Tax Benefits of Self Directed & Solo 401ks – Video
John Hyre: What are prohibited transactions? Here’s the bad side. High return, I showed you the return. High risk, but the risk can be managed. A prohibited transaction is Code Section 4975. It kills anything but a 401k. We’re going to talk about the 401k separately in this context. Rule one, prohibited transaction kills anything but a 401k.
What does that mean? You have an IRA, it has $1.6 million in it. Now between the distribution, because it’s usually taxable, you have a 1.6 mil IRA, the money comes out, most of the time it’s taxable. That’s a pretty high bracket. Add it to your other income. Throw in a bunch of penalties. I tell people especially in a state like California, a high tax state, you’re probably looking at a large IRA being destroyed, about 60% of that goes to the government. 60% will go to the government. That’s pretty normal.
$1.6 million IRA does a $1 prohibited transaction. Let’s say I make a loan to mom. Most of us know that a prohibited transaction includes the IRA doing business with me, the owner, my ancestors, my descendants, my spouse, and the spouse of my descendants. Once again, you, ancestors, descendants, spouse, and spouses of descendants are direct prohibited parties. Now there are other disqualified persons, that’s a strict term. That’s just the directly prohibited ones. You do business with any of them, the IRA dies and the size does not matter.
You guys remember Caddyshack? The guy throws the Mounds bar in the pool and everybody clears out. One little Mounds bar screws up the whole pool. It’s the same with prohibited transactions. I lend $1 out of my IRA to my mother, the IRA dies. What’s 60% of a $1.6 million IRA? About a million bucks. Could a dollar cost you a million? Yes. Does anybody here think the IRS would not do that? Good. It’s nice to see a little reality.
Just in case you doubt that the government would do it here’s the government’s quote. This is the Tax Court, your defender, your shield against the IRS. Here’s what they say about prohibited transactions and compassion. “We conclude that the prohibited transactions contained in Section 4975 are just that. The fact that the transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence. Furthermore, the fact that the plan benefits from the transaction is irrelevant. Good intentions and a pure heart are no defense.”
Do you understand? Good. Because the context we had previously in today’s conversation is aggressive is good. When the law is gray, let’s be aggressive, this is an exception why. Because the penalty here is much larger. The penalty in a normal tax context is, “I was aggressive. I got busted it. It turns out that the gray position was white, not black, so I have to pay the tax and maybe some interest. If I’m having a really bad day, maybe a 20% penalty.” None of which is really a big deal, but in this context, if we screw up a prohibited transaction, the IRA dies.
We’re not just conservative, we are paranoid. You cannot have anything that could possibly be or even look like a prohibited transaction. Even the appearance of a prohibited transaction must be avoided. Do you understand why? Does anyone disagree? Now let me give you the one exception. Here’s the number one reason for 401k. I’m going to give you multiple reasons. I love, love, love self-directed 401ks. Why? The penalty for a prohibited transaction is only 15% of the transaction per year. 15% of the transaction. It does not kill the account. What does that mean? I lend mom a dollar, that’s my transaction amount. Let’s say we correct the transaction. How do we correct it? Mom pays the money back, we ended the transaction. I have a 15% penalty that year. That beats the hell out of a million bucks.
The number one reason I love 401k self-directed, if you can qualify, and we’ll talk about that. If you can qualify for a self-directed 401k, the protection against prohibited transactions is so much better. Now, there are other reasons. What are the other reasons I love 401ks? Higher contribution limit. Without going into details, you can contribute up to 53K a year to 401ks, and in odd situation, very unusual but sometimes possible situations, you can contribute up to 100 grand to 401k. That’s just one of you.
If you’re married and your spouse legitimately works for your business, two of you can do it. The contribution limits are higher. There’s no income limit on Roth contributions. Roth IRAs, if you make more than a certain amount, you cannot directly contribute. You can still indirectly contribute. All you do is contribute to a traditional IRA, then immediately, 20 seconds later, roll it to a Roth. There actually aren’t any contribution limits based on your income to Roths. You think there are, there aren’t. There are ways around them.
The 401k, they don’t even have a direct contribution limit based on your income. How much can you contribute to a 401k? There’s the part you put in as an employee. You’re getting a salary, presumably from your own company. How much can you put into the 401k as an employee? That’s $18,000 unless you’re 50 or older, in which case it’s $24,000. Then you can get the total number up to $53,000 or up to $59,000 if you’re 50 or older by having the company make a contribution. The company can match up to 25% of your salary. That’s how you get $53,000 in there.
