Solo 401k Plan for Rental Property Self-Employed Business

QUESTION:

I own & manage rental properties.  Am I able to Solo 401k for my rental property business if I have another 401k with my employer?

ANSWER:

 Yes the IRS rules allow for participation in multiple 401k plans. Fore more on these rules, VISIT HERE.
 
However, in order to open a solo 401k plan the eligibility rules have to be satisfied which encompass the following. 
 
1. Not employee any full-time non-owner W-2 employees (those working 1,000 hour or more) in any of your self-employed businesses. Those that own multiple businesses need to be aware of the controlled group rules before proceeding to open a solo 401k plan. To learn more about the controlled group rules, CLICK HERE.
2. The services that you are performing have to be performed at least on a part-time basis and must be material based. For example, in the context of managing rentals, you would need to be managing the non-retirement account owned properties and treat the income earned as earned income not passive income. The purpose of the earned income rules from a self-employment perspective is to provide a solo 401k plan for the self-employed so that they can save for retirement, and to exclude inactive owners whose income is derived only from investments as investment income is not considered “earned income.” 
In sum, if you own multiple properties outside of your retirement account which you actively manage (e.g., screen potential tenants, collects rent checks, performs some of the routine property maintenance, and arranges for contractors to perform some or all of the property improvements or repairs), you are arguably self-employed  and can thus open a solo 401k plan.  To learn more about the solo 401k eligibility rules, VISIT HERE.

Making Voluntary After-Tax Contributions to Combined Hybrid 401k and Defined Benefit Plan | DB(k) Plan

In the following post, we explain how voluntary after-tax contributions made to a Solo 401k plan does not limit the ability to fully fund a defined benefit plan.

Question from Carolyn from Scottsdale, Arizona

My income is W-2 from my own PLLC, about $230k.  My CPA calculated my solo 401k contributions up to (i) $18500 as an employee contribution and (ii) $13800 as a profit sharing contribution of 6% since I also have a defined benefit plan.  My Defined Benefit Plan contribution for 2018 will be approximately $200k.

Does my solo401k plan allow for a Mega Back Door Roth contributions?  Is there any way for me to put more money away for 2018?

Answer:

Good question.  Let’s first review the regulatory history and then address your specific question.

The Pension Protection Act (PPA) of 2006 amended the contribution limitations which made the practice of employers adopting both a Defined Contribution Plan and a Defined Benefit Plan (DBP) more favorable (see IRS Notice Certain Deduction Limits under the Pension Protection Act of 2006).  This type of structure is sometimes referred to as a Combined Hybrid 401k and Defined Benefit Plan or DB(k) Plan.

Previously, few businesses used a dual plan strategy because Section 404(a)(7) of the Internal Revenue Code limited the total contribution made to both plans to 25% of eligible compensation.

This means that under old rules there was no reason for a business to offer both plans when the business could obtain the same tax deduction with just one plan.

The PPA relaxed the limitations that apply when an employer sponsors and makes contributions to both a defined benefit plan and defined contribution plan.

Under the revised rules, employers can fully fund a DBP, make salary deferrals to a 401(k) plan and make profit sharing contributions up to 6% of compensation.

Under the new rules, if profit sharing contributions exceed 6% of compensation, there will be a corresponding decrease in the ability to fund the defined benefit plan.

You are now asking whether voluntary after-tax employee contributions made to a 401k plan could limit the ability to fully fund the DBP.

This confirms that making voluntary after-tax contributions to the solo 401k will not reduce the ability to make deductible contributions to the defined benefit plan.  This is because (i) voluntary after-tax employee contributions are not counted toward the IRC 404(a)(7) deduction limit and (ii) only contributions that are tax-deductible to the employer count toward the IRC 404(a)(7) limit.

Please note that you would need to also confirm that the 401k plan allows for voluntary after-tax contributions and ensure that such voluntary after-tax contributions are deposited into a separate sub-account.  Please also see the following post regarding Mega Back Door Roth contributions: CLICK HERE

Top Items to Consider When Taking Solo 401k Distribution Including In-Kind Distributions

