Self directed IRAs and 401ks, including the almighty Solo 401k, really are fantastic retirement vehicles. Many people are absolutely amazed to learn of the features and benefits these accounts offer.
Typical reactions include:
- You mean, I can rollover my existing retirement funds and get checkbook control over them?
- I can diversify out of the stock market which I was forced to be invested in despite not understanding it at all?
- I can invest into real estate if I want? Like, actual direct sole ownership of real property?
- I can have all this flexibility and pay less than I have been for a severely limited account when I add up all the management fees they’ve been charging me?
If someone were to ask “What’s the catch?” however, no answer would be complete without mention of prohibited transactions. Prohibited transactions aren’t unique to self directed retirement accounts such as the IRA LLC and Solo 401k. They apply to all retirement accounts. They just become more important for an individual to understand once they have or are considering acquiring this heightened level of control and responsibility with their retirement funds.
Prohibited transactions are transactions between a plan and a disqualified person.
Here’s a quick tip:
Anytime you are considering a transaction with your Solo 401k that involves a disqualified person, you need to either avoid that transaction completely, or get the appropriate help to determine if the transaction is indeed prohibited (and of course, avoid it if it is).
So, what is a disqualified person? Disqualified persons with respect to your retirement account are you and most of your family members. More specifically, these disqualified persons include you, your spouse, your lineal ascendants, your lineal descendants and their spouses, as well as fiduciaries and service providers to your plan. Businesses owned by disqualified persons should also be on your watch list.
To quote the IRS, disqualified persons are:
- A fiduciary of the plan.
- A person providing services to the plan.
- An employer, any of whose employees are covered by the plan.
- An employee organization, any of whose members are covered by the plan.
- Any direct or indirect owner of 50% or more of any of the following.
- The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4).
- The capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4).
- The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
- A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
- A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following.
- The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation.
- The capital interest or profits interest of a partnership.
- The beneficial interest of a trust or estate.
- An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
- A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
- Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.
Now that you know who shouldn’t be “involved” in these transactions, here are the things that the IRS considers involvement:
- A disqualified person’s transfer of plan income or assets to, or use of them by or for his or her benefit
- A fiduciary’s act by which he or she deals with plan income or assets in his or her own interest
- A fiduciary’s receipt of consideration for his or her own account in a transaction that involves plan income or assets from any party dealing with the plan
- Any of the following acts between the plan and a disqualified person:
- Selling, exchanging, or leasing property
- Lending money or extending credit
- Furnishing goods, services or facilities
What does all this mean? Well, it means you shouldn’t setup a Solo 401k plan so you can unload a piece of property you currently own by purchasing it with your retirement funds. It also means you shouldn’t try to convince your parents to downsize to an apartment so you can buy their house using your self directed 401k – regardless of whether or not it’s a “good deal” for the plan. You’d also want to cancel any plans to buy a rental property in your IRA LLC with the intentions of staying in the home yourself from time to time. Funding a loan to a grandparent or grandchild using retirement funds would also be off the table.
In other words, all transactions need to be done “at arms length” and should be in the best interest of the Solo 401k instead of in your own personal best interest. Remember, retirement accounts are for your benefit, but not your immediate benefit. These are tax advantaged investment vehicles that you are to grow as best you can until your retirement, at which time you can start to benefit from all those great investment decisions. These rules help to eliminate conflicts of interest between what is best for the plan and what is maybe just best for you.
Ultimately, what all this means is that you need to understand the laws that govern retirement accounts and seek qualified legal advice if you are unsure about a transaction before entering into it.