Can I Contribute to a Traditional IRA and Roth IRA in the Same Year?
One of the most common dilemmas facing Self-Directed IRA investors is whether they should make annual contributions in pretax or Roth. This article will explore the rules that govern IRA contributions in 2023.
- One can choose to contribute to a traditional or Roth IRA, or both
- There are income limitations in place for direct Roth contributions and deductible pretax contributions
- Choosing which plan is better is an individual's decision based on his or her unique situation
Traditional IRA vs. Roth IRA – Tax Characteristics
Traditional IRA
The traditional IRA is an individual retirement arrangement (IRA) that was established by the Employee Retirement Income Security Act of 1974 (ERISA). It was created to help more Americans save for retirement. In 2026, the maximum IRA contributions are $7,500 or $8,600 if you are at least age 50. Contributions to a traditional IRA are tax deductible, meaning they lower your taxable income for the year(s) you make contributions to the plan. Distributions taken before the age of 59 1/2 are subject to tax and a 10% early distribution penalty. Upon reaching the age of 73, you must take an annual required minimum distribution, or RMD.
Roth IRA
The Taxpayer Relief Act of 1997 introduced the Roth IRA. It is an after-tax IRA which allows any US person with earned income under a set income threshold (under $153,000 if single and $228,000 if married and file jointly in 2023) to make after-tax contributions. The same contribution limits for a traditional IRA are applied to Roths. Unlike a Traditional IRA, Roth IRA contributions are not tax deductible. However, so long as any Roth IRA has been opened for at least five years and the plan holder is at least age 59 1/2, all Roth IRA distributions would be tax free. Further, there are no RMD for Roth-type plans, which is a great estate planning tool.
Who Can Contribute to an IRA or Roth IRA?
In general, in order for one to contribute to an IRA, the IRA owner or his or her spouse must have sufficient earned income. According to the IRS, earned income is defined as wages; salaries; tips; and other taxable employee compensation, whether in the form of a 1099, W-2, guaranteed payment, or net Schedule C income. Earned income also includes net earnings from self-employment. Earned income does not include amounts such as passive income, pensions and annuities, welfare benefits, unemployment compensation, worker's compensation benefits, or social security benefits. Hence, if an individual only has passive income or is retired and does not have any earned income during the year and neither does the spouse, the individual would not be able to contribute to an IRA or Roth IRA.
You cannot contribute to your IRA (or your spouse's IRA) more than you the earned income you have. For example, if you are semi-retired making $10,000 annually, that is the most you can contribute to both plans. Obviously, you can first max out your plan first, and use the remainder for your spouse's plan. One does not have to contribute to an IRA every year; only when you want to.
Income Limitations for IRA & Roth IRAs
Traditional IRA
It is not widely known that not all individuals with earned income can make a pretax and tax-deductible traditional IRA contribution. He or she may be able to make an after-tax traditional IRA contribution, but the IRS includes an income limitation and certain restrictions on who can make a pretax IRA contribution if they have access to a 401(k) plan at work.
If you are single and have access to a 401(k) plan at work, your ability to make a tax-deductible Traditional IRA contribution in 2026 phases out between $81,000 and $91,000. If your income is above $91,000, you cannot deduct your contribution. If you do not have access to a workplace retirement plan, there are no income limits for deductible contributions.
For married couples filing jointly, if the spouse making the contribution is covered by a workplace retirement plan, the deduction phases out between $129,000 and $149,000. If neither spouse is covered by a workplace plan, the joint income limit for fully deductible contributions is $242,000.
Roth IRA
For 2026, if one is married filing jointly and makes in excess of $242,000 or $252,000 if single, he or she is technically not permitted to make Roth IRA contributions. However, beginning in 2010, the IRS removed any income restrictions for making Roth conversions.
For high income individuals, contributing funds to a Roth IRA is only possible through a solution known as the "Backdoor" Roth IRA. Since that time, the strategy has been used by high income earners to take advantage of the Roth IRA benefits.
Below is a summary of the steps needed to make a Backdoor Roth IRA contribution:
- Open a traditional IRA
- Make an after-tax contribution to the plan. Do not treat the IRA contribution as tax deductible on your tax return.
- Notify your IRA custodian that you want to convert the after-tax traditional IRA to Roth
- Funds are transferred to the Roth
- IRA custodian issues a 1099-R in the following year indicating that a no-tax conversion occurred.
