Self-Directed IRA Versus Solo 401(k)

Photo of a crossroad in a forest with the text "Self-Directed IRA Versus Solo 401(k)."Many self-directed investors have the option of choosing between a self-directed IRA or a self-directed solo 401k. Both accounts can be self-directed so that you can invest into any investment allowed by law such as real estate, LLCs, precious metals, or private company stock. However, depending on your situation, you may choose one account type over the other. What are the differences? When should you choose one over the other?

 IRASolo 401K
QualificationMust be an individual with earned income or funds in a retirement account to rollover.Must be self-employed with no other employees besides the business owner and family/partners.
Contribution Max$5,500 max annual contribution. Additional $1,000 if over 50.$53,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer.
Traditional & RothYou can have a Roth IRA and/or a Traditional IRA. The amount you contribute to each is added together in determining total contributions.A solo 401(k) can have a traditional account and a roth account within the same plan. You can convert traditional sums over to Roth as well.
Cost and Set-UpYou will work with a self-directed IRA custodian who will receive the IRA contributions in a SDIRA account. Most of the custodians we work with have an annual fee of $300-$350 a year for a self-directed IRA.You must use an IRS preapproved document when establishing a solo 401k. This adds additional cost over an IRA. Our fee for a self-directed and self-trusteed solo 401(k) is $1,200.
Custodian RequirementAn IRA must have a third party custodian involved on the account (e.g. bank. Credit union, trust company) who is the trustee of the IRA.A 401(k) can be self trustee’d, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.
Investment DetailsA self-directed IRA is invested through the self directed IRA custodian. A self-directed IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate.A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.

Keep in mind that the solo 401(k) is only available to self-employed persons while the self-directed IRA is available to everyone who has earned income or who has funds in an existing retirement account that can be rolled over to an IRA.

Conclusion

Based on the differences outlined above, a solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions as the solo 401(k) has much higher contribution amounts. On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts that can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier to and cheaper to establish.

Another major consideration in deciding between a solo 401(k) and self-directed IRA is whether there will be debt on real estate investments. If there is debt and if the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.

Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account.

How to Document and Write Down a Failed IRA Investment

Photo of a man holding his head in front of three large stacks of file folders with the text " How to Document and Write Down a Failed IRA Investment."While every self directed IRA investor enters into investments with high hopes and expectations of large gains, sometimes an IRA has to declare a loss on its investments and sometimes those losses are total losses. However, how does an IRA document a loss on a private partnership investment or an uncollectible promissory note investment? Two Tax Court opinions released today show us what not to do. Berks v. Commissioner, T.C. Summary Opinion 2014-2, Gist v. Commissioner, T.C. Summary Opinion 2014-1.

Berks v. Commissioner and Gist v. Commissioner

In Berks and Gist, self directed IRA owners invested their IRAs into various real estate partnerships and had equity interests and promissory note interests. Approximately five years after the investments were made, the IRA owners sought to declare the values on all of the investments worthless as the partnerships were no longer in business and as the IRA owner was told by their friend who they invested with that the investments were worthless. The IRA custodian for Berks and Gist sought additional documentation before agreeing to write down the value of the investments. Writing down the value of an investment and closing an account is a red flag for the custodian and the IRS as both want to ensure that IRA owners are not unfairly writing down investments in an effort to avoid taking distributions from the IRA which are taxable. As a result, the IRA custodian sought documentation as to the valuation change and upon receiving no documentation; the IRA custodian distributed the account to the IRA owners with the original investment amounts made from the account.

The self directed IRA accounts were closed by the custodian and the IRA owners were responsible for the taxes due from the 1099-R as well as accuracy related penalties. Eventually the un-claimed 1099-R went into collections with the IRS and the IRS sought payment of the additional taxes owed. The taxpayers disputed the amounts owed and took the case to Tax Court. The case eventually proceeded to trial and the taxpayers both lost in separate cases because they went into the case with no documentation or evidence of collection attempts. Instead, there was only testimony from the IRA owner and from their advisor that assist them in the investments. In Berks, the Court stated, “…[the IRA owner] simply took Mr. Blazer [their friend they invested with] at his word, and they apparently never saw the need to request any documentation that would substantiate that the partnerships had failed or that the promissory notes in the IRA accounts had become worthless.” Accordingly, the Court ruled against the IRA owners and held that the investment values as reported by the custodian (the initial investment amounts) were the best representation of fair market value. As a result, the IRA owners were subject to taxes owed on the higher valuation amounts.

I handled a very similar case to this one in Tax Court myself. In my case, the case resulted in the IRS reducing the valuation of the distributed IRA down to the proper discounted fair market valuation the IRA owner was seeking. As a contrast to what the taxpayers did to document their losses in Berks and Gist (e.g., no documents or records), I have outlined the steps that should be taken to properly document a loss with your IRA custodian and/or with the IRS/Tax Court.