There are some anomalous situations that you can actually get a hundred in there. I’m not going to go over them because it takes too long to explain it with the time we’ve got. What else do I like about 401ks? Better asset protection for most of them. 401k solos are a little different. A full-blown 401k has asset protection under federal law. What do I mean by asset protection? Things that happen inside the account, you are not protected from.
If you buy a rental in your 401k, you buy a rental in your IRA and somebody trips and falls, can you be sued directly? Yes, in most jurisdictions. Certainly, the account is liable. The rest of the 401k, the rest of the IRA has liability. That’s not the kind of asset protection I’m talking about.
Sometimes what we do is set up an LLC inside of a 401k or an IRA to provide that kind of asset protection for the same reason you would set up an LLC instead of owning rentals directly in your name. Same reason. The type of asset protection I’m talking about is from the outside. I always make fun of California on this one, so I guess I might as well be consistent.
Let’s say I accidentally– we got somebody who’s got one of those little purse animals, the animal jumps out and I accidentally run over it with my Humvee five times. You guys, California jury’s so compassionate, kind, sensitive and giving. Let’s say that there’s a judgment against me for $5 million. Just a lot of harm and suffering and, I don’t know, peoplism. Yes, favoring people over animals.
I could be punished. There’s a $5,000 judgment against me. Can you seize what’s in my IRA? Depends, depends on state law. Most states provide some protection for IRAs. They don’t necessarily provide protection for Roth IRAs. Depends on the state there. There are exceptions under the state statute. Is California the kind of state that is generous about protecting people? It is, it’s just they protect the wrong people typically.
401ks, a regular 401k is protected Federal law. There’s no busting open a regular 401k. Now, 401k solo is protected under state law. What’s the difference between a 401k solo and a regular 401k? A 401k solo is a simpler 401k. It’s cheaper and easier to operate. It has fewer administrative requirements. You can probably run one for a grand or less a year, but it has otherwise, aside from asset protection, otherwise functions just like a 401k in terms of contribution limits, self-direction, et cetera.
What do you have to do to qualify? You have to have earned income. What is earned income? Typically from the sale of services or from the sale of inventory. We can also define that by exclusion. What is earned income not? Earned income is not rents, not dividends, not interest, not capital gains, not royalties, so it’s active earned income. It’s a lot like a W-2.
You have to have some sort of side business, because if you have a 401k through your regular W-2 employer, their version of self-directed is which mutual fund would you like. You’re not going to be able to invest in properties and such. It’s not truly self-directed. You have some sort of side business that produces earned income.
Now if you have rentals and you manage them, could the rental company pay you a salary to manage them? Sure. That could be the side business. You have a side business, that will qualify you for any 401k, earned income and a side business. What qualifies you for the solo, which is much easier to run? The only employees in the business are you, your spouse and partners. You, your spouse and partners are the only employees in the business. If you have any other employees, you don’t qualify for solo, you have to decide as a regular 401k. Still can be self-directed, but it’s more complex. You’ve got to decide if that’s worth doing.
You can’t set up an entity and shut out other employees. If there’s 80% common ownership between entities, you’ve got to include the other employees. What do I mean? These three work from my one company and looking at them, I don’t want to share. I’m going to come over and set up an LLC here and it’s going to have a 401k. Can I do that? Not if I have 80% common interest. In this case, I own both 100%. My spouse, my kids, what they own is attributed to me, so I can’t have 80% common ownership.
Now let’s say I own that one 100%, we set up a partnership. We’re not related. He looks relieved. We set up our own LLC, he owns 30%, I own 70%. Is it now 80% common control? No, I only own 70% here, 100% there, we didn’t hit the 80% threshold. In that case, this entity can set up the 401k. If I own both companies, 80% common control, direct or indirect, just put all the schemes out of your mind. What if I have 15 Nevada LLCs that have a C corporation management company on the moon with 32 trusts of which my dog is the beneficiary? No. It doesn’t work.
If I have common control, I can set up a 401k solo here. Well no, I can’t. I can set up a normal 401k and I have to offer them the benefits. There’s the rough requirement. You’ve got to have a side business if you want to qualify for the solo. No other employees other than spouse and partners.
Now, can you still do a 401k? Yes, it gets more complicated and costly. It may be worthwhile, and then again, it may not be. That’s my situation. I have a law firm, I have employees, I have to share. It makes me sad.