Solo 401k VS SDIRA for Real Estate Investing
Investing in Real Estate Syndications Using a Self-Directed IRA VS a Solo 401k
By: Kristen Ray of Vital Investment Partners, LLC [https://vitalinvestmentpartners.com/]
While millions of Americans have one type of retirement plan or another, many are not aware that there are options that would not only allow them a better control over their funds, but also the opportunity to invest in alternative assets and potentially generate much higher returns. In this article, we will discuss the benefits of investing self-directed IRA and solo 401k account funds in real estate syndications, as well as highlight the similarities and differences between the two retirement plans.
Self-Directed IRA and Solo 401k Definitions
Before reviewing some of the details of how these retirement accounts could be used as a financial source for real estate syndication investments, it is important to have a clear definition of the plans.
A self-directed IRA (SDIRA) [https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras] is an Individual Retirement Account that allows the account owner to use their retirement savings for other types of investments besides the traditional options of stocks, bonds, CDs, and ETFs. The list of alternative choices is virtually limitless as the IRS only specifies what investments are not allowed. Some of the more popular options include real estate syndications, precious metals, franchises, cryptocurrencies, tax liens, startups, and intellectual property. Self-directed IRAs are offered by certain financial institutions, which are usually lesser-known companies that specialize in this type of retirement plans. These institutions act as a trustee or custodian that holds and manages the account funds as per the IRS requirements for self-directed IRAs.
A solo 401k (also very similar to the eQRP) is also a retirement plan, however it is only available to self-employed individuals or business owners with no employees, and their spouses. If the business has any full time employees, who are eligible to participate in a retirement plan, then the solo 401k plan cannot be utilized by the company. A solo 401k plan can be sponsored by a brokerage or self-directed by the business owner. While the solo 401k plan funds can be used for various types of investments, brokerage-based plans typically offer options limited to market-based assets, whereas a self-directed account can invest in real estate syndications, private businesses, cryptocurrencies, precious metals, and more.
Similarities Between Self-Directed IRA and Solo 401k
In addition to the option to invest account funds in real estate syndications, there are several additional similarities between self-directed IRAs and solo 401k retirement plans.
The roots of both plans lie within the Employee Retirement Income Security Act of 1974 (ERISA), which was enacted by the 93rd Congress in order to establish some common rules and regulations for retirement plans in the United States. By the early 1990s some trust companies began offering alternative investment options to IRA account owners, however the truly self-directed IRA was formalized in 2001, after the Swanson legal case. The modern solo 401k plan was the result of the Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA).
Alternative Investment Options
As we mentioned in the previous section, both plans allow account owners to pursue other investment opportunities in addition to stocks and mutual funds. Aside from real estate, alternative investments allowed under these plans include gold and silver, oil and gas, tax liens, trust deeds, private company stock, etc. Account owners can invest in any type of real estate including apartment syndications, single family homes, multifamily properties, land, and even commercial real estate and leases.
Section 408(m) of the Internal Revenue Code specifies the assets that are not allowed as investments under either plan. Generally referred to as “collectibles,” these items include works of art, antiques, rugs, stamps, coins, gems, metals, alcohol, and certain other tangible personal property. There are exceptions for certain types of bullion and selected coins minted by the U.S. Treasury. Investing in a “disqualified person’s” business is also prohibited.
Both self-directed IRA and solo 401k retirement plans offer the option for Roth [https://www.irs.gov/retirement-plans/roth-iras] contributions. In this scenario, the account owner pays taxes on their retirement funds before contributing the money to the plan. No additional taxes are due once the plan owner begins receiving distributions, including on any gains made by the account over the years.
Unless the plans were funded with Roth contributions as we discussed in the section above, distributions from either plan at retirement age are going to incur federal income tax. This means that both the originally contributed funds and any associated gains will be subject to taxation.
Neither plan allows transactions between the plan and “disqualified persons.” The definition of a “disqualified person” as it relates to retirement plans includes the plan owner, their family members, or any business entity in which the plan owner or their family has majority ownership. Some examples of prohibited transactions include buying, selling, and renting of real estate property, providing free or paid services and goods to the plan, or covering any plan expenses with personal funds.
Checkbook control refers to the plan owner’s ability to direct the use of account funds at their sole discretion. While there is a slight difference in how checkbook control is established in a self-directed IRA and solo 401k (that we will discuss in one of the following sections), in both instances the plan owner can literally write a check in order to put account funds in an alternative investment of their choice.
Differences Between Self-Directed IRA and Solo 401k
While self-directed IRA and solo 401k retirement plans may appear very similar at a quick glance, there are also a number of differences between the two. In this section we will look at some of the most important features differentiating the two plans.
One of the main differences between the self-directed IRA and solo 401k plans is who is eligible to participate. Self-directed IRA accounts can be opened by anyone, whereas solo 401k plans require some type of self-employment. This could be a small business or any type of self-employment activity producing income. Eligibility in solo 401k is not affected by full-time employment.
