Solo 401(k) And SEP IRA: Can You Have Both at the Same Time?
The simple answer is yes and no, you may contribute to a Solo 401(k) and SEP IRA in the same year. It all depends on the forms you use, which we'll explain later. Your small business can maintain both plans, but there's really no advantage to utilizing both. Generally, unless you have full-time employees, the Solo 401(k) plan is the superior option. Once you hire employees for your business (other than a spouse or partner), you can no longer have a Solo 401(k). These plans are for owner-only businesses and the self-employed. The SEP IRA remains a solid option for expanding small businesses.
- If you are self-employed, you need to decide on the best retirement plan for yourself.
- You can have both a SEP IRA and Solo 401(k) plan, but should you?
- If you have no full-time employees, the Solo 401(k) is the best option for the self-employed.
What is a Solo 401(k)?
A Solo 401(k) is a retirement plan specifically designed for the self-employed. You don't need your own business to open one. In fact, many people who have regular jobs can have one. The key is that you need some sort of self-employed income. This will generally come from a side job, oftentimes "gig" work. This may include driving for a ride-share company, hiring speaking engagements, or an Etsy store.
Of course, if you have your own business, you can get the most advantage of the Solo 401(k). The caveat is that you cannot have any full-time employees, aside from your spouse or a business partner. A full-time employee is someone who works more than 1,000 hours for you during the year. Of course, temp workers and seasonal employees can be hired, so long as they don't exceed the hour threshold.
One of the biggest advantages of the Solo 401(k) is the high annual contribution limits. For 2025, contribution limits to a Solo 401(k) plan are as follows:
- Employee Deferral – $24,500
- Catch-up Contribution – $8,000
- Total Contribution Limit – $72,000 or $80,000 for those aged 50 and older
Read More: Solo 401(k) Contribution Limits
What is a SEP IRA?
A SEP IRA, known as a Simplified Employee Pension, is another option for the self-employed. It's especially beneficial for small business owners who have full-time employees. There are two major differences between a Solo 401(k) and SEP IRA. First, there is "no catch-up" contribution. There is no increase in the amount you may contribute at age 50. Secondly, there isn't an employee deferral. All contributions are based on a percentage of your annual income. Generally, it's 20% for business owners and 25% for self-employment work. Therefore, it's harder to max out your contributions to the max.
If you have other employees, you must contribute on their behalf the same percentage you take yourself. However, you do not have to make contributions every year. During a down year, you may skip saving altogether. A SEP is a very cost-effective way to offer a retirement plan for small business owners. On the other hand, it doesn't really make much sense for an owner-only business.
Learn More: How to Correctly Diversify Your Retirement Account
When Can You NOT Do Both?
If you use a financial institution or custodian to set up your SEP IRA, you need to be aware of what form they use. If they use the standard IRS Form 5305, then you cannot also set up a Solo 401(k). This form is provided by the IRS, so it is unusual that you are limited in your options when you use it.
However, there is a workaround. You simply need to set up the SEP IRA not using the From 5305. You can essentially take the basics of the form and tweak it for your use. Of course, your financial institution must accept the form in order to be eligible. You can work with an attorney or financial planner to help design the form. But again, if you have zero full-time employees, it's probably not worth the hassle anyway!
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Solo 401(k) vs. SEP IRA
As detailed above, the Solo 401(k) is the far superior option for the self-employed. It is only when you hire non-spouse or non-owner full-time employees that a SEP IRA makes sense. Contributing to both plans makes little sense. The only time it may be useful is if you have both a small business and other self-employed income. A SEP IRA can be set up for your business where only that income will be contributed to the plan. If you have a side job, apart from the business, you can set up a Solo 401(k) for your own use.
Example
Let's say Phil is a part owner in a small cafe. He has two partners, and each owns 33% of the business. He starts a SEP IRA for the business and decides to contribute 10% of his compensation to the plan. Generally, all partners would contribute the same percentage, assuming they earn compensation from the business. If the business allocates $200,000 in compensation to Phil for the year, he will contribute $20,000 to his SEP IRA (10% of $200,000).
Phil also works for DoorDash on the side and earns an extra $15,000 per year. He sets up a Solo 401(k), which allows him to contribute both employee and employer portions, up to IRS limits. In total, Phil will save $35,000 toward retirement for the year.
During a challenging financial year for the cafe, Phil may choose not to contribute to the SEP IRA. However, he can still contribute to his Solo 401(k), as long as he has other self-employed income to fund it.
Self-Directing Your Solo 401(k) and SEP IRA
Lastly, we wanted to mention the benefits of self-directing your Solo 401(k) and SEP IRA plans. The benefits of opening your plan with IRA Financial is that you can have checkbook control of your funds. This allows you to make both traditional investments, in addition to alternative investments, such as real estate, precious metals and cryptocurrencies, like Bitcoin.
Further, with checkbook control, you never need to ask for permission to invest. A bank account is associated with your plan and can be used to make investments without a middleman. This allows you to make any investment you want in a timely matter. The checkbook control structure can be used with both a Solo 401(k) and SEP IRA.
If you have any questions about either plan, please contact us to discuss. We can help decide if a Solo 401(k) or SEP IRA is right for you. In certain circumstances, you may want to contribute to both. As always, you should work with a financial advisor to come up with a financial plan that fits your needs.
Do I need an EIN for my Solo 401(k)?
The Solo 401(k) plan, also known as an Individual 401(k) plan, has quickly become the most popular retirement plan for the self-employed or small business owner with no full-time employees. One may wonder if you need an EIN for your Solo 401(k) plan.
- When deciding on a Solo 401(k) plan provider, make sure they offer what you want
- An EIN is used as an identifier for a business or trust
- If you wish to open a bank acount for the plan, you will generally need an EIN
An Overview of the Solo 401(k)
Not all Solo 401(k) plans are the same! A business can acquire a Solo 401(k) plan from a bank or traditional financial institution. However, the plan will likely not include many of the most popular plan options, such as Roth contributions, a loan feature, and the ability to make alternative asset investments, such as real estate.
However, companies, such as IRA Financial, will help you establish a Self-Directed Solo 401(k) plan that include all IRS-permitted options, including a Roth sub-account, if interested, the ability to borrow up to $50,000 tax-free, and the option of investing in traditional, as well as alternative, asset investments on your own as trustee of the plan.
Solo 401(k) Plan EIN
An Employer Identification Number (EIN) is also referred to as a Federal Tax Identification Number, or FIN. The EIN is generally used to identify a business entity or trust, such as a retirement plan. In general, an EIN will be acquired on behalf of the plan. The EIN is used to allow the plan to open a bank account.
There is no formal requirement that an EIN be acquired for a Solo 401(k) plan since it is an owner-only plan. Many plan sponsors will use the plan participant’s social security number or business EIN as the plan tax identification number.
However, any Solo 401(k) plan that wants to establish a bank account will likely need an EIN for the plan. With IRA Financial, we can establish the plan's bank account via Capital One without an EIN, however, if you wish to use your own bank, you will need to have IRA Financial acquire an EIN for you.
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Does the Solo 401(k) Plan Trust Need an EIN?
A 401(k) plan is a trust, and under Internal Revenue Code Section 401, plan assets must be held in trust. There is no IRS or Department of Labor requirement that a separate trust be created in connection with the establishment of the plan. As a result, a separate trust is often not established as per the plan documents.
