“Mistakes are the portals of discovery.” ~ James Joyce
Mistakes are undeniably the true predecessors of great discoveries, and making mistakes indicates that you're trying to better your life. However, some mistakes are costlier than others. For an instance, launching a product that didn't get the necessary traction adds to your learning, but a financial mistake that could impose serious penalties and wipe out your financial resources is a pricey one.
One such costly mistake in the financial life of Solo 401k retirement plan owners is to partake in prohibited transactions. With our primary clientele involving small business owners and self-employed professionals, we conduct events, discussing responsibilities of plan owners and latest regulations to follow. Our team decided to take a look at some of the most common mistakes made by Solo 401k retirement plan owners.
What are prohibited transactions in Solo 401k retirement plan?
In case of a Solo 401k retirement plan, none of the regulatory documents, including the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code (IRC), defines eligible transactions for the plan. Instead, they discuss who or what is prohibited from investing, and these transactions are termed as prohibited transactions in a Solo 401k plan.
One of the common traits of a prohibited transaction is the involvement of a disqualified person. In simple terms, a disqualified person is either the owner, or service provider, or the beneficiary of a Solo 401k plan, or certain family members of these parties. The key reason behind describing prohibited transactions is to ensure that this retirement tool is not used for the personal benefit of the plan owner.
Sale, lease, or exchange of property to a disqualified person
4975(c)(1)(A): The direct or indirect sale, trade, or renting of property between a Solo 401k Plan and a “disqualified person.”
The IRS allows you to invest in real estate, but it is important that these transactions are handled at an arm's length, which means the plan owner or any other disqualified person should not receive personal benefits from the plan. Let's look at some examples of prohibited transactions.
- Nathan uses his Solo 401k fund to purchase a property owned by his father.
- Amanda sells a property she owns to her Solo 401k plan.
- Mark leases a property owned by his Solo 401k plan to his son.
- Joe uses his personal funds to pay for the closing costs involved in his Solo 401k plan real estate investment.
Each of these examples has the involvement of a disqualified person, including the plan owner, or their lineal descendants or ancestors. The IRS prohibits any such transactions that directly or indirectly involve a disqualified person.
Loaning of money or credit to a disqualified person
4975(c)(1)(B): The direct or indirect loaning of money or other extension of credit between a Solo 401k Plan and a “disqualified person.”
As per the Internal Revenue Code guidelines, a Solo 401k plan loaning money or any form of credit to a disqualified person counts as a prohibited transaction. Some examples of such transactions are listed below.
- Judy offers personal guarantee for a mortgage loan to purchase a residential property in her Solo 401k plan.
- Martha lends $30,000 from her Solo 401k plan to her husband.
- Mitchell acquires a credit card for his Solo 401k bank account.
- Jason lends a loan to an LLC controlled and owned by his father.
Exchange of goods, services, or facilities with a disqualified person
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between a Solo 401k Plan and a “disqualified person.”
The current IRC guidelines prohibit a Solo 401k plan from receiving any type of services from a disqualified person. It could be something as simple as painting the house to resolving major structure issues. Some examples of such prohibited transactions are mentioned below.
- Ron purchases a property using his Solo 401k and fixes it himself.
- Sally hires her father to manage a property owned by her Solo 401k plan.
- Tiffany prepares an investment plan for her Solo 401k and receives a compensation for it.
- Doug acts as a real estate agent for a property purchased by his Solo 401k.
Transfer of income or assets to a disqualified person
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of a Solo 401(k) Plan.
The assets or income generated by a Solo 401k plan investment should not benefit a disqualified person directly or indirectly. Some examples of such prohibited transactions are discussed below.
- Merissa uses $10,000 of Solo 401k money to pay a personal debt.
- Harry lives in a house owned by his Solo 401k plan.
- Steve deposits rental income of a Solo 401k property to his personal bank account.
- Rob lends money from his Solo 401k to a company he controls.
A Solo 401k plan can accelerate retirement savings and help you build a sizeable nest quickly; however, as the plan sponsor/fiduciary, it is your responsibility to ensure legal compliance of the plan. Never hesitate in seeking professional help, especially when it comes to something as important as your retirement planning.