Solo 401(k) plans have grown significantly and are often used by self-directed investors. Solo 401(k)s are an excellent tool for self employed persons to maximize contributions in their own business or self-employment just like large companies who offer plans for their employees. The basic rules for solo 401(k)s are that you must be self-employed and that you must have a no other employees other than the business owner and family. As happens with many good things, this is starting to get over-sold and we are seeing common problems arise with persons who create them on-line or with the assistance of someone who has no credentials or experience outside of creating a catchy website. Here are a few things to watch out for.
Top Three Mistakes in Solo 401(k) Plans
1. Failure to Update/Amend– Pursuant to Revenue Procedure 2007-44, 401(k) plans shall be amended and restated every six years to conform with current law. The company who provided your plan document, usually what is called a pre-approved plan document for solo 401(k)’s, should be providing you with these updates so that your plan stays in compliance with the amendment cycles established by the IRS. Failure to properly update the plan can result in significant penalties and revocation of tax status.
2. Using an LLC With Rental Income as The Employer/Company – Solo 401(k)s must be established by an employer company. Unlike IRAs, where any individual may establish an account, a 401(k) may only be established by a company and is a benefit for its employees. For example, a solo 401(k) for a self-employed real estate agent with no other employees is created for the real estate agent who is the sole employee/owner. For many self-employed persons who have no other employees, this type of 401(k) is an excellent retirement plan too.
Unfortunately, the solo 401(k) is being oversold and over promoted to real estate investors who only own rentals. We have seen many promoters (operating out of a basement somewhere) who state that you can establish a solo 401(k) with your LLC that owns rental real estate. After all, they say, the LLC is a company and you are the only owner. Therefore this company can establish a solo 401(k). This is only partly true. The LLC that owns rental properties is not a proper entity in which to establish a solo 401(k) since the LLC receives “rental income” and since the owners of the LLC are not considered “employees” receiving wages or earned income that may be contributed to a retirement account. Rental income cannot be contributed to a retirement account and as a result the owner of the LLC is not an employee or person receiving earned income that qualifies to have a solo 401(k) account. All 401(k)s, solo 401(k)s included, must be established by a company for the benefit of its employees with wages or earned income. See IRS Publication 560. As a result, we recommend that clients use companies where there is wage income (e.g. s-corps) or self-employment income that creates earned income on schedule C be used to establish a solo 401(k). While an LLC may be used to adopt a solo 401(k), that would only be the case if the LLC receives ordinary income for its owner that is then claimed on schedule C of the owner’s tax return.
3. Failing to File Form 5500-EZ – In general, 401(k)s are required to file a return called from 5500. Solo 401(k)s, however, have some exemptions to the 5500 filing requirement but there are many situations where a solo 401(k) is still required to file an annual form 5500-EZ return. The first instance where a 5500-EZ tax return is required is when the solo 401(k) has over $250,000 in assets. The second instance is when the plan is terminated. Regardless of assets, a form 5500 must still be filed at termination.
Our law firm has experience in creating solo 401(k)s that can be self-trustee’d and self-directed and we also assist our clients with annual maintenance, plan amendments, and required annual 5500-EZ filings. Contact us at the law firm to learn more information about our services.
All retirement account owners must be familiar with the required minimum distribution (“RMD”) rules applicable to their accounts. These rules require you, in most instances, to take partial distributions from your retirement account when you reach age 70 ½. And, surprise, the rules for Traditional IRAs, Roth IRAs, and 401(k)s differ. In fact, even 401(k)s where you are a 5% or greater owner have different rules than 401(k)s where you aren’t an owner. Thanks, Congress.
So what rules apply to Solo 401(k) owners? Well, generally speaking, you must begin taking distributions from your Solo K when you reach age 70 ½. Despite what you may think or presume, there are three quirks to be aware of when it comes to RMD and Solo 401(k):
Still Working Exception Does Not Work on Solo Ks
There is a general RMD 401(k) rule which states that even after age 70 ½, you are not required to take distributions from an employer 401(k) when you are still working for that employer. However, this exception does not apply to account holders or their spouses who own 5% or more of the company. In other words, business owners who use a Solo 401(k) will be forced to take RMD from their Solo 401(k) after age 70 ½ even if they are still working in the business.