This is the reason why, in such a case, no separate trust agreement is required to be included in the plan documents, and it is also why a separate EIN is not required to be acquired for the plan trust. Typically, an EIN would only be acquired for the plan itself. Most Solo 401(k) plans will acquire an EIN for the plan for purposes of opening a bank or brokerage account.
Related: Popular Investments in a Solo 401(k)
Process for Acquiring a Solo 401(k) Plan EIN
For purposes of this article, let’s assume that Mike and his business ABC LLC establish a Solo 401(k) plan with IRA Financial. He requests IRA Financial to acquire an EIN for the plan so he can open a plan bank account. An EIN can be acquired by completing an online questionnaire at the IRS website or by completing and sending in IRS Form SS-4 to an IRS representative. When securing an EIN for a Solo 401(k) plan, the IRS will require the following information:
- Name of adopting employer
- Address and phone number of adopting employer
- Name of the trustee of the Solo 401(k) plan
- Name of plan
The IRS website will then provide the EIN# that can be used to open a bank account. Typically, the bank will require a copy of the plan adoption agreement, basic plan document, and EIN to open a plan bank account.
Why Work with IRA Financial?
It is important to work with a company that has the tax expertise to help establish an IRS-approved Solo 401(k) plan. Here are a few items that we feel sets IRA Financial apart from other providers:
- We literally wrote the book on the Self-Directed Solo 401(k) plan
- Get started in minutes with our industry leading app!
- Customized plan design based on your retirement & investment goals
- Never step foot in a bank—we open your self-directed bank account for you at Capital One
- We handle all IRS reporting and offer annual IRS compliance services
- Checkbook Control
- No Transaction fees
- No minimum balance fees
- No account valuation fees
- No wire fees
- Invest in alternative assets
- Dedicated one-on-one support from a 401(k) plan specialist
You will be assigned a dedicated self-directed retirement tax specialist that will assist you in setting up your IRS-compliant Solo 401(k) plan. Your specialist will finalize your plan documents as well as acquire the plan EIN.
Conclusion
In general, one is not required to acquire an EIN for his or her Solo 401(k) plan. However, most plans will acquire an EIN from the IRS for purposes of opening a bank account or establishing a plan brokerage firm.
Feel free to reach out to us if you have any questions about the Solo 401(k) plan and when you need to acquire an EIN for your plan.
Is ERISA Testing Required for a Solo 401(k) Plan?
A business owner with no common-law employees, who adopts a Solo 401(k) plan, is generally not required to perform ERISA nondiscrimination testing for the plan. This is because there are no non-owner employees. In fact, one of the requirements for opening a Solo 401(k) is the absence of full-time employees, other than a spouse or other owner.
- ERISA testing was put in place to protect all employees of a business
- Owners and highly compensated employees should not have an unfair advantage over those earning less
- A Solo 401(k) plan is designed for owner-only businesses and, therefore, ERISA testing is not reequired
What is ERISA?
The Employee Retirement Income Security Act (ERISA) is a 1974 federal law that oversees how employers provide benefit plans to employees. ERISA is administered by the Department of Labor (DOL). ERISA set forth rules and procedures for employers and benefit plan managers, trustees, and certain other service providers involving employer-sponsored retirement plans.
ERISA generally confirms minimum standards are set for most of the private industry retirement and pension plans. Rules under ERISA provide that eligible plan participants must be notified of benefit plan terms, including funding, coverage, and costs. Employees are also offered protections against fiduciary misconduct.
Related: Solo 401(k) Benefits
ERISA Testing – Quick Summary
Employer-sponsored 401(k) plans that cover non-owner employees are subject to ERISA law. ERISA was created to ensure that highly compensated employees (HCEs) or key employees do not receive or are provided with greater benefits than are available to lower paid workers. Therefore, ERISA has included certain compliance tests in order to compare benefits paid to lower paid employees to the HCEs.
The ERISA 401(k) plan annual compliance tests are the following:
- General Nondiscrimination Test (IRC 401(a)(4) (ADP & ACP)
- The Minimum Coverage Tests (IRC 401(b))
- Top Heavy Test (IRC 416)
- 402(g) limit test (i.e. employee deferral limit - $20,500 for 2022 - $27,000 if age 50+)
- 415 limits (i.e. $61,000 for 2022 - $67,500 for those age 50+)
Related: Solo 401(k) Investment Options
ERISA & the Solo 401(k)
A Solo 401(k) plan is essentially a 401(k) plan adopted by a business that has no full-time employees (over 1000 hours during the year) other than the owner(s) or spouse(s) of the owner(s). Under ERISA law, a spouse is not deemed an employee for testing purposes.
In other words, because a Solo 401(k) plan is not subject to the ERISA rules, as the adopting employer has no full-time employees other than the owner(s) or spouse(s), it is not required to perform any nondiscrimination testing. This makes a ton of sense since a business with no full-time employees is not in need of supervision by the DOL since they are in control of the plan.
The Solo 401(k) no-testing advantage vanishes if the employer hires employees. No matter what the 401(k) plan is called by a plan provider, it must meet the rules of the Internal Revenue Code. If employees are hired and they meet the eligibility requirements of the plan and the Code, they must be included in the plan and their elective deferrals will be subject to nondiscrimination testing (unless the 401(k) plan is a safe harbor plan or other plan exempt from testing).
Conclusion
If you are self-employed or own a business with no full-time employees, the Solo 401(k) plan is the best retirement plan you can open. ERISA was put into place to protect the "little man." One would hope every business owner would do right by all their employees (not just the owners or HCEs). Obviously, some business owners put their bottom line over that of the best interests of their employees. Hence, why the ERISA laws were created.
Obviously, when a business owner does not have other employees to worry about, they will choose the plan that is best suited for them. Because of this, the complicated ERISA non-discrimination testing is not needed. It's also one of the deciding factors when choosing a retirement plan when you are self-employed.
As mentioned above, as soon as you do hire any non-owner full-time employees, your plan will be subject to ERISA. You must ensure the plan benefits not only you, as the owner, but everyone who works for you. After all, the better benefits you offer your employee, the better employees you will attract, and retain.
Buy Tax Liens with Your Self-Directed IRA or Solo 401(k)
Few IRA holders realize they can use their retirement account funds to invest in tax liens. When you self-direct your IRA or Solo 401(k) Plan, your tax lien investments are tax-deferred. Tax liens are a lesser known and under-appreciated money-maker. However, learning how they can magnify your earnings in a tax-deferred IRA or 401(k) will make them among the soundest investments in your IRA.
Purchasing Tax Liens with Retirement Funds
Tax liens may be purchased using retirement funds. The purchase of tax lien certificates is a surprisingly safe investment, and the use of a Self-Directed IRA is one of the most tax efficient ways to finance your tax lien purchase. The primary advantages of using a self-directed IRA to make tax lien investments are as follows:
- Investment flexibility
- Steady Income Generator with no tax bite
– Tax Deferral
– Gains from the tax liens investment will flow back to the Self-Directed IRA - Control
- Diversification
- Tax Advantaged Investing
What is a Tax Lien?
Purchasing tax lien certificates is one way to get real estate exposure in your portfolio without investing in any property. While sophisticated investors can make decent returns by investing in tax liens, novices can easily get burned. Here’s how it works: When a property owner fails to pay his or her taxes, the municipality in which the property is located can sell its tax lien — the right to foreclose on a property when the owner has failed to pay taxes.