Here are some quick items to consider when taking distributions from a solo 401k plan including in-kind distributions of real estate owned under the solo 401kplan.
  • Distributions including in-kind distributions of real estate from a solo 401k plan are taxed at earned income tax rates.
  • Any taxable in-kind distribution distributed to you is subject to mandatory withholding of 20% of federal taxes, even if you intend to roll the distribution over later to an IRA or back to the solo 401k plan.
  • A 10% early distribution penalty also applies if you are under age 59 1/2.
  • A triggering event (this is an IRS rule) must be satisfied in order to make a solo 401k distribution. A triggering event is the attainment of age 59 1/2, for example.
  •  If you are over age 59 1/2, you can distribute any amounts.
  • If you are not over age 59 1/2, you can generally only distribute any amounts that were transferred/rolled over to the solo 401k from other retirement plans and/or IRAs.
  • In the case of an in-kind distribution of solo 401k real estate, the property will first need to be appraised by a third-party (not the solo 401kparticipant/trustee) to ensure the correct tax amount is paid.
  •  Whether a partial or full distribution of the real estate property, the property will need be assigned from the solo 401k to your personal name, so you will also need to have the property re-recorded with the county recorder.
  • If a full in-kind distribution, the full property is assigned from the solo 401k to your name.
  •  If a partial in-kind distribution of real estate, that portion is assigned from the solo 401k in your name so the solo 401k will still remain a partial owner. As a result, you still cannot use the property for personal use since the solo 401k plan still owns part of the property.
  • In the event the property is now owned by your and your solo 401k plan, all income and expenses will need to be allocated based on the ownership percentages.

Study Confirms Americans Happy with 401k Plans

A recent study by the Investment Company Institute confirms Americans are happy with their 401k plans due to flexibility and control.

While the report does not specifically reference solo 401k plans, a solo 401k is a 401k but for the self-employed and I can tell you that our clients like their solo 401k plans because of control that they have to self-direct the solo 401k accounts into alternative investments such as real estate, metals, notes, tax liens, private equity, bitcoin as well as equities. They also like the flexibility of being able to borrow from their solo 401k plans through a solo 401k participant loan.

Here are some of the findings found in the study performed by Investment Company Institute:

  • Respondents are confident that 401(k) and other DC plans will help them meet their retirement goals.
  • Confidence was higher among households that currently own DC accounts or IRAs at 83%, but even 62% of non-owners expressed confidence in the DC system.
  • Respondents also strongly oppose changes to key DC plan features — and this was consistent even if they are not currently taking advantage of a DC account.
  • 88% of respondents disagreed that the government should either remove the tax advantages of DC plans, or reduce the amount that individuals can contribute to their DC accounts.
  •  85% of DC-owning individuals agreed that the “tax treatment of my retirement plan is a big incentive to contribute.”
  • When asked whether “knowing that I’m saving from every paycheck makes me less worried about the short-term performance of my investments,” nearly 80% of DC-owning individuals agreed with that statement. This finding ranged from 64% of DC-owning individuals with household incomes of less than $30,000 to 84% of those with household incomes of $100,000 or more.
  • Strong majorities of respondents disagreed with proposals to take away investment choices or control of account balances during retirement, further reinforcing the notion that participants strongly support retaining the structure of DC plans.
  • Respondents also largely agree that employer-sponsored retirement accounts help them think about the long-term, making it easier for them to save. Nearly half (49%) of DC-owning individuals agreed with the statement, “I probably wouldn’t save for retirement if I didn’t have a retirement plan at work.”
  • The 11th annual update of ICI’s survey includes the views of more than 2,000 American adults on DC retirement account saving, as well as their reactions to possible policy changes and their confidence in 401(k) and other DC plans.

Solo 401k Reporting Hinges On Certain Factors

Reporting for the solo 401k plan hinges on the factors listed bellow. Please review and let me know if you fall under any of these.

Question: 

When do I need to make my Solo 401(k) Contributions?

Answer: 

Contributions to a Solo 401k plan must be made by your business tax return due date or any timely filed extensions. For more information: Click Here

Question:

When does a Form 5500-EZ need to be completed?

Answer:

If your solo 401k plan balance exceeded $250,000 as of December 31, a Form 5500-EZ is due to the IRS by July 31. A Form 5500-EZ is used by the self-employed business owner to report on a yearly basis the total value of the Solo 401k plan; however, Form 5500-EZ does not need to be filed until the Solo 401k plan total assets exceed $250,000. Since we don’t have access to your funds, it is your responsibility to let us know if you would like us to assist in preparing the Form 5500-EZ.  For more information on this please visit the following link and read our FAQ page on Form 5500-EZ: Click Here

Question: 

When do I need a Form 1099-R?