Checkbook Control Eligibility
As mentioned earlier, both plans are able to have checkbook control over the account funds. With a solo 401k account, as long as you are the plan’s trustee, you have total checkbook control. A self-directed IRA on the other hand has to establish a Self-Directed IRA LLC and transfer the account funds into an LLC bank account. You, as the plan owner also manage the LLC, thus giving you access to the account funds.
Borrowing from the Plan
Self-directed IRA accounts prohibit “self-dealing” transactions that would benefit any “disqualified person.” Since borrowing funds from the plan falls under this category, it is not allowed. The solo 401k account however comes with a personal loan feature that allows the plan holder to borrow up to $50,000 or half of the plan assets (whichever amount is less) by simply writing themselves a check.
The difference between the contribution amounts allowed under each plan is pretty significant. The maximum annual contribution under a self-directed IRA plan for 2019 is $6,000 or $7,000 if the account owner is over the age of 50. A solo 401k plan on the other hand allows for up to $56,000 and $62,000 for individuals 50 and older as of 2019. If your spouse also participates in the solo 401k plan, then the annual limit is doubled to $112,000 or $124,000 for those over the age of 50.
The solo 401k plan allows the account owner to choose anyone as the trustee, therefore they can designate themselves as such. A self-directed IRA plan owner however is not allowed to serve as the trustee for their own account. The IRS requires that a qualified custodian, such as a trust company or bank institution, holds the account funds, executes all transactions, and handles all administrative duties associated with the account.
Unrelated Debt-Financed Income (UDFI) Tax
If you purchase a real estate syndicated investment with partial funds from a self-directed IRA and finance the rest, you will be required to pay Unrelated Business Income Tax (UBIT). [https://www.irs.gov/charities-non-profits/unrelated-business-income-tax] The rationale here is that the self-directed IRA, as a tax-exempt entity, is engaged in a business activity that competes with actual tax-paying businesses, thus creating an unfair advantage for the IRA. In contrast, solo 401k accounts are exempt from UDFI taxation, even if there is a mortgage associated with a real estate acquisition by the plan.
Depending on the plan, there are quite a few differences in how rollovers, contributions, etc. are reported on taxes. Below are some of the more notable discrepancies:
* Pre-tax self-directed IRA contributions are reported on line 32 of Form 1040, whereas pre-tax solo 401k contributions go on line 28 of the same form.
* The fair market value of self-directed IRA assets is reported on Form 5498 while the fair market value of assets held in solo 401k accounts goes on Form 5500-EZ.
* Transfers and rollovers from IRA and former employer 401k plans to a solo 401k account need to be reported on Form 5500-EZ (for accounts with fair market value of over $250K). When rolling over or transferring funds from an IRA or 401k to a self-directed IRA account, Form 5498 needs to be used. Any IRA rollovers to a solo 401k or a self-directed IRA plan are also reported on lines 15a and 15b of Form 1040.
* When terminating a self-directed IRA account, Form 1099-R needs to be filed. A solo 401k account is also required to file a final Form 5500-EZ.
Benefits of Investing in Real Estate Syndications with Self-Directed IRA and Solo 401k Funds
Now that we’ve reviewed in detail the similarities and differences between self-directed IRA and solo 401k retirement plans, let’s look at the benefits of using these types of accounts to invest in real estate assets.
Diversification is one of the fundamental principles of investing, and it also applies to self-directed IRA and solo 401k retirement plans. The ability to pursue alternative investments such as real estate in addition to stocks and bonds, reduces the risk of losing a lifetime of savings due to a financial crisis in one industry. Furthermore, the freedom to invest in virtually any type of real estate (including international properties) allows for even further asset diversification.
Higher Return on Investment (ROI)
Using your retirement plan funds to invest in real estate has the potential to produce higher returns for your account. Flipping houses, buying into apartment syndications, and purchasing property in up-and-coming housing markets are just a few example real estate investment strategies that can deliver generous returns. Furthermore, since any profits are going back into the retirement account, they can be reinvested in other high ROI real estate opportunities, potentially creating exponential growth for your savings.
Hedge Against Economic Downturns
Real estate tends to hold its value relatively well even in bad economic climates. While a market crash could completely wipe out a retirement account invested in stocks, typically it won’t affect real estate prices as severely. Even if your real estate assets lost some of their worth, they are bound to recover quicker and will most likely increase in value in the long run.
Tax Benefits $$$
Any profits and income generated by real estate investments (which may be quite substantial) go directly into the retirement account without taxation. As we mentioned earlier, these new, tax-free funds can be reinvested and thus generate more tax-free returns in the future. Untaxed compounded investment returns grow much faster compared to similar investments outside of a retirement plan, which would be a subject to income tax. Additionally, contributions to the plan can be claimed as a deduction on the contributor’s income tax return, if they fall within certain contribution limits. Some individuals may also be eligible for the Retirement Savings Contributions Credit.
While there are a multitude of potential benefits to investing your self-directed IRA or solo 401k in real estate, there are no success guarantees. In addition to carefully evaluating each prospective transaction, you should consult with a CPA or another financial professional before making any investment decisions with your retirement plan.
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