Documenting a Loss/Failed Investment

  1. Hire a Third Party to Prepare an Opinion as to Value. Your custodian, the IRS, and the Tax Court all want to see an independent person’s opinion as to the value of an investment.
  2. Provide Accounting Records Showing Losses and No Profits/Income. In my Tax Court case on the same issue (obviously different facts and investments), we were able to re-construct the accounting records and losses from the company that demonstrated the significant valuation change. These accounting records we assembled were accompanied by financial records and third party documents which supported our numbers. The IRS agreed with our decreased valuation before trial, and dismissed their case against our client.
  3. Document Fraud. If fraud was involved by persons receiving the income. Was a lawsuit filed? Were complaints made to regulatory bodies (e.g. SEC or state divisions of securities)? Provide those documents to your custodian.
  4. If the Investment Losses are from a Un-Collectible Promissory Note.
    1. Engage a lawyer or collection agency to make collection efforts. Keeps documents of their collection efforts.
    2. If the borrower filed bankruptcy, provide the bankruptcy documentation.
    3.  If the loan is totally un-collectible, Issue a 1099-C (Forgiveness of Debt Income to the Defaulted Borrower, you’ll need the borrower’s SSN/EIN for this).

The best way to document an investment loss is to provide a third party valuation to your custodian.  A custodian cannot accept an e-mail or letter from the IRA owner saying the investments didn’t pan out. If a third party opinion as to value cannot be produced, you’ll need to provide some of the records and documents I outlined above to demonstrate the loss. Remember, as Tom Cruise said in A Few Good Men, “It doesn’t matter what happened. It only matters what I can prove.” To prove an investment loss in your IRA, you’ll need documents and records showing what went wrong.

Who is Prohibited to My Self-Directed IRA?

Image of a blank disqualified person tree with the text "Who is Prohibited to My Self-Directed IRA?"The prohibited transaction rules applicable to self directed IRAs prohibit not what your IRA can invest into but WHO your IRA may engage in a transaction with. For example, the prohibited transaction rules restrict my IRA from buying a rental property from my father. This is not because rental properties are prohibited to my IRA but because my father is prohibited by law from transaction with my IRA. My self directed IRA could buy a rental property from a third party seller whom I have no family or other business relationship with since there is nothing wrong in buying the rental property the question is just who am I buying it from.  Congress decided to restrict investments with certain persons who could potentially collude with the IRA owner to unfairly avoid taxes. As a result, transactions with certain family members and business partners of an IRA owner are prohibited.  The consequence for engaging in a prohibited transaction can be drastic (e.g. no longer have an IRA, penalties and taxes on distribution) so IRA owners must avoid them in all situations.

The prohibited transaction rules therefore provide the greatest restriction on using self directed IRA funds and must be understood by self directed IRA investors. These rules are found in IRC 4975 and state that a prohibited transaction occurs when an IRA engages in a transaction (e.g. buy, sell) with a disqualified person. The question immediately arises, who is a disqualified person to my IRA?

Categories of Persons Disqualified to Your SDIRA

There are essentially four categories of disqualified persons to your IRA and they are as follows.

  1. IRA Owner. The IRA owner is disqualified to his/her own IRA as the fiduciary making decisions for the account. IRC 4975(e)(2)(A), Harris v. Commissioner, 76 T.C.M. 748 (U.S. Tax Ct. 1994).
  2. Certain Family Members. Disqualified family members include the IRA owner’s spouse, children, spouses of children, grandchildren and their spouses, and the IRA owner’s parents and grandparents. Family member who are NOT disqualified persons are siblings (e.g. brothers and sisters), aunts and uncles, cousins, nieces and nephews, and parent in-laws (e.g. spouses parents). IRC 4975 (e)(2)(F), IRC 4975 (e)(6).
  3. Company Owned 50% or More by IRA Owner or Certain Family Members. Any Company that is owned 50% or more by the IRA Owner or Certain Family Members outlined above are disqualified to the IRA. For example, an LLC owned 30% by the IRA owner, 30% by the IRA owner’s spouse, and 40% by an un-related partner is a disqualified company to the IRA (owned 50% or more by disqualified persons) and any transaction between the IRA and the company would be a prohibited transaction.  IRC 4975 (e)(2)(G).
  4. Key Persons in Company Owned 50% or More by IRA Owner or Certain Family Members. Any person who is a 10% or more owner of a company owned 50% or more by disqualified persons (e.g. number 3 above) or any person who is an officer, director, or manager of a disqualified company (owned 50% or more by disqualified persons) is also disqualified. For example, if my wife and I own 60% of a company and if Julie is an officer of that company then Julies is a disqualified person to my IRA. Additionally, if Julie was a 15% or more owner of the company she would also be prohibited to my IRA.

When you are dealing with unrelated persons (not related as family or as business partners) the prohibited transaction rules do not need to be analyzed but once family members or business partners are involved in any part of the transaction, the IRA owner must ensure that the prohibited transaction rules are not being violated.