Answer:

Anytime a plan participant or beneficiary takes a distribution from his or her self-directed solo 401k, IRS reporting requirements apply. 1099-R reporting also applies to in-plan Roth 401k conversions. Payers must send a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to the IRS and to the individual receiving the distribution. The form is due to the IRS by February 28. Again, Since we don’t have access to your funds, it is your responsibility to let us know. For more information please see the following link: Click Here

Question:

When are Solo 401k IRS Required Plan Updates needed?

Answer:

As the solo 401k plan provider, we are responsible for updating the plan for any required IRS changes, with the next required update occurring in 2020. You will be required to sign all new solo 401k plan documents, and only the solo 401k plan provider can handle such an update with the IRS. For more information: Click Here

Use Fidelity Investments for The Mega Back Door Roth Roth Solo 401k

While Fidelity Investments does not offer a solo 401k that allows for voluntary after-tax contributions, which is the first step in implementing the “mega back door Roth solo 401k strategy, “Fidelity does offer a custodial brokerage account to hold the voluntary after-tax solo 401k funds for a solo 401k plan provided by a solo 401k provider such as My Solo 401k Financial.

When you open a solo 401k plan with My Solo 401k Financial, we not only provide an IRS approved plan document that allows for voluntary after-tax contributions  but it allows for in-service distributions of the voluntary after-tax funds which is the second piece of the mega backdoor strategy.

We also fill out all of the applicable Fidelity Investment brokerage forms in order to open the correct voluntary after-tax brokerage account for the solo 401k.

Following are some of the rules regarding this type of solo 401k voluntary after-tax setup for implementing the mega back door Roth solo 401k strategy:

  • Voluntary after-tax solo 401k contributions fall under the employee (salary deferral) contribution umbrella.
  • This type of contribution is not considered employer (profit sharing) contributions, so the contribution is not tax deductible because it is considered made with post-tax dollars.
  • When voluntary after-tax solo 401k contributions are converted to a Roth IRA or the Roth Solo 401k, the conversion has to be documented in writing by completing a conversion Form ( the IRS will expect to see a copy of this form upon request), and a Form 1099-R has to be issued to report the conversion whether taxable or not.  This reporting is covered by our annual service and fee.
  • Voluntary after-tax solo 401k contributions can be distributed and thus converted at any time. This is why the conversion of voluntary after-tax solo 401k contributions has been dubbed the “mega-backdoor Roth solo 401k.”
  • There is a lesser known rule called the “overall 415 limits.” The overall 415 limit for 401(k) plans including solo 401k plans. For 2018, the overall limit is $55,000. The overall limit looks at the total annual additions to all of a participant’s accounts in plans maintained by one employer and includes not just their salary deferrals, but also matching contributions, allocations of forfeitures and other amounts. Voluntary after-tax solo 401k contributions are subject to the overall annual limit (“The 415 Limit) $55,000 for 2018.

Lastly, don’t confuse Roth solo 401k contributions with voluntary after-tax contributions.  VISIT HERE to learn more about the differences.

Who is Not Required to Take a 2019 RMD by December 31?

While most solo 401k owners who are 70 ½ or older will need to take a 2019 required minimum distribution (RMD) by December 31, 2019. However, that deadline does not apply to all solo 401k owners. Solo 401k owners who are age 70 ½ or over are not required to be take an RMD from their solo 401k by the upcoming December 31 deadline if you just reached 70 1/2 in 2019. Generally, when you reached age 70 ½ you must take an RMD. However, for the first year you catch a break. You do not have to take your 2019 RMD until your Required Beginning Date (RBD) which is April 1, 2020. This is only a one-time exception. All future Solo 401k RMDs must be taken by December 31. However, there is a downside to waiting until 2020 to take your 2019 RMD. You will need to take your RMD for 2019 by April 1 and the 2020 RMD for your second distribution calendar year by December 31. That means two taxable distributions, which would need to be included in income so you won’t be able to spread your tax liability over 2019 and 2020 if you took your 2019 RMD in 2020.

With respect to reporting the solo 401k RMD on your Form 1040 tax return,, if you take the 2019 RMD this calendar year, reporting is due when you file your 2019 personal tax return, which will be April 15, 2020.  If you wait to take your 2019 RMD in 2020, then both RMDs (2019 & 2020) will be due on your 2020 personal tax return, which would would be filed by April 15, 2021.

