Self-Directed Solo 401k Prohibited Transactions Review and Illustrations
Even though you can invest your solo 401k (referred by other names such as small business 401k, self-employed 401k, owner only 401k, Solo K, etc.) in many types of alternative investments (e.g., real estate, notes, LLC, Gold, etc.), you still must be careful not to engage in prohibited transactions when investing your Solo 401k. A transaction is deemed prohibited if it benefits you, as trustee/participant of the Solo 401k plan, or other disqualified persons such as your beneficiary, spouse, son, daughter, father or mother, to name a few.
Simply stated, any transaction that does not only benefit your solo 401k, but instead you personally or someone you know who is defined as a disqualified individual by the IRS will be deemed prohibited.
Prohibited transactions are often referred to as “self-dealing.”
This means your Solo 401k/self-directed 401k is prohibited from engaging in transactions that benefit you, your direct family, or your business. The negative consequences to your Solo 401k include tax penalties and loss of tax deferred status. Simply put, prohibited transactions are investments or forms of self-dealing that would put the government at risk of losing its tax on the solo 401k. To be clear, prohibited transactions only occur when funds within your solo 401k are used improperly. You can always withdraw from your solo 401k, pay the tax (and penalty if you are under 591/2 and no exceptions apply) and spend the money any way you wish, because now the government got their tax and the money you are spending is no longer solo 401k money. They worry when you spend money within your solo 401k on certain items because they think you might just be planning to beat them out of the tax that you would have paid on a solo 401k distribution.
Prohibited transactions examples
The rules prohibit your Solo 401k / Self-Directed 401k retirement account from holding property in which you or disqualified persons currently occupy or plan to occupy. In other words, the property must be for investment purposes only.
A lease between Solo 401k plan and daughter of Solo 401k plan trustee
Matt’s Solo 401k owns an apartment building. One of the tenants is his daughter Susan. As a party-in-interest, Susan’s leasing of the apartment is a prohibited transaction because the apartment is Solo 401k asset.
Your Solo 401k / self-directed 401k can’t purchase private shares (for example, company shares that are not traded in a public exchange such as New York Stock Exchange or NASDAQ) in your own business or of a disqualified person (e.g., your son, daughter, father and mother to name few).
The purchase of shares by Solo 401k in your own corporation
John personally owns 15% interest in a private corporation that he manages. Two years later he decides to use his Solo 401k plan to purchase Nick’s, another shareholder, 20% worth of shares. This is a prohibited transaction because John already owns and manages the corporation.
You can’t loan your Solo 401k or self-directed 401k funds to a disqualified person such as your father, mother, son, or daughter for example.
promissory note to daughter
Tina loans $50,000 from her Solo 401k to her daughter charging her 10% interest per year. This is considered a prohibited transaction because Tina’s daughter is considered a disqualified person.
A roundabout transaction occurs when the Solo 401k participant/trustee structures one or more transactions with the purpose of making a prohibited transaction.
For example, you loan money from your Solo 401k /self-directed 401k to your friend (who’s not a disqualified person), and he or she then turns around and loans the same funds to your mother. This is considered a roundabout transaction and viewed by the IRS as not only prohibited but also as an attempt to evade the tax rules because you can’t loan money from your Solo 401k to your mother, even if you first loan it to your friend (who’s not a disqualified person), who then loans it to your mother.
For the most part you can invest your Solo 401k / self-directed 401k in any investment type with the exception of the following:
A collectible includes a work of art, rug, antique, metal, gem, stamp, certain coins, alcoholic beverage, and musical instruments to name a few. The U.S. Treasury has the power to add to this list any other tangible personal property.
Click here to read our blog about the negative tax consequences of investing your Solo 401k in collectibles.
A “disqualified person” is defined as a fiduciary, you, a member of your family or any other entity such as a corporation, partnership, trust or estate that is 50% or more controlled by you or your family members.
For a solo 401k plan, you, the solo 401k owner, are a fiduciary. This is because you have discretion and control over the plan’s investments. In other words, you can’t blame it on the bank or solo 401k provider. If you misuse your solo 401k plan, it’s your fault.
The IRS considers the following as disqualified persons with respect to Solo 401k / self-directed 401k transactions:
- Family members such as your father, grandmother (considered ancestors)
- Your children, grandchildren (considered lineal descendents)
For a full list of disqualified persons visit here
Tax Consequence of prohibited transaction
Whether you intentionally or accidentally subject your Self-Directed Solo 401k to a prohibited transaction, the tax consequences are the same—your Solo 401k will generally be subject to federal taxes, possible state taxes and penalties.
