4 Reasons to Ditch Your SEP IRA for a Solo 401(k)

by | Oct 31, 2017 | Real Estate & Alternative Asset Investing , Retirement & IRAs

Man walking out of a door to the outside.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).

IRS Announces 2018 Retirement and HSA Contribution Amounts

by | Oct 24, 2017 | Retirement & IRAs

Photo of woman standing with her fists raised above her head in front of a sunrise.The IRS announced new contribution amounts for retirement accounts in 2018, and there are some winners and losers in the bunch.

The biggest win goes to 401(k) owners, including Solo K owners, who saw employee contribution amounts go from $18,000 to $18,500. Health savings account (HSA) owners won a small victory with individual contribution maximums increasing $50 to $3,450 and family contribution amounts increasing by $150 to $6,900.

 

However, IRA owners lost with no increase in the maximum contribution amount for Traditional or Roth IRAs. The IRA maximum contribution amount remains at $5,500 and hasn’t increased since 2013.

Breakdown

 

Here’s a quick breakdown on the changes:

  • 401(k) contributions also increased for employees and employers: Employee contribution limitations increased from $18,000 to $18,500 for 2018. The additional catch-up contribution for those 50 and older stays the same at $6,000. The annual maximum 401(k) (defined contribution) total contribution amount increased from $54,000 to $55,000 ($61,000 for those 50 and older).
  • HSA contribution limits increased from $3,400 for individuals and $6,750 for families to $3,450 for individuals and $6,900 for families.
  • IRA contribution limitations (Roth and Traditional) stayed at $5,500, as did the $1,000 catch-up amount for those 50 and older.

There were additional modest increases to defined benefit plans and to certain income phase-out rules. Please refer to the IRS announcement for more details here.

These accounts provide tax advantageous ways for an individual to either save for retirement or to pay for their medical expenses. If you’re looking for tax deductions, you should determine which of these accounts is best for you. Keep in mind there are qualifications and phase out rules that apply, so make sure you’re getting competent advice about which accounts should be set up in your specific situation.

The IRS Does Not Approve IRA Investments – “IRA Approved” or “IRS Approved” Terms Are False

by | Oct 10, 2017 | Real Estate & Alternative Asset Investing , Retirement & IRAs

Photo of the exterior of the IRS building in Washington, DC.There has been a significant increase in the amount of marketing directed towards IRA owners for non-publicly traded investments. Many of these investment sponsors and promoters are using marketing slogans like “IRS Approved” or “IRA Approved”. Don’t be fooled though, as the IRS does not review or approve investments, nor do they comment or issue statements on investments in an IRA. In fact, the IRS recently revised and updated IRS Publication 3125 titled, “The IRS Does Not Approve IRA Investments,” in an effort to inform IRA investors.

 

IRAs Can Invest into Non-Publicly Traded Investments (Real Estate, LLCs and Precious Metals)

Yes, it’s true that a self-directed IRA can invest into real estate, LLCs, LPs, private stock, venture or hedge funds, start-ups and qualifying precious metals, among other things. However, just because you can invest in all of these assets doesn’t mean that you should. Make sure you’re investing your IRA into assets you are familiar with, and with persons and companies with whom you have thoroughly vetted. Non-publicly traded investments can be easier to understand and vet than a mutual fund prospectus, but you need to be careful when investing your funds with another person or when buying investments from third-parties who regularly sell to IRA owners using comforting, yet totally false, representations like “IRA Approved” or “IRS Approved.”

“IRA Approved” or “IRS Approved” Representations are False

In Publication 3125, “The IRS Does Not Approve IRA Investments,” the IRS provided some guidelines for IRA owners to evaluate and protect their account from “IRA Approved Schemes.”

  1. Avoid any investment touted as “IRA Approved” or otherwise endorsed by the IRS.
  2. Don’t buy an investment on the basis of a television “infomercial” or radio advertisement.
  3. Beware of promises or no-risk, sky-high returns on exotic investments from your retirement account.
  4. Never transfer or rollover your IRA or other retirement funds directly to an investment promoter.
  5. Proceed with caution when you are encouraged to invest in a “general partnership” or “limited liability company”.
  6. Don’t be swayed by the fact that a bank or trust department is serving as an IRA custodian.
  7. Always check out an investment and promoter before you turn over your money.
  8. Educate yourself about IRAs and retirement planning.
  9. Exercise extra caution during tax season when it comes to making IRA investments.

As a self-directed IRA investor, you are solely responsible for investment decisions, and as a result you must make certain that you understand the investments you are selecting and the associated risks. Beware of slogans and terms like “IRA Approved” or “IRS Approved,” as such slogans are just false. In addition to the consideration from the IRS above, I’ve previously written my own “Self Directed IRA Investment Due Diligence Top Ten List” which includes additional tips and questions to ask when investing your hard-earned retirement plan dollars with others.

Take the IRS guidelines and my Top Ten List into consideration when investing your IRA, but in the end, don’t be scared about investing into non-publicly traded investments. Rather, keep the risk and opportunities in perspective, and realize that you may need to get out of your comfort zone by asking pointed questions, demanding additional documentation, or simply saying “no.” Remember: You are the best person to protect your retirement.

