Kids are going back to school and it’s a great time to think about college and to make financial plans for your children or grandchildren’s education. As you consider the different plan options, you’ll want to make sure you know the two most common tax favored college savings tools.
There are two types of accounts that you can establish to save for higher education expenses in a tax favorable manner. These two types of accounts are Coverdell Education Savings Accounts and 529 Plan accounts.
The first type of account is known as a Coverdell Education Savings Account. A Coverdell account is typically set up for the higher education expenses of a child. The contributed funds grow in the account tax deferred and the money comes out for education expenses tax free. There is no tax deduction for amounts contributed to a Coverdell but you do have significant investment options including self-directed investment options (similar to IRA rules). A Coverdell has the following rules and benefits.
- $2,000 annual contribution limit per beneficiary (e.g. child or grandchild).
- Parents (or grandparents) can contribute without limitations to a Coverdell until a beneficiary reaches age 18 if the contributor has income of less than $190k (married joint) or $110,000 (single). For high-income earners, keep in mind that the child can always contribute to their own account with gifted funds (no need to have earned income) so you can always get around the income limitation by having the child contribute themselves.
- Funds can be used for tuition, fees, books, and equipment for college as well as certain K-12 expenses too.
- There are zero federal or state income tax deductions on Coverdell accounts.
- Accounts can be invested into stocks, mutual funds, and can even be self-directed. They operate similar to an IRA. Self-directed Coverdell accounts can be opened at Directed IRA, www.directedira.com.
- Contributions grow tax-free and can be withdrawn for education expenses until the account beneficiary reaches age 30. Unused amounts can be transferred to another family member beneficiary.
The second type of account is a 529 Plan account. Contributions to 529 Plan accounts can be eligible for a state income tax deduction (depending on the state). Money contributed to a 529 Plan account is invested into a state managed fund. A 529 has the following rules and benefits.
- Amounts are invested into a state run program.
- Amounts can be withdrawn for tuition, fees, books, supplies, equipment, special needs, room and board.
- Up to a few hundred thousand dollars can be invested per beneficiary by any person.
- There are no federal tax deductions or credits for contributions.
- Many states offer tax deductions for contributions to 529 Plan accounts. For example, Arizona offers a $4,000 tax deduction for married tax filers and a $2,000 deduction for single filers. Thirty-five states offer some type of state income tax deduction for 529 Plan contributions. However, there are some states, like California, who offer no tax deduction for contributions to 529 Plan accounts. Click here to see a comprehensive list that outlines the different state funds and tax deductions (or credits for some states).
- Downside, invested amounts must be invested solely into state run programs. There are no other investment options.
In summary, Coverdell accounts have the benefit of allowing account owner’s to decide how the money will be invested with zero tax deductions available on contributions while 529 Plan accounts give you zero investment options (all funds go to state run fund) but offer state income tax deductions in most states.
If you live in a state that offers a tax deduction on contributions, such as Arizona, then the 529 Plan account is a great option if you can stomach having the money go into a state run fund. On the other hand, if you live in a state with zero income tax (e.g. Texas or Florida) or if you live in state with zero 529 Plan deductions (e.g. California) then you might as well use a Coverdell account because you’re not trading any tax deductions for investment options. For those who can’t make up their mind and who have the funds, consider doing both but do the Coverdell first. There is no restriction against doing a Coverdell account (no tax deductions, but investment options) and a 529 Plan account (possible state tax deductions but no investment options).
HSAs (“Health Savings Accounts”) are growing in popularity as Americans are discovering significant tax savings with these accounts. Why are they popular? There are many reasons why; some well known and others not so well known.