Roth 401(k) Funds are Subject to RMD
RMD applies to Roth 401(k)s. I know what you’re thinking, “Wait, but why would RMDs apply to Roth 401(k)s when Roth IRAs are exempt?” Because Congress said so. I know, it doesn’t make much sense, Roth 401(k) distributions at retirement will be tax-free, like Roth IRA distributions, and the IRS will not receive any revenue from the distribution so why treat Roth 401(k)’s differently? There’s not a good answer, but you should write your Congressperson or Senator and ask. In the meantime, if you’re 70 ½ and you have funds in a Roth 401(k) which you don’t want distributed, you can roll those Roth 401(k) funds out to a Roth IRA and you can avoid the distribution requirement by letting those funds sit in your Roth IRA where no RMD is required. Checkmate, IRS.
Every 401(k) Must Have RMD Taken, No Aggregating
Every 401(k) account you have must take RMD. So, for example, if you have a Solo 401(k) and a 401(k) account with an old employer then you need to take RMD from each 401(k) account. You cannot aggregate those accounts together and take RMD out of one to satisfy both RMD requirements. This aggregating is allowed in Traditional IRAs but unfortunately does not work with different 401(k) plan accounts. If taking RMDs from multiple accounts is getting too complex, you can roll the old employer 401(k) to the Solo K or to a Traditional IRA (or Roth IRA if Roth 401(k) funds) to consolidate your accounts and your RMD requirements.
Make sure take RMD when you are required to do so. Failure to take RMD results in a 50% penalty tax on the amount you failed to take. As a result, it’s critical that you understand the RMD rules for each retirement account you hold. If you have made a mistake though, the IRS does have penalty waiver programs whereby you can correct some failed RMDs and request a waiver of the penalty due. This doesn’t work in every instance, but if you’ve failed to take RMD ask your tax lawyer or accountant on whether a penalty waiver could apply in your instance.
As 2017 comes to an end, it is critical that Solo 401(k) owners understand when and how to make their 2017 contributions. There are three important deadlines you must know if you have a Solo 401(k) or if you plan to set one up still in 2017. A Solo 401(k) is a retirement plan for small business owners or self-employed persons who have no other full time employees other than owners and spouses. It’s a great plan that can be self-directed into real estate, LLCs, or other alternative investments, and allows the owner/participants to contribute up to $54,000 per year (far faster than any IRA).
New Solo 401(k) Set-Up Deadline is 12/31/17
First, in order to make 2017 contributions, the Solo 401(k) must be adopted by your business by December 31st, 2017. If you haven’t already adopted a Solo 401(k) plan, you should start now so that documents can be completed and filed in time. If the 401(k) is established on January 1st, 2018 or later, you cannot make 2017 contributions.
2017 Contributions Can Be Made in 2018
Both employee and employer contributions can be made up until the company’s tax return deadline including extensions. If you have a sole proprietorship (e.g. single member LLC or schedule C income) or C-Corporation, then the company tax return deadline is April 15th, 2017. If you have an S-Corporation or partnership LLC, the deadline for 2017 contributions is March 15th, 2018. Both of these deadlines (March 15th and April 15th) to make 2017 contributions may be extended another six months by filing an extension. This a huge benefit for those that want to make 2017 contributions, but won’t have funds until later in the year to do so.
W-2’s Force You to Plan Now
While employee and employer contributions may be extended until the company tax return deadline, you will typically need to file a W-2 for your wages (e.g. an S-Corporation) by January 31st, 2018. The W-2 will include your wage income and any deduction for employee retirement plan contributions will be reduced on the W-2 in box 12. As a result, you should make your employee contributions (up to $18,000 for 2017) by January 31st, 2018 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31st, 2018. If you don’t have all or a portion of the funds you plan to contribute available by the time your W-2 is due, you can set the amount you plan to contribute to the 401(k) as an employee contribution, and will then need to make said contribution by the tax return deadline (including extensions).