The winner of a tax lien certificate is typically the investor willing to accept the lowest interest rate. Most tax liens purchased at auction are sold at rates between 3 percent and 8 percent nationally. The property owner has a redemption period — generally one to three years — to pay the taxes plus interest. If the property owner fails to pay the property taxes by the end of the redemption period, the lienholder can initiate foreclosure proceedings to take ownership of the property. However, this rarely happens because the taxes are generally paid before the redemption date. The interest rates make tax liens an attractive investment.
Types of Tax Liens
There are two types of tax lien sales through auction: the tax lien certificate and the tax lien deed. Both can be a safe yet profitable opportunity for investors with checkbook control.
Tax Lien Certificates
Tax Lien Certificate sales offer the delinquent homeowner one last chance to retain ownership of their property. This occurs by using third-party investment money to pay off the taxes and give them a bit more time to collect the money necessary to pay their debt without the risk of losing their home.
When an investor bids on a tax lien certificate, he is in essence agreeing to loan the homeowner the money necessary to pay all taxes due. The homeowner, in turn, agrees to pay back the tax lien certificate holder - with interest - by a specified date.
If the homeowner fails to pay the debt on time, the deed to the property is transferred to the investor for the amount paid on the taxes. Either way, the investor makes a profit. Either on the interest he earns on the loan, or by obtaining the property for a fraction of its value through the tax lien sale, and then reselling it.
Tax Lien Deed
Tax Lien Deed sales are handled a bit differently since the investor is actually bidding (or buying), the complete property at the time of auction. The investor has no responsibility to give the homeowner more time to pay his/her tax debt.
Once the selling price is approved, the deed is automatically transferred to its new owner. This gives the investor full reign as to what to do with the property next: renovate it, sell it as-is, or raze the existing house and build anew.
Investors usually pay more for properties in this type of tax lien sale, which may lower their profit margins in comparison to the acquisition of tax lien certificate properties.
But many investors prefer outright purchases to eliminate problems with current homeowners. Either way, this is a profitable and easy way to enter the real estate market in virtually any area.
Facts & Opportunities Surrounding Tax Liens
Real estate has long been considered one of the best (and safest) investment opportunities for both the large and small capitalist. Savvy investors know that the trick to making money in a downward spiraling market is to purchase properties for a fraction of their value.
The question is…How? Many are finding the perfect answer in the high-profit possibilities of investing in Tax Lien Sales.
When a property owner falls behind on their taxes, failing to pay for one or more years, the local taxing authority has the legal right to place a lien or repossess the property. They often sell it at auction to recoup the lost tax revenue.
The lien laws in your area detail how long local authorities wait to seize your properties. It also determines how much they allow to be owed in the property.
In many cases, properties can be acquired for a few thousand dollars, regardless of how much it's actually worth. Similarly, paying off the lien on others may more than the house or land is worth. A savvy investor takes the time to research each property carefully prior to sale day.
Tax Lien Sales
Tax lien sales usually happen at public auctions once or twice a year. This depends on the area in which it is located, and how many properties the government may seize annually for back taxes.
Larger urban areas may hold monthly auctions, while smaller rural ones might only have one a year.
Investing in Tax Liens with Retirement Funds
The use of a Self-Directed IRA is one of the most tax-efficient ways to finance your tax lien purchase. IRA Financial Group’s IRA LLC allows investors to participate in a wide range of investment vehicles including, but not limited to:
- tax liens
- real estate
- mortgages
- franchise
- notes
- stocks and mutual funds
- partnerships,
- Cryptocurrencies and more!
Learn More: Open a Self-Directed IRA Online
The Solo 401(k) Plan
The Solo 401(k) Plan offers a highly attractive loan feature. This can allow for the purchase of tax liens. Under the Solo 401(k) Plan, you can borrow either $50,000 or 50% of their account value - whichever is less.
The IRA Financial Group Solo 401(k) Plan documents will allow you to use a loan from your Solo 401(k) to finance your tax lien purchase.
These unique IRS approved structures are created by IRA Financial Group’s in-house tax and ERISA professionals who personally customize your account structure to suit your needs.
Only a handful of institutions are skilled in these specialized account structures and IRA Financial Group is the “gold standard” for Compliance, Leadership, Customer Service, and Technological Innovation.
Read More: How to Open a Solo 401(k) Online
Are Tax Liens a Good Investment?
While we can't give you investment advice, investing in tax lien certificates in an IRA or Solo 401(k) has the following benefits:
Double Your Money Quickly
You can supercharge a Self-Directed IRA LLC or Solo 401(k) plan when you buy tax lien certificates.
Example: A tax lien certificate can earn up to 16% annually in your Self-Directed IRA or Solo 401(k). When you buy tax lien investments you generally receive the amount invested plus interest within 12 months.
If you continue to reinvest in tax liens year after year at 16%, you can double your money in about 4.4 years. Only a Self-Directed IRA LLC can preserve this 16% return.
Your Money Grows Tax-Free
When you buy tax liens in an IRA Financial Self-Directed IRA LLC or Solo 401(k), you can avoid all taxes until the money invested is withdrawn from the IRA or 401(k). The distribution usually occurs around age 59 1/2.
You can invest the money once, twice or a thousand times. Continue to grow your investments tax-free, so long as it is not withdrawn for personal use. If you use a Self-Directed Roth IRA LLC, your investment will grow tax-free and you can withdraw the funds tax-free once you reach the age of 59 1/2.
The Flexibility to Buy Time Sensitive Investments
IRA Financial Group’s Self-Directed IRA LLC allows you to carry a checkbook that is tied to the account. The Solo 401(k) Plan allows you to serve in the trustee role. This means that all assets of the 401(k) trust are under your sole authority (“checkbook control”).
This gives you incredible freedom to fund the investment at a moment's notice. In this arrangement, you can buy tax liens with the stroke of the pen. You don't need a custodian or other bureaucrat saying no or try to slow down the process.
Tax liens are backed and leveraged by real estate and guaranteed by the governmental taxing authority. In most states, they are a first lien on real estate. When foreclosed, they wipe out all junior liens, including mortgages.
This allows you to potentially receive a valuable piece of real estate for pennies on the dollar!
Time to Act
Real property has been the cornerstone of wealth for thousands of years. While ill-informed speculators have fled real estate because of the housing bust, intelligent real estate investors are enjoying immense profits by expanding their geographic scope and investing for predictable income.
Get in Touch
Do you still have questions that were not discussed in this article? You can contact IRA Financial Group directly at 800-472-0646 with your questions. Or fill out the form and speak with an IRA or 401(k) specialist today.
How to Transfer a Roth IRA to a Self-Directed Roth IRA
Individuals may generally transfer Roth IRA or rollover eligible qualified retirement plan assets into a Self-Directed Roth IRA structure. Individuals may not rollover Roth IRA funds into a qualified retirement plan, such as a Solo 401(k) Plan, or a pretax IRA account, such as a Traditional IRA or SEP IRA.
- Roth IRAs are funded with after-tax money, however, all qualified distributions are tax free
- A Self-Directed IRAs allows for alternative asset investments, including real estate, cryptos and private businesses
- A transfer occurs when funds are moved from one IRA (or Roth IRA) to another
What is the most Common Way to Fund a Self-Directed Roth IRA?
Transfers and rollovers are types of transactions that allow movements of assets between like IRAs – Roth IRA to Roth IRA. Note – only after-tax funds can be rolled into a Roth IRA. No pretax retirement funds are eligible to be rolled into a Roth IRA.
