IRAs are the most overlooked opportunity in real estate. Let me explain.
First, there are over 9 Trillion Dollars in IRA accounts in the U.S. This number is staggering and makes IRAs one of the largest sections of investable cash in the world. Source, Investment Company Institute & Federal Reserve Board. But what does this have to do with real estate? Well, contrary to popular belief, IRAs have always been able to invest in and own real estate. They can own single family rentals, or flip properties, or own LLCs that own multi-family or commercial real estate. They can also invest as a private lender on real estate.
At this point in the IRA and real estate conversion. I’m usually asked, why have I never heard of this before? Well, the major providers of IRAs have generally found real estate to be “administratively unfeasible” as it takes more work to handle and administer than a publicly traded stock or REIT does. In other words, the brokerage and insurance firms who administer most IRAs restrict their IRAs to…well…the stuff they sell like publicly traded stock, mutual funds, and annuities. You’ve always been able to own real estate in an IRA but there have been few IRA custodians who allow it and as a result it isn’t as widely known as it should be. This have been changing over the past decades as awareness has spread.
IRAs can own single-family rental properties. IRAs can own properties being flipped for profit. IRAs can invest in small private LLCs that own commercial properties or multi-family properties with other individuals or IRAs. IRAs can own options on real estate. And IRAs can lend money secured to other real estate investors as a private investor or hard money lender. You can’t, however, buy real estate for personal use or for use by certain disqualified family members. The assets owned by your IRA must be held for investment purposes.
In sum, any real estate owned for investment purposes can be owned by an IRA. The law has very few restrictions on assets owned by a retirement account. In fact, the only investment assets restricted for IRAs is life insurance, collectible items (e.g. art, antique car), and s-corporation stock. IRC 408(m);IRC 408(a)(3);IRC § 1361 (b)(1)(B). So all investment real estate is fair game for IRAs.
To own real estate with an IRA, you must establish what is called a self-directed IRA and transfer the funds from your current IRA provider (or prior employer 401(k)) to the “self-directed IRA” provider. There are many companies who offer these types of accounts, like my own company, Directed IRA and Directed Trust Company.
What is a Self-Directed IRA?
A self-directed IRA is an IRA that can invest into any investment allowed by law. Real estate is the most common investment for self-directed IRAs but they can also be invested into start-ups, private equity funds, venture capital funds, precious metals, and even crypto-currency. Let’s focus on real estate though.
There are a few critical issues to consider when buying real estate with an IRA.
The IRA Owns the Property, Not You Personally
Let’s go over a real estate rental or property you plan to flip with the IRA. The purchase contract to buy the real estate must be in the name of the IRA and the deed to the property will be in the name of the IRA. The IRA funds, including the earnest money deposit, will come from the IRA account. Keep in mind, the IRA account owner is not buying the property so the contract should not be in their personal name nor should the IRA owner’s personal funds be used. IRAs are held in the name of the custodian of an IRA. So, for example, if your IRA is with my company, Directed IRA & Directed Trust Company, the titling of your IRA would be Directed Trust Company FBO John Doe IRA. That is the name of the buyer on the contract and is the name on title to the property.
Improvement costs and expenses for the IRA owned property must be paid by your IRA and not personally by the IRA owner. Conversely, when there is rental income on the property or when the property sells for a gain then that income goes back into the IRA. Now, one of the huge perks of investing with an IRA is that there is no tax when the IRA makes money. That works with buying and selling stock for gain as well as buying and selling real estate for gain. Consequently, the rental income and the income when you sell the property is not taxable. If this is a Traditional IRA, then the money comes out tax-deferred at retirement and you pay tax as you draw it out. But if it is a Roth IRA, then money comes out tax-free at retirement…so put your best real estate deals in your Roth IRA. But remember, even the Traditional IRA grows tax-deferred with all income accumulating and growing until retirement.
Avoid Prohibited Transactions
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules restrict WHOM your account may transact with, not what kind of investment your account may own. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). Similarly, you couldn’t buy a rental property from a third-party and then rent to your child as your child is a disqualified person. On the other hand, your retirement account could buy real estate from your cousin, friend, sister, or a third-party, as these parties are not disqualified persons under the rules.