Now let’s bring this all together and take an example to outline how this may work. Sally is 44 years old and has an S-Corporation as an online business. She is the only owner and only employee, and had a Solo 401(k) established in 2017. She has $120,000 in net income for the year and will have taken $50,000 of that in wage income that will go on her W-2 for the year. That will leave $70,000 of profit that is taxable to her and that will come through to her personally via a K-1 from the business. Sally has not yet made any 2017 401(k) contributions, but plans to do so in order to reduce her taxable income for the year and to build a nest egg for retirement. If she decided to max-out her 2017 Solo 401(k) contributions, it would look like this:
- Employee Contributions – The 2017 maximum employee contribution is $18,000. This is dollar for dollar on wages so you can contribute $18,000 as long as you have made $18,000. Since Sally has $50,000 in wages from her S-Corp, she can easily make an $18,000 employee contribution. Let’s say that Sally doesn’t have the $18,000 to contribute, but will have it available by the tax return deadline (including extensions). What Sally will need to do is let her accountant or payroll company know what she plans to contribute as an employee contribution so that they can properly report the contributions on her payroll and W-2 reporting. By making an $18,000 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $32,000. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,500.
- Employer Contributions – The 2017 maximum employer contribution is 25% of wage compensation. For Sally: Up to a maximum employer contribution of $36,000. Since Sally has taken a W-2 wage of $50,000, the company may make an employer contribution of $12,500 (25% of $50,000). This contribution is an expense to the company and is included as an employee benefit expense on the S-Corporation’s tax return (form 1120S). In the stated example, Sally would’ve had $70,000 in net profit/income from the company before making the Solo 401(k) contribution. After making the employer matching contribution of $12,500 in this example, Sally would then only receive a K-1 and net income/profit from the S-Corporation of $57,500. Again, if she were in a 20% federal and a 5% state tax bracket, that would create a tax savings of $3,125. This employer contribution would need to be made by March 15th, 2018 (the company return deadline) or by September 15th, 2018 if the company were to file an extension.
In the end, Sally would have contributed and saved $30,500 for retirement ($18,000 employee contribution, $12,500 employer contribution). And she would have saved $7,625 in federal and state taxes. That’s a win-win.
Keep in mind, you need to start making plans now and you want to begin coordinating with your accountant or payroll company as your yearly wage information on your W-2 (self employment income for sole props) is critical in determining what you can contribute to your Solo 401(k). Also, make certain you have the plan set-up in 2017 if you plan to make 2017 contributions. While IRAs can be established until April 15th, 2018 for 2017 contributions, a Solo K must be established by December 31st, 2017. Don’t get the two confused, and make sure you’ve got a plan for your specific business.
Note: If you’ve got a single member LLC taxed as a sole proprietorship, or just an old-fashioned sole prop, or even or an LLC taxed as a partnership (where you don’t have a W-2), then please refer to our prior article here on how to calculate your Solo K contributions as they differ slightly from the s-corp example above.
Bitcoin, Ethereum, Litecoin, and other cryptocurrencies have seen dramatic price increases this year. Have you thought about cashing in? Are you wondering how will you be taxed?
Cryptocurrency is a Capital Asset
The IRS has clearly stated that cryptocurrency (aka virtual currency) is a capital asset like property. And therefore, the buying and selling of it for profit results in short-term capital gain if held for under one year, and long-term capital gain if held for over a year. Short-term capital gain rates are based on your regular income tax bracket, while the long-term capital gains rate is 15-20%, depending on income level. IRS Notice 2014-21.