Roth IRA Transfers to a Self-Directed Roth IRA
A Roth IRA-to Roth IRA transfer is one of the most common methods of moving assets from one Roth IRA to another. A transfer usually occurs between two separate financial organizations, but a transfer may also occur between Roth IRAs held at the same organization. If a Roth IRA transfer is handled correctly the transfer is neither taxable nor reportable to the IRS. With a Roth IRA transfer, the Roth IRA holder directs the transfer but does not receive the Roth IRA assets. Instead, the transaction is completed by the distributing and receiving financial institutions. In sum, for the Roth IRA transfer to be tax-free and penalty-free, the Roth IRA holder must not receive the Roth IRA funds in a transfer. Rather, the check must be made payable to the new Roth IRA custodian. Also, there is no reporting or withholding to the IRS on a Roth IRA transfer.
The retirement tax professionals at the IRA Financial will assist you fund your Self-Directed Roth IRA LLC by transferring your current Roth IRA funds to your new Self-Directed Roth IRA structure tax-free and penalty-free.
Considering a Roth Conversion?
Our Experts are Here to Help
How The Transfer Works
Your assigned retirement tax professional will work with you to establish a new Self-Directed Roth IRA account at a new FDIC and IRS-approved Roth IRA custodian. The new custodian will then, with your consent, request the transfer of your Roth IRA assets from your existing Roth IRA custodian in a tax-free and penalty-free Roth IRA transfer. Once the Roth IRA funds are either transferred by wire or check tax-free to the new Roth IRA custodian, the new custodian will be able to invest the Roth IRA assets into the new Roth IRA LLC “checkbook control” structure. Once the funds have been transferred to the new Roth IRA LLC, you, as manager of the Roth IRA LLC, would have “checkbook control” over your retirement funds so you can make traditional as well as non-traditional investments tax-free and penalty-free.
Read More: What is Checkbook Control Self-Directed IRA?
60-Day Rollover Rule
An individual generally has sixty (60) days from receipt of the eligible rollover distribution from a Roth IRA account to roll the funds into a Self-Directed Roth IRA LLC structure. The 60-day period starts the day after the individual receives the distribution. Usually, no exceptions apply to the 60-day time period. However, in cases where the 60-day period expires on a Saturday, Sunday, or legal holiday, the individual may execute the rollover on the following business day.
An individual receiving an eligible rollover distribution may rollover the entire amount received or any portion of the amount received. The amount of the eligible rollover distribution that is not rolled over to a Roth IRA is generally included in the individual’s gross income and could be subject to a 10% early distribution penalty if the individual is under the age of 59 1/2.
Read More: Roth IRA Distribution Rules
How the 60-Day Rollover Works
The retirement tax professionals at the IRA Financial Group will assist you in rolling over your 60-day eligible rollover distribution to a new FDIC and IRS-approved IRA custodian. Once the 60-day eligible rollover distribution has been deposited with the new Roth IRA custodian within the 60-day period, the new custodian will be able to invest the Roth IRA assets into the new Roth IRA LLC “checkbook control” structure. Once the Roth IRA funds have been transferred to the new Roth IRA LLC, you, as manager of the Roth IRA LLC, would have “checkbook control” over your retirement funds so you can make traditional as well as non-traditional investments tax-free and penalty-free.
Learn More:
Alternative Investments in an IRA
Real Estate Investing with a Self-Directed IRA
Investing in Precious Metals with Your Retirement Account
It has been almost 50 years since the establishment of IRAs. Yet most retirement account holders are still not aware that they can buy real estate, precious metals, and other alternative assets with an IRA (individual retirement account).
By using a self-directed IRA, an IRA holder can make traditional as well as alternative asset investments. Such investments include:
- Real estate
- Notes
- Tax liens
- Precious metals
- Cryptocurrencies
- Private businesses
In fact, the Internal Revenue Code only describes two assets you cannot invest in: collectibles and the prohibited transactions under IRS 4975. Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain types of transactions, but in general, the self-directed IRA can make just about any investment.
Because of advertising by precious metals dealers, more people are becoming aware that they can invest in precious metals with retirement funds. In fact, as an IRA investor, you can purchase some of the most popular metals, such gold, silver, and palladium.
Individual retirement accounts can even hold certain coins. The IRC has a list of coins and precious metals that you can purchase, because the IRC doesn't consider them to be "collectibles." You can find this list in IRC Section 408(m). Section (m) applies to both IRAs and 401(k) plans.
Related: Most Popular Alternative Investments
Investing in Precious Metals
Gold, palladium, and silver are always a good investment, especially when being held for retirement. With a Self-Directed IRA, investors can devote their funds to many different alternative assets that are not as affected by stock market fluctuations and other volatility.
Alternative assets are investments outside of traditional investments. Common examples of alternative investments include real estate, private equity, precious metals, such as gold, and venture capital investments. Whereas traditional investments include stocks, bonds and bank CDs. Alternative investments are more complex than traditional investments, which is why they appear to be better suited for “accredited” or “qualified” investors.
Learn More: Gold IRA Rollover
Is Gold a Good Investment?
Recently, there has been much discussion over the impact of alternative investments with the recent Stock Market downturn. The price of Gold and other precious metals have remained high over the past two years. As the future of gold appears more and more favorable, is now the time to buy?
IG Index contributor and author of the Brookville Capital Newsletter, Simon Popple reiterates what every investor should know: investing is all about timing.
“For the past few years there have been many other, more traditional investments that have been doing very well,” Popple explains. “But all these markets are either at or close to all-time highs, so people are being forced to look elsewhere.”
Gold is an inflation hedge and is a more attractive investment during times of inflation. As the cost of the U.S. dollar declines, the value of gold rises. With the current global financial market, the latent inflationary fears have rebounded and as a result, more individuals are turning to gold investments.
Certainty in an Uncertain World
“In the current market, you have a lot to worry about,” says Popple. “For many, physical gold provides a degree of certainty in an uncertain world.”
The importance of retirement portfolio diversification has increased with the devalue of currencies and the concerns of debt and inflation.
Self-Directed retirement plans, such as the Self-Directed IRA, are perfect retirement vehicles for retirement diversification. For example, retirement investors have the ability to purchase traditional assets, such as stocks and bonds – but they can also purchase alternative assets, like gold to mitigate risk of investments moving in the same direction.
“Bonds and the U.S. dollar used to be viewed as the go-to assets in weak markets,” says Popple. “But with many bonds offering little or negative yield, investing where you’re going to lose money does not make a huge amount of sense.”
Related: How to Correctly Achieve Retirement Portfolio Diversity
Palladium Emerging as a Hot Investment
Unlike gold and silver, palladium has been relatively ignored by self-directed IRA investors over the years. However, over the last year or so investors are starting to look more positively at palladium as an appropriate investment for their retirement account.
On March 19, 2019, palladium rose to an all-time high as the supply outlook tightened further, while gold dipped ahead of an interest rate decision in the United States.
Spot palladium hit a record $1,608 an ounce earlier before easing back to trade 0.29 percent lower at $1,591.85. Because of the tight supply in the palladium market, along with Russia’s threat of potentially cutting supply, the Palladium market has heated up over the last several months. However, the main reason the price of palladium has increased over the years is because its primary use is as an emissions reducing catalyst in automobiles and gasoline engines.
Common Uses of Palladium
In general, about 80 percent of palladium ends up in the exhaust systems in cars, where it helps turn toxic pollutants into less-harmful carbon dioxide and water vapor. It is also used in electronics, dentistry and jewelry. The metal is mined primarily in Russia and South Africa.