In sum, thread carefully when investing your Solo 401k, also commonly referred to as a Self-Directed Solo 401k, Self-Directed 401k, Individual 401k, Individual K, Single K, Single 401k or Self-Employed 401k, because of the many different possible ways of structuring alternative investments such as real-estate, private investments, promissory notes, etc.
Additional Information on Prohibited Transactions
The prohibited transaction rules are found both in the Internal Revenue Code (IRC) and in ERISA.
- Click here to learn about prohibited transactions under ERISA.
- To learn about prohibited transactions under Internal Revenue Code click here.
The following pages also cover the prohibited transactions rules:
Who Should Not Open a Self-Directed 401k Plan?
- If you plan to perform sweat equity work on the property, you should not open a self-directed 401k plan.
- If you plan to draw a salary for managing (e.g., collecting rent checks for deposit into the 401k plan, hiring contractors for performing repairs or improvements on the 401k owned property, seeking tenants, etc.) the self-directed 401k owned property, you should not open a self-directed 401k plan.
- You plan to use the self-directed 401k owned property for personal or business use even if you pay a fair market rent rate, you should not open a self-directed 401k.
- You plan to have your children or parents use the self-directed 401k owned property for personal or business use even if a fair market rate rent is paid, you should not open a self-directed 401k.
- You or your children or parents later plan to vacation in the self-directed 401k owned property.
- You plan to sale, exchange or deposit real estate that you own personally or through your business, or your parent or children personally own or through their business into the self-directed 401k plan.
Exchange Promissory Note Investment QUESTION:
Such investment would result in a prohibited transaction. You cannot assign an investment that you personally own to your own solo 401k plan.
- Your Spouse
- Your natural parents and/or your adoptive parents
- Your natural grandparents
- Your natural children and/or your adopted children
- The spouses of your natural children
- Any fiduciary of your Solo 401k
- Any people providing services to your Solo 401k–such as your stockbroker–as well as his employees and both his and his employees’ blood relatives
- Your Solo 401k trust document provider or administrator
Investment Type QUESTION:
Good question. The IRS considers investing in cars and watches as disallowed investments. For a list of disallowed solo 401k investments, VISIT HERE.
Investment Real Estate Swap QUESTION:
Good question. However, such transaction would run afoul with the prohibited transaction rules. While it is true that siblings are not disqualified parties on the surface, what would make such transaction prohibited is that the siblings would be using their respective solo 401k plans to swap their personal investment properties.
Buying or Distributing Solo 401k Real Estate QUESTION:
Excellent and popular questions. First, no you cannot buy property such as a condo from your own solo 401k plan as that would result in violation of the following prohibited transaction rule.
“Sale, exchange, or leasing of property between a plan (e.g., Solo 401k plan) and a party in interest (the solo 401k trustee).”
However, it would not be prohibited if you take an in-kind solo 401k distribution of the property (the condo) since the rules allow for distributions in the form of an asset instead of cash. You can also spread the tax liability by taking partial in-kind distributions of the property. You will need to get the property appraised each time you process a partial distribution, however.
Roundabout Prohibited Transaction QUESTION:
While the solo 401k investment rules allow for promissory note investments, this transaction would result in a “roundabout” prohibited transaction because the rules do not allow for a transaction that is prohibited to be done indirectly. In other words, while your brother is not a disqualified party from a solo 401k investment perspective, if he were to turn around and loan those borrowed funds or other funds to you, the IRS would view as you essentially processing a promissory note from your own solo 401k which is prohibited. Don’t confuse this rule with the solo 401k participant loan rules, though. To learn more about the difference between a “promissory note investment” and a solo 401k participant loan” CLICK HERE.
Note Investment with Sister-in-law QUESTION:
Correct that a sister-in-law is not a disqualified party from a solo 401k investment perspective. To learn more about the promissory note rules, CLICK HERE.
Guarantor on Loan to Solo 401k Trust QUESTION:
1. You cannot be and officer, director, or 10 percent or more shareholder, or highly compensated employee as this would run afoul with the prohibited transaction rules.
Invest in Cars QUESTION:
Transactions Between Two Companies QUESTION:
Quick question: are transactions between:
1) a company (A) that’s 100% owned by my solo 401(k) and;
2) a company (B) that’s 100% owned by me
So for instance, if company A sold products to company B, would that be a prohibited transaction?
Purchase Car for Business Use QUESTION:
- Metals – with exceptions for certain kinds of bullion,
- Coins – (but there are exceptions for certain coins),
- Alcoholic beverages, and
- Certain other tangible personal property.