“Mistakes are the portals of discovery.” ~ James Joyce
Mistakes are undoubtedly the true predecessors of great discoveries, and making mistakes indicates that you are trying to improve your life. However, some mistakes are more costly than others. For example, launching a product that didn’t get the necessary traction adds to your learning, but a financial mistake that could impose serious penalties and drain your financial resources is costly.
One of those costly mistakes in the financial lives of 401k-only retirement plan owners is engaging in prohibited transactions. With our core clientele that includes small business owners and self-employed professionals, we hold events, discuss plan owner responsibilities, and the latest regulations to follow. Our team decided to take a look at some of the most common mistakes owners of Solo 401k retirement plans make.
What are the prohibited transactions in the Solo 401k retirement plan?
In the case of a 401k Only retirement plan, none of the regulatory documents, including the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code (IRC), define the eligible transactions for the plan. Instead, they look at who or what is prohibited from investing, and these transactions are called prohibited transactions in a Solo 401k plan.
One of the common features of a prohibited transaction is the involvement of a disqualified person. In simple terms, a disqualified person is the owner, service provider, or beneficiary of a Solo 401k plan, or certain family members of these parties. The key reason behind the description of 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 disabled person
4975(c)(1)(A): The direct or indirect sale, exchange, or rental of property between a Solo 401k Plan and a “disqualified person.”
The IRS allows you to invest in real estate, but it’s important that these transactions be handled at 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 from his father.
- Amanda sells a property she owns to her Solo 401k plan.
- Mark rents a property from his Solo 401k plan to his son.
- Joe uses his personal funds to pay the closing costs involved in his Solo 401k real estate investment.
Each of these examples involves a disabled person, including the plan owner, or their direct descendants or ascendants. The IRS prohibits such transactions that directly or indirectly involve a disqualified person.
Loan of money or credit to a disabled person
4975(c)(1)(B): The direct or indirect loan of money or other extension of credit between a Solo 401k Plan and a “disqualified person.”
Under Internal Revenue Code guidelines, a Solo 401k plan that lends money or any form of credit to a disqualified person counts as a prohibited transaction. Some examples of such transactions are listed below.
- Judy provides personal guarantee for a home loan to purchase a residential property in her Solo 401k plan.
- Martha loans $30,000 from her Solo 401k plan to her husband.
- Mitchell purchases a credit card for her Solo 401k bank account.
- Jason lends a loan to an LLC owned and controlled by his father.
Exchange of goods, services or facilities with a disabled person
4975(c)(1)(C): The direct or indirect supply of goods, services, or facilities between a Solo 401k Plan and a “disqualified person.”
Current IRC guidelines prohibit a Solo 401k plan from receiving any type of service from a disqualified person. It could be something as simple as painting the house to solve major structural issues. Some examples of such prohibited transactions are listed below.
- Ron buys a property with his Solo 401k and fixes it up himself.
- Sally hires her father to manage a property for her Solo 401k plan.
- Tiffany prepares an investment plan for her Solo 401k and is compensated 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 from a Solo 401(k) Plan.
The assets or income generated by a Solo 401k plan investment must not directly or indirectly benefit a disqualified individual. Some examples of such prohibited transactions are discussed below.
- Merissa uses $10,000 of Just 401k money to pay off personal debt.
- Harry lives in a house owned by his Solo 401k plan.
- Steve deposits rental income from a Solo 401k property into 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 sizable nest egg quickly; however, as the plan sponsor/fiduciary, it is his or her responsibility to ensure legal compliance with the plan. Never hesitate to seek professional help, especially when it comes to something as important as planning for your retirement.