Depending on where the supply goes, the price of palladium may increase in the future. Some self-directed IRA and solo 401(k) plan investors are counting on this.
Related: Beginners' Guide to Alternative Investments with Retirement Funds
Buying Silver with Retirement Funds
Silver prices have climbed higher in the last few weeks than they have been in years, lifted by factors such as soaring investor demand for precious metals. In this WSJ article, we learn that silver has climbed a whopping 68% since the middle of March. Almost all asset classes tanked at the start of this crisis. However, silver has made a remarkable improvement. Investors are encouraged by the steps governments and central banks have taken to strengthen an economy decimated by COVID-19.
In addition, silver prices have also benefited from the reopening of factories in the U.S., China and elsewhere. Silver has industrial applications, medical purposes, and use in consumer electronics, among other uses. From jewelry and table settings, to dentistry and more, there are common uses for silver throughout the world. Although many people flock to gold, silver should not be overlooked!
Related: Investing in Silver with a Self-Directed IRA
What Type of Precious Metals and Coins are IRS Approved?
Internal Revenue Code Section 408(m) lists the type of precious metals and coins that you can purchase with your IRA funds. These include:
- Any coin that is:
- Gold
- Silver
- Platinum
- Any coin issued under the laws of any state
- Any gold, silver, platinum or palladium bullion of a fineness equal to or exceeding the minimum fineness that a contract market requires for metals which may be delivered in satisfaction of a regulated futures contract. This is the case if such bullion is in the physical possession of a trustee under subsection (a) of this section.
The IRS approves American Eagle and U.S. state mined coins of a certain finesse. The Technical and Miscellaneous Revenue Act of 1988 allows the purchase of state minted coins.
The Advantage of a Precious Metals IRA
Many IRA investors avoid precious metals investments due to lack of knowledge. But a precious metals IRA is a good way to increase your wealth as the value of the dollar decreases. All it takes to start investing in this asset is due diligence. Make sure you do your research on all investments.
The most popular precious metals are, as you may know, gold and silver. However, all precious metals are in great demand and that doesn't appear to be changing. Take a look at additional benefits this alternative asset has to offer:
- Easily convert precious metals, like gold and silver, into cash.
- During inflation, precious metals can act as a hedge.
- Because it's an alternative asset, precious metals help to diversify your retirement account portfolio.
- Precious metals, such as gold and silver, are accepted all over the world. There are a few investments that are accepted across the globe.
Read More: Traditional vs. Roth IRAs Tax Deferral vs. Tax Free, Which is Better?
While purchasing precious metals in a retirement account has multiple benefits, it is important that you work the right Self-Directed Custodian. Many Self-Directed IRA Custodians allow precious metals to be held in retirement accounts. However, many also charge account valuation fees that can quickly eliminate your profits. Unlike other IRA Custodians, IRA Financial charges a flat annual account fee.
Related: Why Invest in Alternative Investments with Your Retirement Account
Rules for Holding Precious Metals in an IRA
There are certain IRC rules to be aware of before purchasing, holding and selling precious metals. Some of the rules are as follows:
- According to IRC Section 408(m), gold, silver or palladium bullion must be held in the physical possession of a U.S. Trustee. This is otherwise known as a U.S. bank or financial institution. The safest approach to holding IRS approved bullion is with an approved depository. However, many retirement investors have interest in potentially holding metals in a safe deposit box at a U.S. bank. Such metals include gold, silver and palladium bullion. It will be in the name of the Self-Directed IRA LLC, and not in the possession of the IRA holder, because they are being held in the safe deposit box of the bank. However, an argument can be made that the safe deposit box is in control of the IRA holder, since he or she has the keys for the box.
Learn More: Types of Self-Directed IRAs
Holding Precious Metals in a Self-Directed IRA
A number of IRA investors are not aware that they can use their retirement funds to invest in precious metals. This is because traditional financial institutions don't tell their clients about alternative asset investments. They want IRA holders to invest in their products, such as stocks, bonds and mutual funds. In other words, traditional investments.
However, you can purchase, hold and sell precious metals with a Self-Directed Precious Metals IRA. Additionally, you can make withdrawals of bullion to physically possess this asset.
You can use an IRA to invest in precious metals in a few simple steps. You must first establish a Self-Directed individual retirement account.
1. Establish Your Self-Directed IRA or Solo 401(k)
Take control over your investment decisions with a Self-Directed IRA. If you're self-employed or a small business owner with no full-time employees, you can establish a precious metals IRA with a Solo 401(k) plan. If you have a full-time job and contribute to an employer's 401(k) plan and have self-employment income, you are also the option to open a Solo 401(k). With IRA Financial, we will assign you with a retirement tax professional to establish your account at a new FDIC and IRS approved custodian.
Choose a self-directed IRA custodian, such as IRA Financial Trust for a cost-effective, easy solution.
2. Fund Your Self-Directed IRA
Now it's time to fund your SDIRA. Your new custodian will request the transfer of IRA assets from your current IRA custodian. If done correctly, the transfer will be tax-free and penalty-free. Typical, retirement funds move from one account to another by way of a transfer or rollover.
3. Invest in Precious Metals
With the funds now in your newly established Self-Directed IRA, you are the manager of the IRA LLC and you're ready to all IRS approved precious metals tax and penalty-free.
Related: Solo 401k Eligibility & Plan Setup
The Final Verdict on Precious Metals in an IRA
IRA Financial Group suggests that all clients seeking to purchase IRS approved coins or precious metals/bullion with their retirement account hold them in the physical possession of a trustee, such as a depository.
For Self-Directed IRA LLC or self-directed Solo 401(k) plan clients seeking to hold IRS approved coins and precious metals at a bank safe deposit box, we believe that this position has some risk. There is not enough IRS guidance on this matter.
In the case of a Self-Directed IRA, if the bank where the safe deposit box is not the trustee of the IRA that purchased the metals or coins, you can make the argument that the metals or coins don't satisfy the physical possession definition in IRC section 408 since the bank cannot serve as the IRA trustee.
The Final Verdict on the Solo 401(k) Rules
Whereas, in the case of a Solo 401(k) plan, the arguments has less strength. This is because an individual(s) associating with the adopting employer will likely serve as the plan trustee and not the bank holding the plan’s assets. As a result, there is no trustee relationship between the bank and the plan, but it still satisfies the definition of a trustee under IRC 408.
Additionally, IRC Section 408(m)(3)(B) uses the term “a” trustee” and not the “the” trustee” offering some support for the position that the metals/bullion can be held at any trustee and not just the trustee of the IRA holding the metals. This makes sense since a depository is technically a trustee pursuant to IRC 408(a). However, it may not be the actual trustee of the IRA that owns the coins or bullion/precious metals.
Nevertheless, the safest approach to holding IRS-approved coins or bullion/precious metals is with a trustee. One thing that is clear, you should never hold IRS-approved coins or precious metals/bullion personally.
Work with a Professional
The rules surrounding the ownership and possession of IRS precious metals or coins are complex. Therefore, it is crucial that you work with a firm, such as IRA Financial Group, to help you navigate the IRS rules.
How to Buy Mortgage Notes with a Self-Directed IRA
Over the last few months, with skyrocketing interest rates and a slowdown in the real estate market, a growing number of home buyers turned to private lenders to help secure the funds necessary to purchase a home. This article will explore the details surrounding private mortgage notes and then discuss the various ways one can use a Self-Directed IRA to serve as a private mortgage lender and generate tax-free returns.