If you have no pretax funds in any IRA, the conversion is tax free. However, if you do have untaxed money, a portion of the conversion will be taxable. You cannot choose to only convert after-tax contributions. The IRS will always get their share!
Can I make Pretax & Roth IRA Contributions in the Same Year?
The answer is yes, you can choose how you wish to contribute to your IRA plans. In order to contribute to both types of plans, you will need multiple IRAs - one traditional and one Roth. The next question is should you? Experts agree that not only should you diversify your portfolio, but also when your distributions are taxed.
Every individual's situation is unique, and some years you may want the upfront tax deduction rather than the future tax benefits. The more time until retirement, the more you can take advantage of the tax-free growth of the Roth IRA. However, no one knows what the future will bring. You can choose to pay a known tax rate now, or wait to pay later (when taxes might be higher). Obviously, the more money you earn, the higher your tax bill is. It's generally better to pay the taxes when your earned income is not at its peak.
You should consult with a financial advisor to determine if you are better off contributing to a traditional or Roth IRA, or both!
Taking RMDs from Retirement Accounts
As we approach the end of the year, it's time to start getting your retirement accounts in order. There are certain things you must do, depending on your age and the type of account(s) you have. Today, we are going to look at required minimum distributions or RMD. Taking RMDs must be done by anyone who is at least age 73. Again, this depends on your retirement accounts. Therefore, if you turned 73 this year (or have already reached that age), this article is for you. We will explain RMDs, how to calculate them and even ways to avoid them.
What is an RMD?
As stated on the IRS website, an RMD is "the minimum amount you must withdraw from your account each year." Once you reach the magical age of 73, you must start taking RMDs. Traditional retirement plans are funded with pretax money. Taxes are tax-deferred until you start taking distributions during retirement. The RMD ensures you don't have an unlimited, tax-advantaged account. The IRS felt 73 was the right age to make withdrawals mandatory.
You may ask yourself, I'm retired, why wouldn't I take funds from my retirement account? Believe it or not, there are people who don't need their retirement funds to live off. They'll use the account as a way to lower their annual tax bill and then pass it on to one of their heirs. However, the IRS won't let that money grow tax-free indefinitely. Hence, the RMD rules.
Who Must Take RMDs?
Apart from reaching the age of 73, you must have the types of plans subject to the RMD. Generally, these account for most plans. If you have a workplace 401(k) or 403(b) plan, most types of Individual Retirement Accounts (IRA) or a Solo 401(k), you must take RMDs. The one exception is the Roth IRA. However, if you have a Roth 401(k), you must take RMDs as well. However, thanks to SECURE Act 2.0, Roth 401(k) plans will no longer be required to take RMDs beginning in 2024.
There is one other exception if you are still working. If you are currently employed and own less than 5% of the company, you do not have to start your RMDs until you leave the job. Please note that this only applies to the retirement account at your current job. For example, if you have a 401(k) from a previous employer or an IRA, you must satisfy the RMDs for those plans. The RMD is only on hold for the retirement account at your current job. For those with a Solo 401(k), you cannot avoid RMDs since you probably own more than 5% of the company.
Read More: Understanding Required Minimum Distributions (RMDs) for Retirement Accounts
Calculating Your RMD
There are two important factors to consider when taking your RMD: your age and your account balance. Obviously, your current age of the time of the RMD is considered. You will use the account balance(s) as of December 31 of the previous year. Using the life expectancy table provided by the IRS, you can calculate your RMD for the year. (Check out the RMD worksheets.)
Using the table, you can find your life expectancy factor. Then, you take your account balance and divided it by that number. Here's an example: Sam is 75 years old and has a $100,000 balance in his 401(k). Looking at the table, you see 22.9 is the distribution period. $100,000 divided by 22.9 = $4,366.81. This is the amount of Sam's RMD.
If you have multiple retirement accounts that requires taking RMDs, you must do this for each of the accounts. Now that you've figured out all the RMDs you must take, it's time to distribute the funds. IRAs and 401(k) plans differ in this regard. Your IRA RMD can be taken from one or multiple IRAs. Depending on how your investments are doing in each one, it might make sense to take your entire RMD from one account. Alternatively, all things being equal, you can spread it across several IRAs.