So, for example, let’s say I bought 10 Bitcoin in June 2017 for $25,000 US dollars when the price of Bitcoin was approximately $2,500. I decide that in December 2017 that I would like to sell my Bitcoin. The price is now approximately $16,500 per Bitcoin, so my holdings are now worth $165,000. As a result, my $25,000 investment has generated a taxable profit of $140,000. Since I owned the Bitcoin for less than one year, the income will be short-term capital gain income and I will pay at my regular federal rate.
If I instead held the cryptocurrency until July 2018, then I would have long-term capital gain and would be paying tax at a much lesser rate.
Any realized gain from the cryptocurrency profit is taxable. This is the case if you exchanged Bitcoin for other cryptocurrency, or for goods or services. In this instance, you take the value of the Bitcoin in US dollars at the time of the exchange for other property and treat whatever gain you have when that Bitcoin was exchanged (at the value of the other property) as your taxable gain. Let’s say you bought 10 Bitcoin in 2015 for $250 per Bitcoin for a total purchase price of $2,500. You decide to exchange one Bitcoin, valued at $16,500 in December 2017, for 17 Ethereum valued at approximately $500 per Ethereum. Your gain on the Bitcoin being exchanged is the value of the Ethereum, $16,500, minus the cost of the Bitcoin, $250, for a long-term capital gain of $16,250.
Cryptocurrency mining is the process of using servers and other computers to verify the blockchain and transactions that are the backbone of the cryptocurrency. This IRS has stated that income from cryptocurrency mining, whether received in dollars or cryptocurrency, is taxable as regular income. Consequently, if you have engaged in the cryptocurrency mining business or are otherwise self-employed doing cryptocurrency mining then the income you received is taxable at your ordinary income rates and it will also be subject to self-employment tax.
Retirement Accounts and Cryptocurrency
Retirement accounts such as IRAs and 401(k) can own Bitcoin and other cryptocurrency. This requires a self-directed IRA or 401(k) and some careful structuring. For a more detailed discussion on this topic, check out my prior article and video here. When gains are made from the sale of cryptocurrency, whether for US dollars or other cryptocurrency, there is no tax owed on the gain. And, if you use a Roth IRA or Roth 401(k), there will be zero tax owed when you pull the funds out at retirement. For traditional IRAs and 401(k)s you pay tax when you withdraw the funds at retirement and these distributions, as is the case for all traditional IRA or 401(k) distributions, are subject to tax at your ordinary income tax rate at the time of distribution.
If your self-directed IRA or 401(k) is invested into cryptocurrency mining, as opposed to holding cryptocurrency for investment, then the income from such mining activities will likely cause unrelated business income tax.
If you are self-employed and use a SEP IRA to save for retirement, you should carefully consider moving those funds to a new Solo 401(k) (aka “Solo K”).
Both SEP IRAs and Solo Ks are retirement plans commonly used by self-employed persons with no employees, such as: Real estate professionals, investors, consultants, direct-marketing professionals, 1099 salespersons, and other small business owners. Here’s why: Both the SEP IRA and the Solo K offer big annual contribution amounts that far exceed the $5,500 ($6,500, if over 50) that you can put into a Roth or Traditional IRA. In fact, in both the SEP IRA and Solo K, you can contribute, depending on your income, up to $54,000 annually – $60,000, if over 50 in a Solo K. That’s almost ten times the contribution limit of an IRA. And, if you’re really trying to build up a retirement account you can retire on, you’re going to need to contribute more than $5,500 a year.
Now, if you have a SEP IRA, you should really look at changing that SEP IRA to a Solo K. Sure, SEP IRAs are good, but Solo Ks are great. Here are four major reasons why you should make the switch:
1. You Can Contribute More to a Solo K on Less Income
You can contribute more to a Solo K each year on less income. Let’s consider the following example: Sally is 41 and the 100% owner of Sally, Inc. She sells products online and Sally, Inc. is taxed as an S-Corp. The total cash flow income from her company is $8,000 and she ends up paying herself a W-2 of $40,000 for the year. Based on the $40,000 W-2, she could contribute the following amounts:
- SEP IRA – 25% of Wage Income: $10,000
- Solo 401(k) – $18K on the first $18K Wage Income, plus 25% of Wage Income: $28,000
That’s right: Sally can contribute $28K a year to her Solo K on a $40,000 W-2. If she was using a SEP, she’d only be able to contribute $10,000. The significant difference is that, under a Solo K, you get to contribute $18K on the first $18K ($24k, if 50 or over), plus you get to contribute 25% of the wage income.