A prohibited transaction can also arise if there is self-dealing where the IRA owner or disqualified family members are personally benefitting or making money from the IRAs investments. For example, if you are a real estate agent/broker and your IRA buys real estate you cannot receive the buyer’s agent commission as that would result in a financial benefit to you personally. You’d have to waive this fee and have the purchase price reduced or have someone else represent the IRA.
If an IRA engages in a prohibited transaction, the entire IRA account involved is deemed distributed and is no longer an IRA. Taxes and possible early withdrawal penalties apply under the normal distribution rules.
Use an IRA Owned LLC (aka, IRA/LLC or checkbook control IRA)
Many self-directed retirement account owners, particularly those buying real estate, use an IRA owned LLC as the vehicle to hold their retirement account assets. Under the IRA/LLC structure, the IRA typically owns the LLC 100% and the LLC in turn owns the real estate So, rather than buying real estate and owning it directly in the IRA custodian’s name, your IRA would invest and own an LLC and the LLC in turn would own the real estate.
The IRA/LLC is typically managed by the IRA owner. Under the structure, the IRA owns all of the membership/ownership units of the LLC but the IRA owner can serve as the manager of the LLC. Manager of an LLC is like the president of a corporation. The manager can sign for the LLC and can act on behalf of the LLC. As manager of the LLC, the IRA owner would establish an LLC bank checking account for the LLC and the IRA funds would be invested and deposited into that LLC business checking account. Because the IRA is funding all the investment dollars into the LLC, the IRA owns 100% of the LLC.
Now, the LLC is funded with the IRA cash and the IRA owner is the manager of the LLC. The IRA owner can decide how much cash to invest into the LLC from the IRA depending on the real estate they are planning to buy with the IRA/LLC. When offers to purchase real estate are made with an IRA/LLC, the LLC is the buyer on the real estate purchase contract and the earnest money deposit and final funds to close on the property would come from the LLC bank checking account. The IRA owner, as manager of the LLC, signs the real estate purchase contract and has control of the LLC bank checking account and can sign checks or send wires for the LLC account. Keep in mind, the LLC is owned 100% by the IRA and the LLC funds cannot be used for personal purposes and cannot be used to pay the IRA owner. If you ever want to take money from the IRA/LLC, you must send money from the LLC bank account back to the IRA (since the IRA owns the LLC) and you then take a distribution from the IRA.
And lastly, the IRA/LLC docs are unique and most contain IRA provisions in the LLC operating agreement and subscription sections. As a result, you should use a lawyer who is familiar with IRA/LLCs as many IRA custodians who allow for IRA/LLCs require an attorney or CPA to sign off on the docs. My law firm, KKOS Lawyers, has been drafting IRA/LLCs for over 12 years and charges a flat fee of $800 plus state filing fees. There are more complex IRA/LLC structures that involve multiple IRAs (e.g. spouses or other investors) and or combinations of IRAs and individuals and those structures are called Multi-Member IRA/LLCs and typically cost more to set-up.
How to Properly Get a Mortgage Loan With Your IRA?
Your IRA, or IRA/LLC, can get a mortgage loan when you buy real estate, but you need to know two things before you do.
First, the loan must be non-recourse to the IRA owner as the rules regarding IRAs do not allow the IRA owner to personally be responsible for the loan or to personally extend credit to the IRA. Under a non-recourse loan, the bank lends money to the IRA, or IRA/LLC, and gets a deed of trust or mortgage against the property securing the loan. In the event of default, the lender can foreclose and take the property back but cannot go after the IRA or the IRA owner for any deficiency in the loan. Because the lender’s ability to collect is limited to the property they loaned on, the banks who lend to IRAs require 30-40% down. There are several banks who specialize in these non-recourse loans to IRAs and an IRA owner is best served by using a bank or private lender who routinely provides these type of non-recourse loans.
Second, there is a tax called unrelated debt financed income tax (“UDFI”) that applies to an IRA when the IRA leverages its investment dollars with debt. Essentially, the IRS will tax the income from the debt invested while leaving the percent of the deal attributed to the IRAs cash investment not subject to tax. So, for example, let’s say your IRA bought a rental property for $100k with the IRA putting $40k cash down and getting a non-recourse loan for $60k. To the IRS, 40% of this deal is the IRA funds and 40% of the income is not subject to tax while the other 60% is non-IRA funds and that 60% is subject to tax. The tax on this 60% is UDFI tax. The tax rate on UDFI is the trust tax rates which maxes out at 34% on rental income. This is after expenses of course; which expenses include depreciation.