Lastly, don’t get confused with the IRA RMD aggregation rules which allow the IRA owner to aggregate all her IRA balances and take the RMD one IRA. This same rule does not apply to qualified plans such as a solo 401k plan. The RMD due from the solo 401k must be withdrawn from the solo 401k plan, not from your IRA  or from your current employer 401k plan if you also have a full-time job and participate in that employer’s 401k plan.

Investing a Self-Directed IRA in Notes Vs Investing a Solo 401k Plan in Notes

After physical real estate, investing retirement funds such as self-directed IRA and solo 401k funds in promissory notes secured by real estate (also known as trust deeds) is quite popular.

Investing in notes is especially attractive for those not looking to contend with the challenges that can arise with real estate. Challenges from making sure the property remains occupied  to actually managing the property. With note investments, the self-directed IRA or the solo 401k plan is effectively acting like a bank since the funds are loaned out to an unrelated third-party.

SIMILARITIES of Investing a Solo 401k or a Self-Directed IRA in Promissory Notes:

Since the retirement account is making the note investment, the note investment cannot be to a disqualified party such as the retirement account participant, her spouse, parents,children, grandchild, and her business, to name a few.

The promissory note can be structured as a secured or unsecured note. It is preferable to invest in notes secured by real estate in the event the borrower cannot make the note payments. In which case, the retirement account will take over the property.

When processing the funding of the promissory note, the funds have to flow from the retirement account directly to the borrower, not your personal or business bank account, as doing so would result in a taxable event.

The note investment must be documented in writing and list the retirement account as the lender (beneficiary).

A note interest rate that will benefit the retirement account must be charged while also not running afoul with the usury rules.

All note payments must be deposited directly into the retirement account not your personal bank account.

DIFFERENCES of Investing a Solo 401k or a Self-Directed IRA in Promissory Notes:

It is generally easier and less costly to invest in notes via solo 401k plan over a self-directed IRA.  For example, because the solo 401k owner is the trustee of the plan and thus manages the solo 401k bank account, she can process the funding of the note by wiring a check to the borrower from the solo 401k bank account or submit a wire directive to the bank.  On the other hand, if the investment is done through a self-directed IRA the IRA custodian will charge a transaction fee, a wire fee and an ongoing note holding fee.

When titling the note investment, the self-directed IRA custodian is listed as the lender (beneficiary) for the benefit of the IRA.  If processed through the solo 401k plan, tile is taken in your name as trustee of the solo 401k plan. Click here to learn more on how to title the note investment.

The promissory note instrument is safe-kept by the solo 401k owner. With an IRA, the self-directed IRA custodian safe-keeps the note paperwork and charges a holding fee for doing so.

The promissory note payments flow to the solo 401k bank account instead of the self-directed IRA custodian for deposit into your IRA.

 

Consider Using Roth IRA for College Savings

With college tuition increasing each year, utilizing a Roth IRA to cover some of those college costs may be be a good idea. Also, Roth IRA contributions will not affect the amount of financial aid your student receives because Roth IRA contributions are not tax deductible.

Roth IRA Distributions

Roth IRA contributions can be distributed at any time tax and penalty free and used for any purpose including paying for college. What is more, Roth IRA earnings can also be distributed penalty free (i.e., the 10% early distribution penalty does not apply even if you are under age 59 1/2 at time of the distribution); however, federal and state taxes still apply unless you are both age 59 1/2 or older and meet the 5 year holding requirement which would allow for tax free distribution for earnings.

What is an Educational Institution?

Any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the U.S. Department of Education, which generally includes all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

Other Options

If you are self-employed and participate in a solo 401k plan, you can take a participant loan up to the applicable limit (50% of account balance or maximum amount of $50K.) from the solo 401k and use those funds for any purpose including to pay for higher education expenses.

 

TCJA Impact to Alimony Payments from Solo 401k Plans

In addition to impacting IRAs, the Tax Cuts and Jobs Act (TCJA) of 2017 (TCJA) also impacts alimony payments from solo 401k plans. Prior to 2019, the alimony payer (i.e. the solo 401k participant) received an above-the-line deduction and the recipient treated the alimony as income.  Now any divorce agreements adopted on or after January 2019 no deduction for alimony payments are allowed, and alimony payments are not treated as income.

This essentially means that the rules are now more favorable to the payee but results in higher tax liability to the payer (i.e., the solo 401k participant).  What is more, alimony payments no longer can be treated as earned income for the receiving spouse so the funds can no longer be used for IRA contributions purposes effective January 1, 2019.

  • About MySolo401k

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