You've probably heard of a 401(k). A Solo 401(k) is a retirement plan designed for self-employed individuals or businesses who only employ the owners of a business along with their spouses.
These plans are attractive to small business owners because of their high contribution limits. Contributions are made by both the employer and employee, those who are eligible can contribute up to $61,000 per year for 2022 and $66,000 for 2023. Additional contributions may be made for individuals who are age 50 or older. The business owner is the alpha and omega when it comes to a Solo 401(k) plan.
Did you know that it’s possible to invest in real estate trough retirement plans like a Solo 401(k)? Read on to find out about 401(k) real estate investment rules to get the inside scoop.
There are a few things that are as comforting as the safe and sound feeling of home, sweet home. People will always need a place to live. That’s one of the reasons investing in real estate has such lucrative potential. Plus, you’ve likely had some experience dealing with real estate in some capacity.
As a hard asset, real estate is less speculative compared to cryptocurrencies and other investments. The income generated from the investment (via rental or sale) goes back to the retirement account tax deferred. And there are many ways for you to invest in real estate— whether it be residential, commercial, or through some kind of real estate trust.
Because retirement accounts usually hold long-term investments, investment property is a popular choice.
Solo 401(k) plans are specially designed for the self-employed. You, as the owner-employee, are eligible to open a solo 401(k) if you run your own business alone or with a partner or a spouse and have no full-time employees. There are two basic requirements to open a Solo 401(k):
Must be a business
To meet the first requirement the individual must own a business, whether a sole proprietorship, partnership, or corporation.
Passive income generated through investments doesn’t qualify to open a Solo 401(k) either. You need to have some form of earned income from your business.
To be eligible to use that income for a Solo 401(k) contribution, you would need to report that income as self-employment income. Please note that there could be additional social security tax on the income declared as self-employment income.
No Other Full-Time Employees
The second requirement states that there can be no full-time employees other than yourself, your spouse (if your spouse works for the business), or another business partner(s). Thanks to the , your business partner could be your spouse.
The Solo 401(k) allows you to bypass dealing with the hassles of nondiscrimination tests and immediate IRS Form 5500 annual filings. These tests could limit the employer’s ability to maximize their contribution. Essentially having no rank-and-file employees makes things a whole lot easier.
Is Rental Income from Real Estate Considered a Business?
The answer is — it depends! How income is generated and how you report that income determines if it is self-employment income, passive income, or tax-deferred income.
If you are a real estate investor generating passive income, you are not allowed to use this business as a funding source for your Solo 401(k).
Here’s an example of earned income for a self-directed solo 401(k):
Let's say you are a self-employed consultant who provides marketing services to various clients. In this case, your earned income for your self-directed solo 401(k) would consist of the fees you earn from your consulting work. This income is considered earned because it is a direct result of your active participation and effort in providing your services to clients.
On the other hand, income from investments, such as dividends, interest, or rental income from a property that you're not actively involved in managing, wouldn't qualify as earned income for your solo 401(k).
Income From an Investment Made with a Solo 401(k)
When you invest in real estate with retirement funds, the income generated is tax-deferred until retirement. This means that you will not pay taxes on the investment income until you take distributions at retirement age. How you get taxed at retirement will depend on the funds source used from your solo 401(k) to make the investment.
A Solo 401(k) can be used to purchase a myriad of real estate-related investments. This can include certain types of foreign and domestic real estate. Check out this non-exhaustive list of real estate-related investments that you can make with a Solo 401k:
Real estate notes
Real estate purchase options
Tax liens certificates
For starters, you’ll want to find a reputable provider to establish your Solo 401(k) plan and open an account. You’ll also need to have your employer identification number (EIN) on standby. You will need this number to open a bank account for the plan.
It is your responsibility to make sure your plan provider adheres to regulations and has a plan that allows the alternative investments you’re interested in, like real estate. Not all plan providers allow these types of investments.
Your Solo 401(k) provider will then give you a plan adoption agreement which is the document used to establish the plan. Once you’ve completed, signed, and dated the plan documents you have established the plan. This process can easily be done online.
You must also create a recordkeeping system to account for all types of contributions separately. You can either hire someone to do this for you or find a system that is compliant to help guide you through the process of administering your plan.
You can fund your 401(k) plan in different ways. One way is through contributions. This will be determined by your income as an employer. Involve your tax advisor in determining your income and contributions.
You may also fund your account by rolling over a previous employer’s 401(k) plan. If the rollover is sent directly from your previous plan to your new Solo 401(k) it is called a . These funds can be used to establish your small business retirement account if you meet the criteria we discussed earlier. Once your plan has been funded, you are ready to purchase a property.
For investments, you will need to do your own due diligence in choosing the right ones. Involve your tax or legal advisor if you need expert help. You’ll need to do the comps analysis by checking the appraised value, potential return on investment, neighborhood or property location, or any other comparative market assessment. This is vital to the success of your investment as you are the rainmaker of your self-directed retirement plan.
We'll provide you with information on prohibited transaction rules and disqualified persons, but ultimately, you are in charge of your real estate buys and sells through your Solo 401(k). Remember, breaking the rules could result in penalties and possibly the disqualification of your retirement plan.
All asset income must be deposited back in the Solo 401(k) with the rest of your plans funds and any expenses must come from the plan as well. For example, if you need to pay property taxes, the payment must come from the plan funds. If you are making an annual contribution, it must go into the plan's checking account. These are not to be comingled with personal funds to keep the account and assets in a tax-free environment.
Our recordkeeping platform can help you run reports for required annual reporting. For instance, for individuals with more than $250,000 in their Solo 401(k) in assets or capital, an IRS Form 5500-EZ form will be required to be filed annually.
There are some great benefits when it comes to investing in real estate with a Solo 401(k). For one, it’s tax deferred. You won’t pay taxes on any income or gains until you retire and begin taking distributions, allowing you to get the most out of your compounding return.
As Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pays it.”
Taxes on Solo 401(k)s can be deferred until the account holder reaches the age of 73, when Required Minimum Distributions (RMDs) are mandated for the year 2023. However, starting at the age of 59 1/2, individuals can begin taking distributions from their Solo 401(k) without incurring early withdrawal penalties. The distributions taken from the plan are taxed as income.
Investors can also use their solo 401(k) to leverage a non-recourse loan acquired through their plan to purchase real estate. Only if an investor purchases real estate solely through their IRA and generates more than $1,000 in annual income, it can trigger an Unrelated Business Taxable Income (UBTI) or Unrelated Debt Finance Income (UDFI). UBTI tax rates can go up as high as 37%. However, under tax code 514(c)(9), Solo 401(k)s are not subject to the same income taxes as a Traditional or Roth IRA.
Losses are a downside of a 401(k). There are no tax deductions when it comes to a 401(k) since you don’t pay taxes on it. Losses can also occur through the real estate investment itself.
In that case, there’s no way to salvage those losses. Your retirement account simply declines in value. Patience is the key to any investment.
Ultimately, when it comes to investing in real estate for retirement, your goal is to generate the most income and gains possible. Investing in real estate through a retirement account allows you to optimize your investment using leverage and tax advantages. Having a trusted and reliable provider will help you navigate how to create a cash flow for your retirement account.
For nearly 30 years, IRAR has proudly helped investors achieve their retirement goals. Call us at 888-322-6534 or contact us for a to find out how you can build wealth and save for your retirement through alternative investments like real estate.