However, 401(k) plans are different. If you have multiple 401(k)s, you must figure out the RMD for each plan and the amount must be taken from each account. If you have two 401(k) plans that each owe $2,000 in RMDs, you cannot take $4,000 from one plan. You must take the $2,000 from each plan.
Taking RMDs on an Inherited Plan
401(k) plans
Assuming you are married, you must leave your 401(k) to your spouse. The plan can remain where it is, so long as the company allows it. You may also choose to roll the funds into an Inherited IRA. If choosing the latter, the rules will differ based on the relationship of the beneficiary to you (spouse or non-spouse).
Learn More: Making Sense of the Inherited IRA Rules
IRAs
As for IRAs, the rules are different depending on who you were to the deceased. Spouses are treated differently than non-spouses. Other entities, such as a trust, are also different. If you are a spousal beneficiary, you have essentially two options. The first one is to assume the IRA as your own. You can roll over the funds into an IRA that you control. RMDs start when you reach age 70 1/2. Your other option is to open an inherited IRA. The benefit of this is if you are under age 59 1/2. You can withdraw from the plan without paying an early withdrawal penalty. RMDs would start when your spouse would have reached 70 1/2. Obviously, if he/she was older, RMDs would need to be taken the year after your spouse passed.
If you are a non-spouse beneficiary, such as a son or sister, you have two options as well. You can choose to take RMDs based on the original owner's age (if at least 70 1/2) or yours if he/she was not yet taking RMDs. The other option is known as the five-year rule. You must distribute all funds within five year of the owner's death. You don't have to withdraw anything until that time (or you can take it all if you wish). That way, it can continue to grow unhindered until you must withdraw.
Related: Essential Self-Directed IRA Rules: Dos and Donâts
Roth IRAs
Again, there are differing rules depending if you were a spouse or not. Spouses can assume the Roth IRA as his/her own. Therefore, RMDs will not come into play for you. Non-spouses, however, cannot do this. They must follow the above rules, and either start taking RMDs based on their life expectancy, or distribute the entire account within five year.
Roth 401(k) Workaround
Unlike a Roth IRA, you are required to take RMDs from a Roth 401(k). However, there is a way to avoid this. You can simply roll the entire balance into a Roth IRA before reaching age 73. Thus, leaving the Roth 401(k) with a zero balance and therefore no RMD will be required. Since the funds are now in the Roth IRA, they can continue to grow on a tax-free basis. As we mentioned above, this won't be a concern next year. However, RMDs are still required from Roth 401(k) plans for 2023.
What if You Don't Take Your RMD?
Failure to take all the necessary RMDs will lead to stiff a stiff penalty. FIFTY PERCENT is the cost of a missed RMD. You will be penalized 1/2 of the amount of the RMD that was not taken. For example, if you were supposed to withdraw $5,000 and you only took $4,000, you will be hit with a $500 penalty (50% of the missed $1,000). This penalty will continue until you remedy the situation.
Update: Another change to RMDs brought about by SECURE Act 2.0 is the reduction in penalty of a missed RMD. As per the IRS, "SECURE 2.0 Act drops the excise tax rate to 25%; possibly 10% if the RMD is timely corrected within two years."
The deadline, for most years, to take your RMD is December 31. It's important that you don't wait until the last minute to satisfy your RMD. The exception is the year you reach age 73. You have until April 1 of the following year to take your initial withdrawal. Keep in mind, if you choose to wait until the next year, you will be taking two distributions during year two. Consider the fact that distributions are treated as taxable income and will effect your tax bill.
It's important to work with an expert when taking your RMDs (at least for the first year or two). Failure to do so appropriately will have adverse consequences. Once you are familiar with the process, you can generally do it yourself.
Related: The Importance of Beneficiary Forms
Conclusion
With the end of the year approaching, it's important to make sure your affairs are in order. Missed distributions have the steepest penalty, so it's the first thing you should focus on once you reach 73. Taking RMDs may not be in your best interest, however they are required for most retirement plans.
If you have any questions about the RMD rules, please contact one of our retirement experts @ 800.472.0646 before it's too late!