What is a Mortgage Note?
A mortgage is a type of contract and is essentially a loan secured by real estate. A mortgage note is the document that one signs as part of the home purchase process. In general, a mortgage note is a legal document that sets forth the terms of the mortgage between a borrower and a lender. A mortgage note includes terms such as:
- The total amount of the loan
- The amount the borrower will be paying as a down payment
- Schedule for loan payments under the note
- The mortgage terms - is the note fixed or adjustable interest rate
- Whether the note has a prepayment penalty.
A private mortgage note is an attractive investment for many because the note returns a steady stream of interest, and it is generally secured by the underlying property which gives the lender a solid base of collateral. In addition, there is a growing marketplace where companies are looking to buy your mortgage largely because these are collateral-backed securities.
Why Use a Self-Directed IRA to Invest in Mortgage Notes?
A Self-Directed IRA is a type of IRA that allows for alternative asset investments, including real estate. The major advantage of making investments with an IRA, such as mortgage notes, is that all interest and returns will flow back to the IRA without tax.
Tax deferral is when all gains generated by a pretax retirement account investment flow back into the plan tax-free. This allows your retirement funds to grow at a much faster pace than if the funds were held personally, allowing you to build for your retirement more quickly.
Best Ways to Use a Self-Directed IRA to Invest in Mortgage Notes
When using a Self-Directed IRA to invest in private mortgage notes, there are two ways one can use a self-directed to make investments: (i) full-service custodian controlled, and (ii) checkbook control IRA LLC:
Full Service – Custodian Controlled
A custodian-controlled Self-Directed IRA offers an IRA investor more investment options than a financial institution plan. A special IRA custodian, such as IRA Financial Trust, will serve as the custodian of the IRA. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products or platforms. With a full-service plan, IRA funds are generally held with the custodian, and at the IRA holder’s sole direction, will invest the funds into the investment; in this case, private mortgage notes.
The lender of the note would be titled in the name of the IRA custodian for the benefit of the IRA owner. All interest and principal on the mortgage note would be paid back to the IRA custodian for the benefit of the IRA owner. The custodian would be required to handle all IRS administration concerning the Self-Directed IRA, including filing IRS Forms 1099-R and 5498.
Checkbook Control IRA LLC
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as private mortgage notes which require a high frequency of transactions.
Under the checkbook IRA format, a limited liability company (LLC) is created which is funded and owned by the IRA and managed by the IRA owner. This allows the IRA owner to have more control over the investment process, as well as provide limited liability protection in addition to greater privacy.
The structure is IRS- and tax court-approved. The idea of using an entity owned by an IRA to make investments was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996). In Swanson, the Tax Court, in holding against the IRS, ruled that the capitalization of a new entity by an IRA for making IRA-related investments was a permitted transaction and not prohibited. The Swanson Case was later affirmed by the IRS in the Field Service Advice Memorandum (FSA) 200128011.
In the case of a private mortgage note investment, the lender of the note would be the LLC and not the IRA directly. By having the IRA own the LLC, the investment will be made in the name of the LLC giving you complete control and added protection.
For example, assume Jane Doe opened and funded a Self-Directed IRA LLC with $50,000. Assume further that Jane has asked IRA Financial to establish an LLC in her state of residence, Florida. The name of the LLC will be Hot Money Loan LLC. IRA Financial establishes the LLC, acquires a tax ID# for the LLC, provides the LLC operating agreement, and opens a bank account at Capital One. IRA Financial sends the $50,000 to the LLC bank account. Jane, as manager of the IRA LLC, sends the funds to the borrower as part of the mortgage note transaction. The note is titled in the name of Hot Money Loan LLC. Since Jane’s IRA owns 100% of the LLC, all interest and principal will flow back to the LLC without tax.
Conclusion
The use of a Self-Directed IRA to invest in private mortgage notes has become a hot investment over the last several years. You may choose the less hands-on approach by going full-service or getting your hands "dirty" with a Checkbook IRA LLC. Either way, the tax advantages are the same. Taxes are never due so long as the note is held in the IRA. All gains wouldn't be taxable until assets are distributed from the plan. If you elect to use a Roth IRA, qualified distributions are tax-free.
Buying Stocks in a Self-Directed IRA
As you probably know, you can invest in just about anything with a Self-Directed IRA. Here at IRA Financial, we stress the importance of properly diversifying your holdings. Generally, we tout the benefits of alternative investments in your IRA. These include real estate, precious metals, tax liens, and cryptocurrencies. Today, our focus is on a traditional asset, stocks! Stocks are an essential part of everyone's retirement plan. Over the last several years, we've seen huge gains in the stock markets. Of course, that all came crashing down due to the current pandemic that's spread across the globe. However, now may be a good time to look at stocks in your Self-Directed IRA. It seems we have bottomed out, and the markets can only go up right now. Using a brokerage account to invest in stocks with an IRA is very tax-advantageous.
- A Brokerage Account allows you to buy and sell stocks
- A Self-Directed IRA can be used for traditional and alternative investments
- Checkbook Control gives you the freedom to make any investment you want
What is a Brokerage Account?
A brokerage account is a type of investment account that one can open with a brokerage firm. The brokerage account can be opened by an individual or an entity, such as an LLC. It can be funded by depositing money into this account by writing a check, wiring money, or a fund transfer. Once funds have been deposited, the available funds can be used to buy or sell several types of investment securities, such as individual stocks, exchange-traded funds (ETFs), mutual funds, bonds, etc.
A brokerage account is the only way one can invest in traditional securities. There is no limit on the number of brokerage accounts you can open. One should be aware of the financial strength of your broker and the extent of its Securities Investor Protection Corporation or SIPC coverage. This insurance compensates investors if their stock brokerage firm goes bankrupt.
Related: Buying GME Stock in a Self-Directed IRA
Opening a Brokerage Account with a Self-Directed IRA
When investing with a Self-Directed IRA LLC, it is important to remember that the investment should be made in the name of the LLC and not the IRA, which is the owner of the LLC.
A single-member limited liability company (“LLC”) owned by an IRA is treated as a disregarded entity for Federal Income Tax purposes. In other words, the LLC is treated as an "invisible" entity for tax purposes and the sole owner of the LLC, the IRA, is treated as the owner. Accordingly, when opening a brokerage account for a single-member LLC owned by an IRA, the account should be opened in the name of the LLC. However, from a Federal Income tax perspective, the LLC is ignored for tax purposes and the IRA is treated as the sole owner of the account. Therefore, even though the account is opened in the name of the LLC, from a tax standpoint, the IRS is the beneficial owner of the account, generally resulting in tax-exempt treatment for all income and gains earned by the IRA LLC.
Rules of the Self-Directed IRA to Buy Stocks
Above all else, the IRA must be the entity that benefits from an investment. In no way should an IRA benefit you (the IRA owner) or any other disqualified person. A disqualified person includes your spouse, children, grandchildren, parents, grandparents, and entities controlled by such persons. As soon as someone other than the IRA gains something from an IRA investment, the IRA will be disqualified. This means you lose out on all the tax benefits of the plan. Traditional IRAs benefit from tax-deferred savings (with an upfront tax break). On the other hand, a Roth Self-Directed IRA offers tax-free withdrawals during retirement (no upfront tax break).