Also, if you are looking to max out the Solo K contribution amount of $54,000, then you’d need to have a W-2 from the S-Corp of $144,000. However, if you were looking to max out contributions at $54,000 using a SEP IRA, then you would need to have a W-2 of $216,000. Bottom line: It’s easier to max out your retirement plan contributions with a Solo K. And, at lower W-2 levels, something S-Corp owners strive for, the contribution difference is significant. For more details on Solo K contributions, please refer to my prior blog article.
2. You Can Self-Trustee and Administer Your Solo K
All IRAs, including SEP IRAs, must have a third-party custodian – a bank, credit union or trust company – for the account. However, with a Solo K, you can self-trustee and can have control of the bank checking account and/or a brokerage account without having a third party as the trustee. This allows you to invest directly out of the Solo K and gives checkbook control. A valuable tool when investing a retirement account into alternative assets like real estate, notes, or private companies, as you can sign off on investments or process funds without waiting on a third party to process and approve your own funds.
3. You Can Loan Yourself Up to $50K from a Solo K
Under a Solo K, you can loan yourself half of the balance of the Solo K not to exceed $50,000. This is known as a “participant loan,” and is a great option to use when you need to access funds you’ve contributed and saved for retirement. Maybe you need funds to grow the business, pay for school expense, or take a trip to Vegas. Whatever the reason, good or bad, your hard-earned money can be accessed without penalty under a Solo K using the participant loan. Now, you will need to pay the funds back over five years with a set interest. But, this money goes back into the Solo K you’ve been building. For more details on the 401(k) loan, please refer to my prior blog article. Unfortunately, the participant loan cannot be done with a SEP IRA, and would actually result in a distribution, penalty and taxes.
4. No UDFI Tax on Leveraged Real Estate with a Solo K
If you self-direct your SEP IRA plan into real estate, you may have heard of a tax called “unrelated debt financed income” (or “UDFI”). This tax applies when you leverage your SEP IRA’s cash with debt. For example, you buy a rental property with your SEP IRA for $100,000. Of this $100,000, $40,000 comes from your SEP IRA’s cash and $60,000 is from the bank loaning your SEP money on the deal. By bringing in 60% debt to the investment, the IRS will require tax on 60% of the net income from the profits of the property. However, this tax on leveraged real estate does NOT apply to Solo Ks as Congress created an exemption for Solo Ks, but not SEP IRAs. So, if you self-direct and leverage real estate investments with debt, you’d be crazy to use a SEP IRA over a Solo K. The tax can be tricky to calculate for IRAs and requires a separate 990-T tax return. Check out my detailed webinar on the topic if you’d like to learn more.
There are a couple of downsides to the Solo K over a SEP IRA:
1. Solo Ks are more expensive to set up, as it requires an IRS-compliant plan document. Expect to pay around $1,000 – $2,000 for an IRS-compliant Solo K that you can self-direct and self-trustee. Under both a SEP IRA and a Solo K, you will have similar on-going annual fees to keep them compliant.
2. The other downside to a Solo K is that once you have $250,000 in assets or more in a Solo K, you must file a 5500-EZ tax return to the IRS each year. This return isn’t overly complex, but it is an annual filing requirement you’ll need to handle, or hire someone else to handle if you are self-administering your Solo K.
So, what if you have a SEP IRA and you want to move over to a Solo K? You’ll first need to establish a Solo K for your business by adopting an IRS-compliant Solo K plan. Once you do that, you can start making your new contributions into the Solo K and also roll over the existing funds from your SEP IRA (or other traditional IRAs).