Navigating the Plan Asset Rules for a Self-Directed IRA Investment
For Self-Directed IRA investors seeking to make alternative asset investments, there are a set of rules known as the “Plan Asset Rules” that must be considered before investing into an investment fund or operating business. Most Self-Directed IRA investors are solely focused on the IRS prohibited transaction under Internal Revenue Code (IRC) Section 4975 but are unaware that triggering the Plan Asset Rules can correspondingly trigger the IRS prohibited transaction rules in a transaction that may otherwise not be prohibited.
- The Plan Asset Rules are important to keep in mind before making a Self-Directed IRA Investment
- Violating these rules could lead to a prohibited transaction and disqualify your IRA
- There are some exceptions to these rules; work with a professional to see if your investment is safe
Because an IRA investor is already conscience of the prohibited transaction rules, they are not as imperative as say one with a pension plan. For those investors, triggering the Plan Asset Rules can require the investment fund manager to navigate various ERISA fiduciary requirements, as well as potentially triggering the IRS prohibited transaction rules.
This article will explain how the Plan Asset Rules work, along with exceptions to the rules. It will also detail the potential impact for a Self-Directed IRA or pension plan that triggers the IRS prohibited transaction rules. In addition, we will offer some examples that displays how the Plan Asset Rules could impact your investment.
The Impact of Triggering the IRS Prohibited Transaction Rules
Before we dive into the Plan Asset Rules, it is important for a Self-Directed IRA investor to understand how the IRS prohibited transaction rules work. This is because triggering the Plan Asset Rules could activate them as part of the "look-through" rules.
When it comes to making investments with a Self-Directed IRA, the IRS generally does not tell you what you can invest in, only what you cannot invest in. The types of investments that are not permitted to be made using retirement funds is outlined in IRC Section 408 and 4975. These rules are generally known as the “Prohibited Transaction” rules. Other than life insurance, collectibles, and transactions that involve a “disqualified person,” one can use his or her IRA to make just about any investment they choose. A “disqualified person” is generally defined as the IRA holder and any of his or her lineal ascendants and descendants and any entities controlled by such persons.
Triggering the IRS prohibited transaction rules under IRC 4975 have serious tax implications. IRC Section 4975(a) imposes a 15% excise tax (the first-tier excise tax) on a prohibited transaction. In addition, IRC Section 4975(b) imposes a 100% excise tax (the second-tier excise tax) on a prohibited transaction if that prohibited transaction is not corrected during the taxable period. The tax applies to any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such); the applicable excise tax is applied to the amount involved in the prohibited transaction.
The Plan Asset Rules
The Department of Labor’s (DOL) plan asset regulations are designed to cause the assets of a certain investment fund or entity owned by an IRA or pension plan to be treated as owned directly by the IRA or pension plan for purposes of DOL fiduciary rules as well as the IRS prohibited transaction rules. In other words, the Plan Asset Rules could turn a transaction that is not, on its face, subject to the IRS prohibited transaction rules and make it subject to them. This is the main reason that many investment funds and private placements investments will disclose in their documentation that they will seek to satisfy the exceptions to the Plan Asset Rules, which are discussed below.
Intent of the Plan Asset Rules
The Plan Asset Rules are important to understand if you are a Self-Directed IRA investor because if relevant, they would trigger a “look through,” which, would treat not only the interests in an investment fund owned by IRA or the pension plan as a plan asset, but also the assets of the investment fund as a plan assets. Whereas, if the Plan Asset Rules look-through applies, the ERISA fiduciary and/or IRS prohibited transaction rules would apply to the IRA investor even though the direct investment into the fund or entity was not in itself a prohibited transaction.
What is a Plan Asset?
Under the Plan Asset Regulations, when an IRA or a pension plan acquires an equity interest in an entity that is neither publicly traded nor a security issued by an investment company registered under the Investment Company Act of 1940 (e.g., a mutual fund), the assets of the IRA or ERISA plan investor include its acquired equity interest as well as an undivided interest in all of the underlying assets of the entity unless an exemption applies. These rules are widely called the “look-through plan asset rules.” Thankfully, the Plan Asset Rules provide a number of exemptions from look-through plan asset treatment to certain types of entities, including certain investment funds and operating companies.