Upon the sale of the property, the IRS allows you to use the capital gains tax rate for the UDFI tax so you can move down from the 34% rate to the max long-term capital gains rate of 20%. Now technically, UDFI is a form of UBIT tax discussed below. But it applies in a very different way, when there is debt, so I explain it separately.
Many self-directed IRA investors will only buy real estate with cash in their IRA and won’t bother with a non-recourse loan and the UDFI tax burden while others view the UDFI tax as a cost of doing business and see debt as a tool to buy more property and thereby increase overall returns. Keep in mind, UDFI tax is only due on net rental income or net gain upon sale and this is after property expenses and depreciation expense.
Watch Out for Unrelated Business Income Tax (UBIT)?
There is a tax that can apply to an IRA’s income called unrelated business income tax (“UBIT”). Usually, when we think of IRAs, we aren’t expecting there to be taxes on the income and this is typically the case. However, there are a few situations where IRAs will have to pay tax on the income they make. These tax situations arise when the income being made is considered “business income” (aka, ordinary income) as opposed to investment income. Most real estate income is automatically exempt from UBIT. Exempt income from UBIT includes rental real estate income, capital gain income when you sell real estate, and interest income when you lend money on real estate. IRC 512. So let’s go over the common situations where UBIT tax is generally due.
First, there is the instance of debt mentioned above which causes UDFI. UDFI is a form of UBIT and applies to the profits attributable to the debt involved.
Second, if the IRA is doing real estate development activities, or is otherwise invested in real estate projects that create ordinary income it will need to pay UBIT tax on the profits. Real estate development income that is ordinary income in nature, as opposed to long-term capital gain, will cause UBIT for the IRA. It is possible to do real estate development with an IRA and hold the property for investment purposes. If a real estate development was done and the property held for investment, then the IRA would avoid UBIT tax. That being said, you should carefully consult with your tax lawyer or CPA on the details of your strategy and whether UBIT would apply.
The last situation where UBIT can apply is when you flip multiple properties with your IRA in a year. Since most fix and flip transactions are short-term in nature (under one-year hold time), IRA owners need to be careful not to do too many flips with their IRA in one year as the IRA can be deemed to be in the business of real estate. If the IRA is deemed to be in the business of real estate, then the income the IRA makes from the flips will be subject to UBIT. If the IRA is flipping one or two properties a year you don’t need to worry about the IRA being deemed in the business of real estate. However, if the IRA is flipping more a couple properties a year you should consult you tax lawyer or CPA on the exact details of your IRAs investments.
If your IRA is subject to UBIT, then the IRA files its own separate tax return called a 990-T and the IRA pays the tax due. This return is separate from the IRA owner’s personal tax return. The 990-T is the responsibility of the IRA owner and is not something that is generally prepared by your self-directed IRA custodian. You’ll need to engage a tax lawyer, CPA, or accountant to prepare and file the 990-T. Or you can complete it on your own, but it is a very technical return and there is little guidance on how it should be prepared for an IRA.
These rules can seem a little foreign and overwhelming at first. But I like to say that learning how to self-direct your IRA is like learning a new board game. It’s not that the board game rules are complicated. Rather, it is something you need to learn first before playing and moving pieces. When we play a new board game, we first read the rule book, or we play with someone who already knows the game. So, like playing a board game, read up on the subject and consider my book, The Self-Directed IRA Handbook, or play the game with others who knows the rules (e.g., a lawyer, CPA, advisor, or other investor). After you’ve properly self-directed your IRA into real estate once, you’ll have the rules down and it’s the same game each time thereafter…at least until Congress changes the rules of the game. And if they do, I’ll update my rulebook.
Self-Directed IRA investors should be aware of their self-directed IRA tax reporting responsibilities. Some of these items are completed by your custodian and others are the IRA owner’s sole responsibility. Here’s a quick summary of what should be reported to the IRS each year for your self-directed IRA. Make sure you know how these items are coordinated on your account as the ultimate authority and responsible tax person on the account is, you, the account owner.
IRA Custodian Files
Your IRA Custodian will file the following forms to the IRS annually:
Filed to the IRS by your custodian to report any distributions or Roth conversions. The amounts distributed or converted are generally subject to tax and are claimed on your personal tax return.