Alert: The RISE Act Will Drastically Impact Self-Directed IRAs

by | Oct 25, 2016 | Retirement & IRAs

The Retirement Improvements and Savings Enhancements Act (“RISE Act“) has drastic changes and provisions that effect self-directed IRA investors. From mandatory third-party valuations on all retirement account investment transactions to changing the 50% disqualified company rule to 10%, the bill has some significant changes that will negatively affect your ability to self-direct your account. There are some favorable provisions for IRA owners, however, the negatives greatly outweigh the positives.

 

Most Important Provisions

The bill sponsor is Sen. Ron Wyden (D-OR) who is the Ranking Member of the Senate Finance Committee and the Joint Committee on Taxation. Here’s a quick run-down of the most troublesome provisions that apply to self-directed IRA investors:

  • Valuation Purchase/Sale Requirement. Mandatory Valuation Requirement for Private IRA (non-public stock market) Transactions: The new proposal seeks to require gifting valuation rules and standards for IRA transactions. This rule will force IRA owners to get a valuation before making any private investment. This valuation would include real estate, private company (e.g. LLC, LP, corporation), and note investments. The gifting valuation rules were created to value gifts where no value is set between a buyer and seller. mandating those same rules on actual transactions between an IRA and another unrelated party is unrealistic and unnecessary to establish actual fair market value.
  • 50% Rule is Reduced to a New 10% Rule: Changes the 50% rule that states a company is a disqualified person to an IRA when it is owned 50% or more by disqualified persons (e.g. IRA owner and certain family). The new rule makes a company disqualified when owned 10% or more by disqualified persons.
  • Roth IRAs Capped at $5M: Roth IRAs will be capped at $5M. Any amount over $5M must be distributed from the Roth IRA.
  • Eliminate Roth Conversions: Traditional IRA funds cannot be converted to Roth IRA funds. Roth IRAs will be allowed only if the account owner makes initial Roth IRA contributions and only when they meet the Roth IRA contribution limits, which restricts high-income earners.
  • Require RMD for Roth IRAs: Roth IRAs are currently not subject to required minimum distribution (“RMD”) rules because the amounts distributed do not result in tax. This rule will change and RMD will apply to Roth IRAs when the account holder reaches age 70 ½.

These proposals will have drastic impacts on self-directed IRA investors. The valuation requirement is perhaps the most dramatic as it will require valuations before an IRA can buy an asset and before it can sell an asset. Not only will this cause administrative issues and increased costs, but it will undoubtedly replace the ability of an IRA buyer or an IRA seller from transacting their IRA at the price and value they determine to represent the actual current fair market value of their investments.

I have written a detailed analysis of the bill which I plan to share with the Senate Finance Committee and the Joint Committee on Taxation. I welcome your input as a self-directed IRA investor and plan to advocate for common-sense rules that help self-directed investors take control of their retirement. My draft bill analysis can be accessed at the link below. Please send your comments to [email protected].

draft-rise-act-2016-analysis-by-mat-sorensen

 

 

Correcting Your IRA’s RMD Failures and Avoiding the Penalty

by | Jan 5, 2016 | Retirement & IRAs, Uncategorized

If you failed to take required minimum distributions (RMD’s) from your IRA, then you are subject to a 50% penalty. The penalty is 50% on the amount you should have distributed from your IRA to yourself. It’s a steep penalty for simply failing to pay yourself from your own IRA and it’s something every IRA owner with RMD needs to understand. For my prior article explaining RMD rules for IRAs, please click here.

Waiver of 50% Penalty Tax

If you’ve failed to take RMD for your IRA, you have a chance at obtaining a waiver from the penalty but you must admit the mistake to the IRS by filing IRS form 5329. In the instructions to form 5329, the IRS outlines the waiver process to avoid the 50% penalty tax.

What You Need to Do

  1. Complete Section IX of Form 5329. You need to specify what you should have taken as RMD  and then you calculate the penalty tax due. You then write the letters “RC”next to the amount you want waived on line 52.
  2. Statement of Explanation. Attach a Statement of Explanation outlining two items.
    1. First, explain what was the “reasonable error” that caused a failure to take RMD. The IRS does not provide a definition or acceptable examples of “reasonable error”. See IRC 4974(d)(1). From my own experience and from examples I’ve heard from colleagues, the IRS does recognize reasonable errors and oversights in most situations where there is reason for the error. This would include situations such mental health, to turning 70 ½ and being new to RMD, to relying on bad advice from an advisor, custodian or accountant, to holding an ill-liquid asset for sale in a self directed IRA.
    2. Second, explain the reasonable steps taken to correct the error. Ideally, by the time you’re filing the exemption request you would’ve already contacted your IRA custodian and would’ve taken the late RMD so that by the time you submit the RMD penalty tax waiver, you would be caught up and would have already remedied the error.  This makes for an easy and clean explanation of what steps you’re going to take as your explanation will be that you already corrected the RMD failure once you realized the error.

Keep in mind that RMD failures won’t go away as your IRA custodian will be updating your account each year with the IRS. Eventually, you’ll start getting collection letters from the IRS requesting the penalty tax. Consequently, IRA owners are well advised to correct the RMD failure and request the wavier as soon as they become aware of the error or oversight.