Exceptions to the Plan Asset Rules
There are a number exceptions that apply so that an IRA or pension plan investment into a company or investment fund would not trigger the Plan Asset Rules. No IRA or pension plan wants to trigger them! Under the Plan Asset Rules, if an IRA or pension plan invests in an entity, the plan’s assets include its investment, but do not necessarily include any of the underlying assets of the entity. However, in the case of a plan’s investment in an “equity interest” of an entity that is neither a “publicly-offered security” nor a mutual fund, its assets include both the equity interest and an undivided interest in each of the underlying assets of the entity (the Look-Through Rule), unless it is established that:
- Equity participation in the entity by IRA or pension plan is less than 25%, or
- The entity is an “operating company.”
Operating Company
IRA and pension plans are generally able to invest in operating companies (i.e., companies selling widgets) without any regulatory impact on the portfolio companies in which they invest. Prior to the Plan Asset Rules in 1986, it was unclear whether a venture capital fund or private equity fund fell within the definition of an operating company and whether the fund’s assets would be considered plan assets subject to ERISA or the IRS prohibited transaction rules.
In addition, an entity’s assets will not be considered “plan assets” (i.e., the Look-Through Rule will not apply) if plan investors are investing in a “publicly offered security." The term “operating company” also includes an entity that is a “venture capital operating company” (VCOC) or a “real estate operating company” (REOC).
Venture Capital Operating Company (“VCOC”)
An entity will be deemed a VCOC and, thus, not be subject to the application of the Plan Asset Rules if:
- On such initial valuation date, or at any time within such annual valuation period, at least 50 percent of its assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, are invested in “venture capital investments” or “derivative investments” (the “50% Test”); and
- During such 12-month period (or during the period beginning on the initial valuation date and ending on the last day of the first annual valuation period), the entity, in the ordinary course of its business, exercises management rights with respect to one or more of the operating companies in which it invests (the “Actual Exercise Test”).
For purposes of the VCOC exception, the “initial valuation date” is the first date on which an entity makes an investment that is not a short-term investment of funds pending long-term commitment. An entity must qualify as a VCOC on its initial valuation date, or it can never qualify as a VCOC. Accordingly, the 50% Test must be satisfied on the initial valuation date. An “annual valuation period” is an annually recurring period of not more than 90 days that begins no later than the anniversary of an entity’s initial valuation date.
Real Estate Operating Company (“REOC”)
An entity will be deemed an REOC and, thus, not subject to the application of the Plan Asset Rules if:
- On such initial valuation date, or on any date within such annual valuation period, at least 50 percent of its assets, valued at cost (other than short-term investments pending long-term commitment or distribution to investors), are invested in real estate that is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities (“REOC 50% Test”); and
- During such 12-month period (or during the period beginning on the initial valuation date and ending on the last day of the first annual valuation period) such entity in the ordinary course of its business is engaged directly in real estate management or development activities (the “REOC Actual Exercise Test”).
The Plan Asset Regulations provide a few examples to better illustrate how the REOC rules would apply. For example, where a plan invests in a limited partnership that is engaged primarily in investing and reinvesting assets in equity positions in real property, such limited partnership would not qualify as a REOC if the properties acquired by the limited partnership are subject to long-term leases under which substantially all management and maintenance activities for the property are the responsibility of the lessee. Though, the limited partnership would qualify as a REOC (assuming it otherwise satisfies the 50% Test) if it owned several shopping centers in which individual stores are leased for relatively short periods to various merchants.
In sum, an IRA and a pension plan can invest in an operating company without triggering the Plan Asset Rules. In addition, if an IRA or pension plans can satisfy the VCOC or REOC rules, then the investment would not be deemed subject to the Plan Asset Rules. Note – the investment can still be subject to the IRS prohibited transaction rules.
Less than 25% Ownership
The “Plan Asset Rules” would not apply to plan investments in an entity or fund if equity participation by the IRA or pension plan investor is not “significant.” Equity participation by an IRA or pension plan is “significant” on any date if, immediately after the most recent acquisition of any equity interest in the entity, 25 percent or more of the value (in the aggregate) of any class of equity interests in the entity is held by “benefit plan investors.” The definition of “Benefit Plan Investors” includes IRAs, 401(k) plans, and pension plans. This is known as the 25% test. The 25% limit must be satisfied separately with respect to each class of equity issued by an entity or fund. The 25% Test must be satisfied on an ongoing basis. For example, the 25% Test could be failed in connection with a subsequent investment, transfer or redemption
What is at Stake for a Self-Directed IRA Investor?