Let’s start with the primary benefits that are generally well known:
First, contributions to an HSA are fully deductible regardless of your income, and there is no high-income phase-out. The deduction also applies whether you itemize on your tax return or not, so everyone gets to use it. This isn’t the case for other major deductions like charitable contributions or mortgage interest, which only apply if you itemize on your tax return and itemizing is getting less common after tax reform that was enacted in late 2017. The other commonly known benefit of the HSA is that it can grow from the investments tax-free and comes out entirely tax-free to pay for or to reimburse the account owner for their qualifying medical expenses. For a quick summary of the basics and for qualifying rules, check out my partner Mark J. Kohler’s article here.
Now, lets discuss the additional benefits of an HSA that aren’t as well known:
You don’t need earned income to contribute to an HSA
Contrary to retirement plan rules for IRAs and 401(k)s, which require you to have earned income (i.e. wage, self-employment income) to contribute, you do not need to have earned income to contribute to an HSA. You can make the contribution from any source and that contribution will be a deduction against other income on your tax return (i.e. rental income, investment income, etc.).
Your spouse can inherit your HSA with no tax due
If you’ve built up an HSA that you don’t end up using, you can pass the HSA on to your spouse. A spouse can inherit the HSA and can transfer it over to an HSA in their name. The surviving spouse can then use the funds for their qualifying medical expenses during their lifetime. If the account is inherited by a non-spouse beneficiary, then the account is considered fully taxable to the person receiving the account. Non-spouse beneficiaries (i.e. children) are allowed to use the account to pay for the deceased account owner’s qualifying medical expenses for up to one year of the date of death as medical bills and expenses are determined, and then any remaining balance is distributed to the non-spouse beneficiaries and is subject to taxation.
You can self-direct your HSA and invest it into real estate or other alternative assets
Many HSA account owners just let their HSA funds sit in a savings account or they invest into mutual funds. Some place their HSA funds into a brokerage account,and buy and sell stock. And others are investing them into real estate, private LLCs, precious metals, private equity, venture capital or start-ups. Like a self-directed IRA, an HSA can be invested into all of these alternative assets and are subject to the same prohibited transaction rules and UBTI tax as IRAs and other accounts. We’ve been advising clients for years on how to self-direct their HSA and are now helping clients establish self-directed HSA accounts at Directed IRA & Directed Trust Company. We’ve seen account holders invest them into private placements, real estate, and into HSA-owned LLCs.
When you establish an IRA, 401(k), or other retirement account you are required to designate the beneficiary of that account so that the institution/custodian holding the account knows who will receive the account upon your death. You will die one day (sorry for the bad news), and without a properly completed beneficiary designation, your account will be stuck and won’t be able to be moved until a probate court orders otherwise. The form can be completed easily, so make sure you take care of this important step when establishing your retirement accounts and bank accounts.
What’s a beneficiary designation?
A beneficiary designation is simply a written and signed statement placed on record with your account custodian that specifies who receives your account upon your death. Beneficiary designations are used on IRA accounts, 401(k) accounts, HSA accounts, and life insurance policies. Beneficiary designations are used by IRA custodians, 401(k) account custodian/administrators, banks/credit unions, and life insurance companies to pass the deceased persons account on to the person(s) designated on the form without reference to the deceased person’s will, trust, and without the involvement of the probate courts. As a result, your beneficiary designation form is a powerful instrument.
You can list a primary beneficiary and secondary beneficiaries. A primary beneficiary is the first person whom you list, and this person or persons receive the account upon your passing. A secondary (aka “contingent”) beneficiary is someone you list who receives the account if the primary beneficiary is not living. For example, a common way to list your beneficiary designations is to list your spouse as your primary beneficiary and your children as your secondary beneficiary. If your spouse is not living when you die, then your account passes to your secondary beneficiary.
To have a valid beneficiary designation you must ensure the following:
- Designation: Use your institution’s/custodian’s form and designate the person(s) you desire as your beneficiary by listing their name, city/state, date of birth, and relationship to you. You can list one beneficiary or multiple beneficiaries in percentages. So, for example, if you had two children you wanted to receive the account, you would list them as 50% each on the designation form.
