real estate. That means you have four dollars in assets earning income and appreciating in value for every dollar invested instead of one dollar earning income and appreciating in value for every dollar invested. Leverage makes it possible to grow your retirement account to the point where it can become self-sustaining. Instead of being required to withdraw a percentage of your retirement account each year to have sufficient money to live on, you can generate enough income through your investments that you don’t have to touch the principal but instead can live off the income. Your assets not only continue to provide income they actually continue to appreciate in value over the remainder of your life. So, at the end of your life, you have a great asset or assets to pass on to the next generation rather than leaving them with a depleted account.
Fourth, 401(k) account are not subject to Unrelated Business Income Taxes (UB IT) or Unrelated Debt Financing Income (UDFI) taxes. If you decide to purchase a business or leveraged real estate, there are no additional taxes owed as there would be with an IRA. IRAs are subject to both UBIT and UDFI taxes if you borrow money to finance the acquisition of the asset. Regardless of UBIT and UDFI, it’s still better to buy leveraged investments, even with your IRA, than it is to purchase these investments with after-tax discretionary income, but the returns are enhanced further if you purchased leveraged investments with 401(k) money. That way you pay no tax until you begin to withdraw the required minimum distribution amount at age 70 ½. Fifth, you can always transfer the money from your self-directed solo 401(k) to an IRA at some time in the future and still maintain your tax-exempt status. At some point in time, usually age 70 ½, you might consider, for estate planning purposes, to begin to transfer a portion of your 401(k) account into a self-directed Roth IRA. That requires the payment of ordinary income taxes on the portion of your account balance that is transferred to your new Roth account. The reason for doing this is twofold: (1) Roth IRA accounts are not subject to Required Minimum Distributions (RMDs) and (2) Roth IRA accounts are not subject to the payment of taxes on the principal or the interest earned. All other retirement accounts are subject to RMDs at age 70 ½. With your self-directed solo 401(k) account, however, prior to making any transfers into a Roth IRA account, you can elect to make Roth (after tax contributions) into your 401(k) rather than make traditional (pre-tax contributions) into your account. That way the contributions or earnings are never taxed.
There are some other things to consider when you create your self-directed solo 401(k) account. First, the LLC you create to handle your new self-directed solo 401(k) accounts must be established with the intent to earn income. That doesn’t mean it has to earn income. It just means that it must have the intent to earn income. When you make the initial contribution from your existing company 401(k) account to your new self-directed solo 401(k) account no earned income is required. It can be a straight trustee-to-trustee transfer. However, any additional contributions into the account must come from earned income. That can be consulting income or any other type of earned income, which is not hard to do. Your accountant can help you figure it out. The other consideration, is that, to invest in leveraged income-producing real estate, the debt must be non-recourse to the self-directed solo 401(k) and to you as its owner. That means neither you or your 401(k) can personally guarantee the loan. The way I handle this with my clients is that I work with lenders who will permit me to be the sole guarantor on the loan without requiring my 401(k) or IRA partners to personally guarantee the debt. There are lenders out there who will not require recourse financing, but you need to know where to find them.
Finally, the easiest way to set up a self-directed solo 401(k) account is through any national Third Party Administrator (TPA) and Custodian who has been approved by the Internal Revenue Service (IRS) to handle these types of accounts. I work with several of the top TPAs who handle these accounts. In summary, there are five major reasons you should set up a self-directed solo 401(k) account when you retire rather than transferring your company retirement funds to an IRA:
- You can personally self-direct your investments;
- You can continue to make significant contributions to your retirement accounts ($24,000 instead of $6,500);
- You can begin to invest your retirement savings in leveraged investments, like income-producing real estate which can give you a significantly higher return;
- You can avoid UBIT and UDFI taxes when you do invest in leveraged investments; and
- You can choose to invest in your new self-directed solo 401(k) with Roth (after-tax) dollars which means you can earn income on those dollars tax free rather than tax-deferred.
To take advantage of your new self-directed solo 401(k) you must establish a limited liability company for just you and your spouse with no other employees and you should work with someone who knows how to structure income-producing real estate investments in a way that avoids any personal guarantees for you and your 401(k). These investments can work for you whether you have $50,000, $500,000 or $5,000,000 in your account. The smaller the amount you have to invest, the more likely you will need partners to invest with. And finally, work with a trusted Custodian and Third Party Administrator who has been approved by the IRS and has a history of working with these types of accounts.