IRA distributions for the year, Roth IRA conversions, and also rollovers that are not direct IRA trustee-to-IRA trustee.
IRA Owner’s Responsibility
Depending on your self-directed IRA investments, you may be required to file the following tax return(s) with the IRS for your IRA’s investments/income:
DOES MY IRA NEED TO FILE THIS?
1065 Partnership Tax Return
If your IRA is an owner in an LLC, LP, or other partnership, then the partnership should file a 1065 tax return for the company to the IRS, and should issue a K-1 to your IRA for its share of income or loss. Make sure the accountant preparing the company return knows to use your custodian’s tax ID for your IRA’s K-1s, and not your personal SSN (or your IRA’s tax ID if it has one for UBIT 990-T tax return purposes). If your IRA owns an LLC 100%, then it is disregarded for tax purposes (a single-member LLC), and the LLC does not need to file a tax return to the IRS.
If your IRA incurs Unrelated Business Income Tax (UBIT), then it is required to file a tax return. The IRA files a tax return and any taxes due are paid from the IRA. Most self-directed IRAs don’t need to file a 990-T for their IRA, but you may be required to file for your IRA if your IRA obtained a non-recourse loan to buy a property (UDFI tax), or if your IRA participates in non-passive real estate investments such as: Construction, development, or on-going short-term flips. You may also have UBIT if your IRA has received income from an active trade or business, such as a being a partner in an LLC that sells goods and services (C-Corp dividends exempt). Rental real estate income (no debt leverage), interest income, capital gain income, and dividend income are exempt from UBIT tax.
April 15th, 6 -month extension available
Most Frequently Asked Questions
Below are my most frequently asked questions related to your IRA’s tax reporting responsibilities:
Q: My IRA is a member in an LLC with other investors. What should I tell the accountant preparing the tax return about reporting profit/loss for my IRA?
A: Let your accountant know that the IRA should receive the K-1 (e.g. ABC Trust Company FBO John Doe IRA) and that they should use the tax ID/EIN of your custodian and not your personal SSN. Contact your custodian to obtain their tax ID/EIN. Most custodians are familiar with this process, so it should be readily available. If your IRA has a tax ID/EIN because you file a 990-T for Unrelated Business Income Tax then you can provide that tax ID/EIN.
Q: Why do I need to provide an annual valuation to my custodian for the LLC (or other company) my IRA owns?
A: Your IRA custodian must report your IRA’s fair market value as of the end of the year (as of 12/31/18) to the IRS on Form 5498, and in order to do this they must have an accurate record of the value of your IRA’s investments. If your IRA owns an LLC, they need to know the value of that LLC. For example, let’s say you have an IRA that owns an LLC 100% and that this LLC owns a rental property, and that it also has a bank account with some cash. If the value of the rental property at the end of the year was $150,000, and if the cash in the LLC bank account is $15,000, then the value of the LLC at the end of the year is $165,000.
Q: I have a property owned by my IRA and I obtained a non-recourse loan to purchase the property. Does my IRA need to file a 990-T tax return?
A: Probably. A 990-T tax return is required if your IRA has income subject to UBIT tax. There is a tax called UDFI tax (Unrelated Debt Financed Income) that is triggered when your IRA uses debt to acquire an asset. Essentially, what the IRS does in this situation is they make you apportion the percent of your investment that is the IRA’s cash (tax favorable treatment) and the portion that is debt (subject to UDFI/UBIT tax) and your IRA ends up paying taxes on the profits that are generated from the debt as this is non-retirement plan money. If you have rental income for the year, then you can use expenses to offset this income. However, if you have $1,000 or more of gross income subject to UBIT, then you should file a 990-T tax return. In addition, if you have losses for the year, you may want to file 990-T to claim those losses as they can carry-forward to be used to offset future gains (e.g. sale of the property).
Q: How do I file a 990-T tax return for my IRA?
A: This is filed by your IRA and is not part of your personal tax return. If tax is due, you will need to send the completed tax form to your IRA Custodian along with an instruction to pay the tax due and your custodian will pay the taxes owed from the IRA to the IRS. Your IRA must obtain its own Tax ID to file Form 990-T. Your IRA custodian does not file this form or report UBIT tax to the IRS for your IRA. This is the IRA owner’s responsibility. Our law firm prepares and files 990-T tax returns for our self-directed IRA and 401(k) clients. Contact us at the law firm if you need assistance.