- Sign the designation: This may be eSigned using an eSign method accepted by your institution/custodian.
- Spousal waiver where applicable: If you have a spouse and you HAVE NOT listed your spouse as your primary beneficiary, then your spouse must sign a spousal waiver agreeing to someone else being listed as the primary beneficiary and your spouse’s signature on the waiver must be notarized. This is required as a matter of law. Failure to provide the waiver will result (at best) to your surviving spouse receiving at least half of your account upon your passing with the rest passing to your secondary beneficiaries.
- Coordinate with your estate plan: If you list your trust for estate planning as the beneficiary of your IRA, 401(k), or other retirement account, you must provide a copy of the trust to your institution/custodian. The trust must have readily identifiable beneficiaries who receive your account upon your passing and must be considered a see-through trust (most revocable living trusts are).
The beneficiary designation is the “trump card”
Your beneficiary designation is the “trump card” when it comes to estate planning documents. For example, your beneficiary designation on your retirement account or bank account will control over a will which states someone different is to receive all your assets. As a result, it is critical that you provide a beneficiary designation for every account you have, and that these designations are updated when certain major life events arise.
Action required in three common situations
If you already provided beneficiary designations on your retirement accounts, bank accounts or life insurance, it is critical that you review them and update them upon the following events:
- Divorce: There are plenty of cases when someone who failed to update their beneficiary designation passes away and their ex-spouse ends up receiving the account. This is usually contrary to the account owner’s wishes, but if you fail to update your beneficiary designations, your heirs could be in this predicament. (Talk about not leaving gracefully!) This situation is now going to be ugly for your ex, your new spouse (if you had one), and your children.
- New child: If you have a new child who was not previously identified as a beneficiary, you should update your designations to add this new child.
- New estate plan: If you establish an estate plan (will, or ideally, revocable living trust), you should ensure that your wishes in your beneficiary designations for your retirement accounts and bank accounts match-up with the terms of your trust.
When to list your trust versus your spouse/children directly
Even if you have a revocable living trust, you may want to list your spouse as your primary beneficiary. As a rule of thumb, most estate planning attorneys recommend that, for IRA or 401(k) accounts, you list your spouse as your primary beneficiary and your trust as your secondary beneficiary. The reason is that your spouse can receive your retirement account upon your passing and can do what is called a spousal rollover. This rule only applies to spouses. For example, under a spousal rollover, the retirement account of the deceased person can be transferred/rolled over into an IRA surviving spouse. This is an advantageous way for a spouse to receive a retirement account as the account is treated simply as an account of the surviving spouse, and is not subject to RMD or other quirky rules associated with inherited retirement accounts (aka “inherited IRAs” or “beneficiary IRAs”). Rather, the funds are just treated as a Traditional IRA or Roth IRA of the surviving spouse.
Your Trust can be listed second, and, in the case where your primary beneficiary is not living, certain provisions in your trust designated to protect the funds from creditors or misappropriation from inheriting children or other heirs would apply. Your children, or other heirs under your trust who are listed as secondary beneficiaries on your form would receive the funds from your retirement account in an inherited IRA (aka “beneficiary IRA”) and would have RMD requirements to remove funds from their account over their life expectancy. This is sometimes called a “stretch IRA” and is a great tax strategy as it allows them to extend the tax-free (Roth) or tax-deferred (Traditional) benefits of the account over their own lifetime.
Remember, the beneficiary designation is critical and must be completed properly. Take the extra time to get it done right, and check up on the designations on any of your existing accounts that you may be unsure of. It’s better to get these things squared away and in order now than to presume that you completed them right when you set-up the account long ago.
Solo 401(k)s have become a popular retirement plan option for self-employed persons. Unfortunately, many plans are not properly maintained and are at the risk of significant penalty and/or plan termination. If you have a Solo 401(k), you need to ensure that the 401(k) is being properly maintained. Here’s a quick checklist to make sure your plan is on track:
1. Does your Solo 401(k) need to file a Form 5500-EZ?
There are two primary situations where you are required to file a Form 5500 for your Solo 401(k).
