“Errors are the portals of discovery.” ~ James joyce
Without a doubt, mistakes are 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 traction it needs adds to your learning, but a financial mistake that could lead to severe penalties and drain your financial resources is costly.
One of those costly mistakes in the financial life of Solo 401k retirement plan owners is engaging in prohibited transactions. With our core clientele that includes small business owners and freelancers, we host 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 that Solo 401k retirement plan owners make.
What are the prohibited transactions in the Solo 401k retirement plan?
In the 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), define the transactions eligible for the plan. Instead, they discuss who or what is prohibited from investing, and these transactions are called prohibited transactions on a Solo 401k plan.
One of the common features of a prohibited transaction is the participation of a disqualified person. In simple terms, a disqualified person is the owner or service provider, or the beneficiary of a Solo 401k plan, or certain family members of these parties. The key reason for 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, 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 is important that these transactions are handled at arm’s length, which means that the owner of the plan 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 buy a property from his father.
- Amanda sells a property she owns to her Solo 401k plan.
- Mark leases a property from his Solo 401k plan to his son.
- Joe uses his personal funds to pay for the closing costs involved in his Solo 401k real estate investment.
Each of these examples has the participation of a disqualified person, including the owner of the plan or their direct descendants or ancestors. The IRS prohibits any transaction that directly or indirectly involves 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.”
According to 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 offers personal guarantee for a home loan to purchase a residential property on her Solo 401k plan.
- Martha loans $ 30,000 from her Solo 401k plan to her husband.
- Mitchell purchases a credit card for his 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 disqualified 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 problems. Some examples of such prohibited transactions are listed below.
- Ron buys a property with his Solo 401k and fixes it himself.
- Sally hires her father to manage a property that belongs to her Solo 401k plan.
- Tiffany prepares an investment plan for her Solo 401k and receives 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 disabled person
4975 (c) (1) (D): The direct or indirect transfer to a “disqualified person” of income or assets from a Solo 401 (k) Plan.
Assets or income generated by a Solo 401k investment must not benefit a disqualified person directly or indirectly. Some examples of such prohibited transactions are discussed below.
- Merissa uses $ 10,000 of the Solo 401k money to pay off a 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 loans money from his Solo 401k to a company he controls.
A Solo 401k plan can accelerate retirement savings and help you quickly build a sizeable nest; however, as the sponsor / trustee of the plan, it is your 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.