Sadly, not many professionals are familiar with the rules and tax procedures for self-directed IRAs, so it is important to seek out those attorneys, accountants, and CPAs who can help you understand your self-directed IRA tax reporting obligations. Our law firm routinely advises clients and their accountants on the rules and procedures that I have summarized in this article and we can also prepare and file your 990-T tax return.
An IRA must report its fair market value to the IRS annually. Fair market value is reported to the IRS by your IRA custodian via IRS Form 5498. For standard IRAs holding stocks or mutual funds, those account values are automatically determined as they simply take the stock or fund price as of the close of the market on December 31st each year. They then use these amounts to set the year-end account fair market value. For self-directed accounts, such fair market values are not readily available, and it becomes the IRA account owner’s responsibility to obtain their self-directed investment values so that their custodian can properly report the account’s fair market value. The value of an account is important for a few reasons. First, the IRS requires it to be updated annually. Second, it is used to set required minimum distributions (RMDs) for those account holders over the age of 70 ½ with Traditional IRAs. Last, the account value is used when converting an entire account, or a particular investment or portion of the account, from a Traditional IRA to a Roth IRA.
What is “Fair Market Value?”
Fair market value of an investment has been broadly defined by the Court as:
“The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” U.S. v. Cartwright, 411 US 546 (1973).
Now here’s the hard part: Even though the IRS requires IRAs to update their fair market value on an annual basis, the Government Accountability Office noted in their recent report that:
“Current IRS guidance includes NO [emphasis added] guidance or advice to custodians or IRA owners regarding how to determine the FMV [fair market value]”. United States Government Accountability Office, GAO-17-02, Retirement Security Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets. (Dec. 2016).
The absence of guidance, however, has not relieved IRA owners or their custodians from obtaining and reporting this information. While there is no specific fair market valuation guidance for IRAs, there are commonly accepted methods of reporting value used by professionals and companies within the self-directed IRA industry. Most of these methods have been adopted from law and regulations governing employer retirement plans or estates.
Methods to be used by Asset Type
The table below outlines preferred valuation methods that are commonly used in the industry for the most common self-directed IRA assets. As you will note, when the valuation is needed for a taxable event, such as a distribution or Roth conversion, greater detail and supporting information will be required as the valuation will result in tax being due.*
Non-Taxable (Annual FMV)
Taxable (RMD, distribution or conversion)
Comparative Market Analysis (CMA) from a real estate professional is preferred. Some IRA custodians accept property tax assessor values or Zillow reports in non-taxable situations.
Real estate appraisal is preferred. Some IRA custodians accept a broker’s price opinion.
Value of a note can be reported by calculating the principal due plus any accrued and unpaid interest. This is the valuation method used for calculating the value of a note for estate tax purposes.
Same as non-taxable, principal amount due plus accrued and un-paid interest. For notes in default, a third-party opinion as to value is typically required in order for the note to be written-down below face value.
For bullion, use the spot value of the metal in question times the ounces owned. Spot value is widely reported on a daily basis on financial sites.
For acceptable coins, use market data for the coin in question via the Grey Sheets available at www.bullionvalues.com.
Same as non-taxable.
LLC, LP, or Private Company Interest
Obtain a third party-opinion of value of the LLC interest. The opinion should rely on IRS Revenue Ruling 59-60. For asset holding companies, the valuation should focus on the value of the assets. For operating companies, the valuation should focus on earnings.
Similar requirement, but the detail of the opinion should be more significant. For example, for an asset holding company where the IRA’s interest is determined by the assets of the LLC. A CMA would be acceptable for calculating that assets value in the company in an annual valuation. However, an appraisal of the real estate to calculate in that asset would be required in a taxable situation.
Since the valuation reporting policies of custodians vary, IRA owners should make sure that they understand their IRA custodian’s policies for valuations of the assets in question.
Our firm routinely assists clients with obtaining third-party opinions of value, and can assist IRA owners who need to produce a report or third party opinion as to an LLC or other investment interest held by an IRA. Call us at (888) 801-0010.
*Please note that there are clearly differences of opinions on these matters, and since there is no specific legal guidance for IRA valuations, please keep in mind that the table above is based on my own industry experience and opinions. Seek a licensed professional in all instances for your specific situation.