The other part of the prohibited transaction rules is the types of investments not allowed by the IRS. These include life insurance, most collectibles, and, as mentioned above, transactions involving a disqualified person. All public stocks and mutual funds are fair game. Therefore, you can invest in any stock with your brokerage account in a Self-Directed IRA.
Checkbook Control
The other main advantage of a Self-Directed IRA is the checkbook control structure. Using an LLC allows the IRA holder to make IRS-approved investments more quickly and with fewer fees. The beauty of a Self-Directed IRA LLC is that, as manager of the IRA LLC, you will have total control over the assets. You have the choice to make traditional investments, such as stocks and mutual funds, as well as alternative assets, such as real estate. We've always stressed that it's your money, invest it the way you see fit! No need to ever ask IRA Financial when you want to invest.
Open a Self-Directed IRA for Stock Trading
- Establish a Self-Directed IRA with an IRA custodian or trust company that allows for alternative investments, such as IRA Financial.
- Transfer (or rollover) your retirement assets that you will be using for investing tax-free to your new IRA custodian.
- A special purpose LLC will be established that will be wholly owned by the IRA.
- Establish a brokerage account for your LLC at any brokerage firm. You will need to have the LLC article of formation, a Tax ID#, as well as a Self-Directed IRA LLC operating agreement. The brokerage account should be opened in the name of the LLC and not the IRA.
- Notify your IRA custodian that you wish to have the funds sent to the newly established brokerage account. The IRA assets/cash will then be transferred tax-free, in exchange for 100% interest in the LLC
- You, as manager of the LLC, will then have checkbook control over all the assets/funds in the IRA LLC to invest.
- Since the LLC will be owned by one IRA, the LLC will be treated as a disregarded entity for federal income tax purposes and no federal income tax return will be required to be filed. All income and gains from the stock investments will flow back to the IRA without tax.
Buy, Sell, and Trade Stocks
Once your brokerage account is all set up, you can then buy, sell, and hold stocks within your Self-Directed IRA. Using a Self-Directed IRA LLC affords the IRA holder a considerable amount of freedom when it comes to making IRS-approved investments, whether traditional or alternative. Now may be the best time to invest your retirement money in stocks, bonds, and mutual funds. Bear in mind, it's still important to properly diversify your portfolio. The easiest way to do that is by looking at alternative investments.
Read More:
Traditional IRA vs Self-Directed IRA
Self-Directed IRA Contribution Limits
Can a Self-Directed IRA Invest into a Company I Serve as a Director?
One of the more popular questions from first-time Self-Directed IRA investors is can I invest in a business or company that I am personally involved in. The good news is that the IRS-prohibited transaction rules are quite simple, especially when it comes to investing in a business where the IRA owner personally serves as a director.
- One can use IRA funds to invest in a business
- You must be aware of the prohibited transaction rules
- Facts and circumstances will determine if you can invest in a particular business
Self-Directed IRA in a Nutshell
There are several types of Individual retirement accounts, or IRAs. In general, if one has income from working for yourself or someone else, you may set up and contribute to an IRA. Most of the more than $12 trillion held in IRA accounts are controlled by the major brokerage firms and invested in stocks, bonds and mutual funds. Alternative investments, such as real estate, have always been permitted in IRAs, but few people seemed to know about this option - until the last several years.
The large financial institutions have little incentive to recommend investments other than their traditional offerings which bring in extremely profitable commissions and fees. A Self-Directed IRA is essentially a type of IRA that allows you to invest in alternative assets (non-publicly traded investments).
IRC 4975 - The IRS Prohibited Transaction Rules
The Internal Revenue Code (“IRC”) does not describe what an IRA can invest in, only what it cannot invest in, which is outlined in IRC Section 4975(c). Other than life insurance and collectibles, one can generally invest in anything that doesn't involve a disqualified person.
In general, the IRS prohibits certain transactions involving “disqualified persons.” The definition of a disqualified person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest
Therefore, an IRA investment cannot include you, your spouse, parents, grandparents, children and their spouses. Other relatives, friends, coworkers and neighbors are allowed.
Investing in a Business with a Self-Directed IRA
When using an IRA to invest in a business the IRA owner will be personally involved in, it is important that the IRA owns less than 50% of the entity. For example, if an IRA owner or any disqualified person will own more than 50% of an entity, that individual should not use IRA funds to invest into that entity, as it would trigger a prohibited transaction under IRC 4975.
On the flip side, an IRA can own more than 50% of an entity so long as the IRA owner nor any disqualified person owns any interest in the entity, or is personally involved in the entity.
Serving as Manager/Director of a Self-Directed IRA-Owned Business
The Court case, Swanson V. Commissioner 106 T.C. 76 (1996), confirmed that an IRA could capitalize a new entity and the entity can be managed by the IRA owner, (who is a disqualified person) without triggering the IRS prohibited transaction rules. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011.
However, what about the case where the IRA wishes to make an investment into an existing company where the IRA owner or a disqualified person will serve as manager or director? The answer generally depends on the facts and circumstances of the investment.
In the simplest case, if the IRA will owns less than 50% of the entity and the IRA owner will not earn any compensation from the entity, then the transaction would likely not trigger the prohibited transaction rules. However, where the IRA will own more than 50% of the entity and the IRA owner will be a paid employee or director, the transaction could be deemed an indirect, self-dealing, conflict of interest prohibited transaction.
The key point to remember is that the Self-Directed IRA investment must be one to exclusively benefit the IRA and not to directly or indirectly benefit the IRA owner personally.
Conclusion
Interpreting the IRS prohibited transaction rules under IRC 4975 tends to boil down to the specific situation. In the case of a Self-Directed IRA investment into an entity managed by the IRA owner or another disqualified person, below are a few key points to consider:
- An IRA investment of 50% or greater into an entity adds greater prohibited transaction risk, especially if the IRA owner or a disqualified person will be personally involved in the entity
- If the IRA will own more than 50% of the entity, the IRA owner, nor any disqualified person, should receive compensation from the entity as manager/director
- If an entity is owned 50% or more by the IRA owner or a disqualified person, the Self-Directed IRA should be cautious of investing into that entity
- If the Self-Directed IRA will be owning less than 50% of the entity, there is more flexibility for the IRA owner or any disqualified person to have a personal interest/compensation relationship with the entity
Get in Touch
The experts at IRA Financial can help you navigate the prohibited transactions rules. If you have any questions, please reach out to us @ 800.472.0646 today.
Do I need an LLC for my Self-Directed IRA Investment?
Over the last several years, there has been a growing trend to use LLCs to start businesses and for investment ventures. There are over 22 million LLCs in the United States. In comparison, there are approximately 2 million traditional C Corporations, and approximately 24 million sole proprietorships. IRS statistics show a year-over-year increase in domestic LLCs since 2004. This article will explain what an LLC is and why it is so popular for businesses and retirement accounts. It will then explore the emergence of the Self-Directed IRA LLC for investors and the types of IRA investments that can benefit from the use of an LLC.
- The use of an LLC for Self-Directed IRA has become increasingly popular
- Although an LLC is not needed, it offers one with protection, privacy and control
- Investments that require frequent transactions benefit from the Checkbook IRA LLC structure
What is an LLC?
A Limited Liability Company (LLC) is a business structure allowed by state statute. The LLC is so popular because it combines the corporate advantages of a corporation with the pass-through tax advantages of a partnership. Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs, and even retirement accounts; there is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner. Obviously, an LLC provides its owners with limited liability protection.