- If your Solo 401(k) has more than $250,000 in assets, and
- If the Solo 401(k) plan is terminated (regardless of total asset amount).
If either of these instances occur, then the Solo 401(k) must file a Form 5500 to the IRS annually. Form 5500 is due by July 31st of each year for the prior year’s plan activity. Solo 401(k)s can file what is known as a 5500-EZ. The 5500-EZ is a shortened version of the standard Form 5500. Unfortunately, the Form 5500-EZ cannot be filed electronically and must be filed by mail. Solo 401(k) owners have the option of filing a Form 5500-SF online through the DOL. The online filing is preferred as it can immediately be filed and tracked by the plan owner. In fact, if you qualify to file a 5500-EZ, the IRS and DOL allow you file the Form 5500-SF online, but you can skip certain questions so that you only end up answering what is on the shorter Form 5500-EZ. We regularly file Form 5500-EZs and 5500-SFs for Solo K clients in the law firm for only $250.
2. Is the plan up-to-date?
The IRS requires all 401(k) plans, including Solo 401(k)s, to be amended at least once every six years. If you’ve had your plan over six years and you’ve never restated the plan or adopted amendments, it is not compliant and upon audit, you will be subject to fines and possible plan termination (IRS Rev Proc 2016-17). If your plan is out of date, your best option is to restate your plan to make sure it is compliant with current law. On average, most plan documents we see update every two to three years as the laws effecting the plan documents change. We’ve had two different plan amendments to our IRS pre-approved plan in the past six years.
3. Are you properly tracking your plan funds?
Your Solo 401(k) plan funds need to be properly tracked and they must identify the different sources for each participant. For example, if two spouses are contributing Roth 401(k) employee contributions and the company is matching employer Traditional 401(k) dollars, then you need to be tracking these four different sources of funds, and you must have a written accounting record documenting these different fund types.
4. Plan funds must be separated by source and participant
You must maintain separate bank accounts for the different participants’ funds (e.g. spouses or partners in a Solo K), and you must also separate traditional funds from Roth funds. In addition, you must properly track and document investments from these different fund sources so that returns to the Solo 401(k) are properly credited to the proper investing account.
5. Are you properly reporting contributions and rollovers?
If you’ve rolled over funds from an IRA or other 401(k) to your Solo 401(k), you should have indicated that the rollover or transfer was to another retirement account. So long as you did this, the company rolling over the funds will issue a 1099-R to you, but will include a code on the 1099-R (code G in box 7) indicating that the funds were transferred to another retirement account, and that the amount on the 1099-R is not subject to tax. If you’re making new contributions to the Solo 401(k), those contributions should be properly tracked on your personal and business tax returns. If you are an S-Corp, your employee contributions should show up on your W-2, and your employer contributions will show up on line 17 of your 1120S S-Corp tax return. If you are a Sole Prop, your contributions will typically show up on your personal 1040 on line 28.
Make sure you are complying with these rules on an annual basis. If your Solo 401(k) retirement plan is out of compliance, get with your attorney or CPA immediately to make sure it is up-to-date. Failure to properly file Form 5500 runs at a rate of $25 a day up to a maximum penalty of $15,000 per return not properly filed. You don’t want to get stung for failing to file a relatively simple form. The good news is there are correction programs offered for some plan failures. But, don’t get sloppy, or you’ll run the risk losing your hard-earned retirement dollars.
There are 28 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments (e.g. Bitcoin and cryptocurrencies). It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. My company, Directed IRA & Directed Trust Company, handles self-directed IRAs and our clients have invested millions in private companies.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old or 55 under some plans). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 37% at about $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
So, here’s a brief summary of what we’ve learned. First, there’s $28 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.