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401(k) plan. Fortunately, this isn’t true.
While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible Traditional IRA and then convert those amounts over to a Roth IRA. Our IRA company – Directed IRA – can help those who want a self-directed “back door” Roth IRA, but the strategy can be done with almost anyone who wants a Roth IRA.
Here’s a few examples of earners who can establish and fund a Roth IRA:
“I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA?” Yes, even though you are high-income, and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA. You just have to use the “back door” method.
“I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high?” Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers. You just have to use the “back door” method.
The strategy used by high-income earners to make Roth IRA contributions involves the deposit of non-deductible contributions to a Traditional IRA, and then converting those funds in the non-deductible Traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction on the amounts contributed, but the funds are held in a Roth IRA and are tax-free upon retirement (just like a Roth IRA). Here’s how it works:
Step 1: Fund a new non-deductible Traditional IRA.
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who has a spouse who does) can’t also make “deductible” contributions to an IRA. However, the account can be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500 for 2018 ($6,000 for 2019 and forward). The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the Traditional IRA. Don’t worry about having non-deductible contributions though, as you’re converting to a Roth IRA, so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you made the non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company-based retirement plan (or a spouse with one), then you simply establish a standard deductible Traditional IRA, as there is no high-income contribution limit on Traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible Traditional IRA funds to a Roth IRA.
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, all taxpayers are able to covert traditional IRA funds to Roth IRAs since 2010. It was in 2010 that this “back door” Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from Traditional to Roth. It has been used by tens of thousands of Americans since.
If you have other existing Traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEP and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible Traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with $95,000, and you have $5,000 in non-deductible Traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to convert your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5k) based on the money you have in all Traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing Traditional IRAs that contain deductible contributions and earnings from those sums.
There are two workarounds to this Roth IRA conversion problem, and both revolve around moving the existing Traditional IRA funds into a 401(k) or other employer-based plan as employer plan funds are not considered when determining what portions of the Traditional IRAs are subject to tax on conversion (the deductible and the non-deductible). If you participate in an existing company 401(k) plan, then you may rollover your Traditional IRA funds into that 401(k) plan. Most 401(k) plans allow for this rollover from IRA to 401(k), so long as you are still employed by that company. If you are self-employed, you may establish a Solo or owner-only 401(k) plan, and rollover your Traditional IRA into this 401(k). In the end though, if you can’t roll out existing Traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing Traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though, as all of the money that comes out of that Traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill, so plan carefully.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: The Roth IRA.
As 2018 comes to an end, it is critical that Solo 401(k) owners understand when and how to make their 2018 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 2018. 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 $55,000 per year (far faster than any IRA).
New Solo 401(k) Set-Up Deadline is 12/31/18
First, in order to make 2018 contributions, the Solo 401(k) must be adopted by your business by December 31st, 2018. 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, 2019 or later, you cannot make 2018 contributions.
2018 Contributions Can Be Made in 2019
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, 2018. If you have an S-Corporation or partnership LLC, the deadline for 2018 contributions is March 15th, 2019. Both of these deadlines (March 15th and April 15th) to make 2018 contributions may be extended another six months by filing an extension. This a huge benefit for those that want to make 2018 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, 2019. 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 $18,500 for 2018) by January 31st, 2019 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31st, 2019. 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 2018. 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 2018 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 2018 Solo 401(k) contributions, it would look like this:
Employee Contributions – The 2018 maximum employee contribution is $18,500. This is dollar for dollar on wages so you can contribute $18,500 as long as you have made $18,500. Since Sally has $50,000 in wages from her S-Corp, she can easily make an $18,500 employee contribution. Let’s say that Sally doesn’t have the $18,500 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 $18,500 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $31,500. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,625.
Employer Contributions – The 2018 maximum employer contribution is 25% of wage compensation. For Sally: Up to a maximum employer contribution of $36,500. 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, 2019 (the company return deadline) or by September 15th, 2019 if the company were to file an extension.
In the end, Sally would have contributed and saved $31,000 for retirement ($18,500 employee contribution, $12,500 employer contribution). And she would have saved approximately $7,750 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 2018 if you plan to make 2018 contributions. While IRAs can be established until April 15th, 2019 for 2018 contributions, a Solo K must be established by December 31st, 2018. 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.
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