A domestic LLC with at least two members is classified as a partnership for federal income tax purposes. Whereas, an LLC with only one member is treated as an entity disregarded as separate from its owner. An LLC has one layer of tax at the member lever. On the other hand, a C corporation has two layers of taxation, an entity level tax and a shareholder level tax. For example, if a C corporation generated $1,000 of net income, it would be subject to a 21% corporate level tax, and if the retained earnings are sent to the shareholder as a dividend, the shareholder would be subject to tax on the dividend. The shareholder tax would be based on whether the dividend is from a private or public company (qualified).
Why Use an LLC?
As discussed above, the primary reasons to use an LLC over a corporation when making an investment are limited liability protection, and pass-through taxation. Whereas, the main advantage of using an LLC versus a sole proprietorship is the limited liability protection.
Protecting one's assets outside of the LLC is extremely important to many business owners and investors. This is why using an LLC as a shield against a creditor attack of the LLCs owner's assets outside of the LLC is so important.
What is a Self-Directed IRA?
As mentioned, over the last 25 years or so, a significant number of Self-Directed IRA investors have elected to use an LLC wholly owned by the IRA and managed by the IRA owner. So what exactly is a Self-Directed IRA?
Since IRAs were created by ERISA in 1974, the IRS rules have permitted a retirement investor to use retirement funds to make almost any type of investment, aside generally from any investment involving a disqualified person. The tax code never distinguished between an IRA that could invest in equities and an IRA that could invest in alternative assets. In fact, the IRA that was created by ERISA permits the IRA to invest in almost any type of investment from stocks to real estate.
The term Self-Directed IRA is not a legal term. You will not find it in the tax code. In general, so long as the IRA is not invested in life insurance, collectibles, or any investment personally benefiting the IRA owner or another disqualified person, the investment can be made.
Two Self-Directed IRA Options
In general, pursuant to Internal Revenue Code Section 408, an IRA can be established and administered by a bank, financial institution, or authorized state-regulated trust company. An IRA trustee, also called a custodian, is the institution that administers the IRA plan. By law, every IRA must have a custodian or trustee.
The IRA custodian has the right to decide what types of IRS approved investments it will allow its IRA clients to invest in, such as real estate. Most banks and traditional financial institutions that offer IRAs only permit their IRA clients to invest in traditional assets, such as equities, mutual funds, and ETFs. On the other hand, a Self-Directed IRA custodian, such as IRA Financial, allows IRA owners to invest in alternative asset investments, such as real estate. In addition, a Self-Directed IRA custodian does not offer investment advice or sell investments and is, thus, not treated as a fiduciary.
There are several reasons why an IRA owner would consider establishing an LLC as an investment vehicle. However, an LLC is not required to make an IRA investment. The following are the two common ways to use an IRA to make alternative asset investments.
Self-Directed IRA
In order to establish a Self-Directed IRA, the plan should be opened with a "special" Self-Directed IRA custodian, such as IRA Financial. Even though ERISA never differentiated between an IRA that invests exclusively in traditional investments, and one that invests in alternative assets, traditional banks and financial institutions generally do not allow their IRA holders to invest in alternative assets for the simple reason that they don’t make any money from those investments.
The IRA custodian is essentially responsible for maintaining and administering the IRA. To this end, the IRA custodian is tasked with the responsibility of complying with all IRS reporting requirements with respect to the IRA, such as the filing of IRS Forms 5498 and 1099-R.
With a Self-Directed IRA, the custodian will serve as the custodian of the IRA and offers alternative asset investment options. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products. The IRA funds are generally held with the custodian and at the IRA owner’s sole direction, the custodian will then invest those funds. The investment is titled in the name of the IRA custodian for the benefit of the IRA owner.
For example, John Smith establishes an IRA with IRA Financial to buy a home. John rolls over $100,000 from his former employer 401(k) plan tax free. John uploads the necessary real estate closing document on the IRA Financial app. IRA Financial processes the closing documents and signs the documents as follows: IRA FINANCIAL CFBO JOHN SMITH IRA. IRA Financial then wires the funds to the seller and the IRA takes title to the property.
Self-Directed IRA LLC
The 1996 Tax Court case, Swanson v. Commissioner, 106 T.C. 76 (1996), facilitated the growth of the Self-Directed IRA industry by allowing IRAs to invest in entities owned by a retirement account and controlled by the IRA owner to make investments. With the growing popularity of LLCs, the Swanson case provided a track for how one could use a special purpose entity, wholly owned by an IRA, and managed by the IRA owner to make investments. The Self-Directed IRA LLC, also known as a Checkbook IRA, has become an enormously popular solution for real estate investors looking to use IRA funds to invest in alternative assets while also benefiting from the power of limited liability protection.
The LLC will have its own bank account that will be controlled by the IRA owner. Once the LLC is funded, the IRA owner, as manager of the LLC, will have the authority to make IRS-approved investments. In other words, you will have "checkbook control" over the IRA assets and will be able to make investments directly from your LLC bank account, which can be opened at any local bank. If there is an alternative investment you want to make - simply write a check or wire the funds straight from your IRA LLC bank account.
For example, Jane Smith establishes an IRA with IRA Financial to buy a home in Texas. Jane rolls over $100,000 from his former employer 401(k) plan tax-free to IRA Financial. Jane works with IRA Financial to establish an LLC in the state of Texas. She names the LLC JS Investments LLC. IRA Financial acquires a Tax EIN for the LLC and even provides an LLC operating agreement showing the IRA as owner and manager of the LLC.
IRA Financial then opens an LLC bank account for JS Investments LLC with Capital One bank, its banking partner. Funds are sent from the IRA to the LLC via the bank account at Capital One. Jane, as manager of the LLC, then wires the funds to the seller of the real estate. Title to the real estate will be titled in the name of the LLC.
Do I really Need an LLC for My Self-Directed IRA?
A Self-Directed IRA investor is not required to use an LLC to make an alternative asset investment. In fact, the majority of investors typically are made directly by the IRA into the underlying investment. There is no right or wrong answer as to whether one should use an LLC, however, the following is a helpful guide that describes the investments categories when an LLC is typically used.
Self-Directed IRA with No LLC
If you are looking to invest your IRA into an investment that is not expected to involve a high number of transactions, the LLC is typically not employed, such as:
- Private placement
- Investment fund
- Real estate fund
- Private business investments
- Debt fund
- Raw land
- Cryptocurrency
Self-Directed IRA LLC
The most popular reason why a Self-Directed IRA owner would use an LLC to invest is the limited liability protection. In addition, the use of an IRA LLC provides the IRA owner with a certain level of privacy since the investment is made in the name of the LLC and not their individual name. The most important reason an LLC is used is the greater control one has over the investment process. Investments can be made quickly and expenses are handled more efficiently.
The following are the most popular investments where a Self-Directed IRA investor will use an LLC to make an investment:
- Rental real estate
- Real estate flips
- Investment fund investments involving fund personnel
- Private business investments involving business management
- International real estate
- Investments requiring an entity, such as a real estate investment using a loan
- Cold wallet cryptocurrency investments
- Defi digital asset investments
Conclusion
The Swanson case set forth the path for Self-Directed IRA owners to use a special purpose entity, such as an LLC, to make investments. The fact that the LLC offers limited liability protection and pass-through tax treatment makes it a perfect vehicle for investors. In general, investments that involve a high frequency of transactions, have liability risk, or involve an IRA owner seeking more control or privacy, are well suited for the Checkbook IRA LLC solution.