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Is a Solo 401(k) My Best Self-Directed Plan Option?

If you’ve been studying self-directed retirement plans, you’ve likely stumbled on the fact that a Solo 401(k) plan is widely considered to be the best available program.

With a self-directed Solo 401(k), you have the best of both worlds in a high-contribution retirement plan capable of investing in anything the IRS rules allow for with direct checkbook control. The Solo 401(k) provides the maximum amount of both flexibility and control in managing your investment portfolio.

The Solo 401(k) is a powerful retirement plan option, but that doesn’t mean it’s always the right plan for every retirement investor. The Solo 401(k) can be over-marketed and promoted to people for whom it isn’t the right choice.

Plan fit — both today and for the long term — is a critical piece of ensuring your investing success. A Checkbook IRA LLC is another great self-directed program, and maybe a better option than the Solo 401(k) for many investors.

Let’s take a look at some of the key questions to ask when evaluating a Solo 401(k) as your self-directed investing platform.

Do I Qualify for a Solo 401(k)?

As an employer-sponsored retirement plan, there needs to be a business that establishes the Solo 401(k) as an employee benefit. With the Solo 401(k), we’re talking about a version of 401(k) that is simple to administer — and that simplicity comes from the fact that it’s tied to an owner-only business.

That means you need to be self-employed and have no qualifying non-owner employees (other than a spouse).  A qualifying employee includes full-time employees working more than 1,000 hours per year, or (starting in 2021), long-term part-time employees working at least 500 hours per year in 3 straight years.  Because your business isn’t offering benefits to non-owner employees, the administrative requirements of the plan are greatly reduced.

Many types of businesses are Solo 401(k) eligible, including sole proprietorships, LLCs, and corporations. The business does need to be producing earned income such as commissions, 1099 income as an independent contractor, or W-2 wages from your own corporation. Passive investment earnings such as rental income don’t qualify to sponsor a Solo 401(k).

What Other Qualifications Are There?

The bar to be self-employed is pretty low. As long as you have a compatible business format with an intent to generate earned income, your business can sponsor a Solo 401(k).

As a result of this low bar, some plan promoters will forward the idea of “anyone can qualify” for a Solo 401(k). This assertion implies you can sell a few things on eBay or do some rideshare driving and claim self-employment.

While not entirely untrue, there are a few catches, which is why we urge caution on this front.

Your business needs to be legitimate and ongoing. You can’t create a wee bit of self-employment income in year one and call it good. To qualify as a business, your activity needs to continue year after year, and needs to generate legitimate income to the scale of filing a tax return.

If your business is configured to operate at a loss year over year, eventually the IRS will deem it a hobby and not a business.

Your business doesn’t need to be hugely profitable to be viable as a plan sponsor. In fact, it doesn’t even need to show a profit each and every year. But profits in two out of every 3 years should be a realistic expectation.

If you get tired of dealing with bar-crawl patrons in the back seat of your car every Saturday evening and decide to shut down your “business”, then the 401(k) plan also needs to be shut down.

With what we might call “marginal” self-employment, one also needs to weigh the cost/benefit of operating and reporting on a business relative to the ability to have the Solo 401(k) plan format. Contact us to learn more details about this consideration.

Will I Qualify Next Year?

While no one has a crystal ball vision of their future employment status, it’s meaningful to take a longer-term view of your business plan and ensure ongoing compliance with the Solo 401(k) eligibility requirements.

If your current self-employment is temporary or somewhat tenuous, then a Solo 401(k) may not be the best fit. The other consideration comes with a growing business.

If your long-term plan is to add employees, there will come a time when your business no longer qualifies to sponsor a Solo 401(k). Any full-time employee, which means anyone over the age of 21 working more than 1,000 hours per year, will push your business out of Solo 401(k) eligibility.  Likewise, plans for long-term use of part time employees who might work more than 500 hours in 3 consecutive years would jeopardize plan qualification.

If you add qualifying employees, you can “upgrade” to a full-blown 401(k) and provide benefits to those employees, but that is not generally a good solution in a self-directed format. The complexities and liabilities that come with allowing your company employees to self-direct within their 401(k) are beyond what most small business owners want to take on.

The more common path at that juncture is to terminate the Solo 401(k) and rollover your holdings to a Checkbook IRA that is not tied to your business. The paperwork and expense associated with such a transition are manageable, but not something to set yourself up for in a near-term cycle if you can avoid it.

Will I Benefit?

There are several aspects of a Solo 401(k) that can be viewed as benefits when compared to an IRA based self-directed plan. Some of the more notable differentiators include:

  • A streamlined structure with no custodian involved
  • Higher contribution limits than most IRA plans, topping out at $63,500 per year
  • The ability to hold both tax-deferred and Roth funds in the same plan
  • The ability for a husband and wife to both participate in the same plan if they are both active in the sponsoring business
  • The option to borrow up to $50,000 from the plan on a participant loan
  • Exemption from UDFI taxation on debt-financed real estate investments
  • Less risk in the event of a prohibited transaction

These are all great features. The real question, however, is what does that mean for you?

  • Does your self-employment generate significant income to the point where you can actually make higher contributions?
  • Will your spouse also have funds to hold within the plan?
  • Do you intend to invest in leveraged rental properties?

If none of those factors apply to your situation, the permanency and simplicity of an IRA-based program may be better suited to your needs.

Does the Benefit Outweigh the Costs?

If you have a legitimate form of self-employment, great. Adding a Solo 401(k) to that is going to be a good solution for you.

If you are essentially making up a side business to have a Solo 401(k), the number one benefit of such plans — higher contribution limits — is likely off the table. You can’t put $63,500 in your 401(k) if the business sponsoring the plan is only netting $3,000.

We often have the opportunity to speak with an investor who has learned something neat about the Solo 401(k), such as the exemption from UDFI taxation on mortgaged real estate investments. As a result, they really want a Solo 401(k) — even if they may not currently have legitimate self-employment today.

Avoiding taxation is always a good thing…except for when it costs more to avoid the taxes than the cost of those taxes.  Is it worth setting up a side business, taking time away from family or other interests, keeping records, and filing taxes for that business to avoid the $200 a year in UDFI taxes an IRA might pay on a typical leveraged single-family rental?

Probably not.

Now, if you have a million dollars of 401(k) to put to work in leveraged real estate, the additional overhead of becoming self-employed might be worth the effort to offset the slightly higher UDFI taxation that may occur on that scale.

The difference between theory and reality hinges on the details of a specific scenario, so be sure to ask all the right questions and not get caught up with shiny object syndrome.

Thinking Long-Term Equals Success

Evaluating a self-directed retirement plan requires taking a long-term view. A big part of what we focus on at Safeguard Advisors is helping each of our clients to maximize their chances of investing success by choosing the right plan for their situation and goals.

Finding out two years down the road that you are in the wrong plan for your needs is not a good spot to be in. Taking the time to do a real analysis of your specific needs for today and the long term is the best approach to the transition into a self-directed investment strategy.

We support the Solo 401(k) plan structure, and find it to be a great fit for about 30% of the investors we work with. We also enjoy getting to see the successes of those investors who find the IRA LLC to be better suited to their needs.

One of the benefits of the Solo 401(k) is the ability to borrow from the plan. Here’s everything you need to know about how a 401(k) loan works »


This page has been updated to reflect law changes implemented with the SECURE Act of 2019.

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