If a Self-Directed IRA investment is deemed to trigger the Plan Asset Rules because the investment will not satisfy an exception to the “look-through” rules, all the fund’s activities would be subject to the prohibited transaction rules of IRC 4975. Among other things, transactions
with affiliates would be restricted.
However, it is important to remember that triggering the look-through rules and, thus, the IRS prohibited transaction rules on a particular investment does not mean the investment will be deemed prohibited. Triggering the Plan Asset Rules simply means that the IRS prohibited transaction rules could apply to the investment at hand.
For Self-Directed IRA investors, the IRS prohibited transaction rules are always under consideration so triggering the Plan Asset Rules is not a major deal for most IRA investors. However, for investment funds and investment managers, triggering the Plan Asset Rules has greater significance.
For example, if a pension plan invests in an entity whose assets are considered plan assets, the manager of the entity would be deemed a plan fiduciary to the extent it exercises any authority or control respecting management or sale of the entity’s assets or provides investment advice for a fee. Any manager that is considered a plan fiduciary would need to comply with ERISA’s prohibited transaction provisions.
In addition, for a fund manager that triggers the Plan Asset Rules, becoming subject to the ERISA fiduciary rules is extremely problematic. Plan fiduciaries are required to act “with the care, skill, prudence, and diligence under the situations then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character.” These duties must be discharged solely in the interest of the participants and beneficiaries of the plan.
Examples
Below are a number of examples that illustrate the broad application the Plan Asset Rules can have on Self-Directed IRA investors:
- Joe wants to use his Self-Directed IRA to invest 27% private equity fund in which he is a partner in the general partnership entity of the fund that receives management fees and the carried interest. Because Joe’s IRA will own 25% or more of the fund, the Plan Asset look-through rules will apply and can trigger the IRS prohibited transaction rules.
- Amy will be using her IRA to invest in a real estate fund that primarily invests in passive real estate investments. However, the fund will also be making several real estate investments in assets where Amy will be paid to manage the real estate properties. The fund will not satisfy the REOC rules since less than 50% of its assets are invested in active real estate activities. Hence, Amy’s receipt of compensation for her management services could trigger the Plan Asset look-through rules and thereby initiate the application of the IRS prohibited transaction rules.
- Gary is the manager of an investment fund that will be owned 30% by pension plans. The investment fund will be investing in exotic options and cryptos. Since the fund will be owned greater than 25% by pension plans and it will not satisfy any of the operating company exceptions, the pension plans and Gary will be subject to the Plan Asset Rules. In Gary’s case, he would be subject to ERISA fiduciary rules which could be problematic based on the nature of the fund’s investments.
- Mara is seeking to use her Self-Directed IRA to invest in a passive venture capital fund that does not get involved in any management activities of its investments. Mara is an executive at one of the investment companies and receives a salary from the business. Because the venture capital fund will not satisfy the VCOC definition, the investment could trigger the Plan Asset look-through rules and thereby initiate the application of the IRS prohibited transaction rules.
Conclusion
The Plan Asset Rules are generally a much greater headache for an investment fund manager working with IRA or pension plan clients and cannot satisfy the 25% or operating company exception to the Plan Asset Rules since triggering them would cause the manager to be subject to the ERISA fiduciary and prohibited transaction rules In the case of an individual Self-Directed IRA investor, the individual would already be required to address the IRS prohibited transaction rules so triggering the Plan Asset Rules would not be overly onerous. In sum, the Plan Asset Rules offer greater risks and complications to investment managers seeking pension plan investors due to the triggering of the ERISA fiduciary and prohibited transaction rules.
Solo 401(k) Paperwork - What You Need to Know
The amazing thing about technology is that you do not have handle any of the paperwork for your Solo 401(k) plan. IRA Financial has an app that, based off your answers of a few short questions, will customize a Solo 401(k) plan document for you. The business that adopts a 401(k) plan will work with a company, such as IRA Financial or Pension Investors, a third-party administrator (TPA), that will handle all the 401(k) paperwork. This article will explore the main documents associated with the creation of a Solo 401(k) plan.
The Basics
Most businesses establish 401(k) plans that are preapproved by the IRS which means that the IRS has blessed the plan documents and have provided an opinion letter. The TPA company is known as the document plan prototype provider. Generally, the plan documents may not be materially modified and are subject to amendments at least every six years.
When a business establishes a 401(k) plan, the business owner will generally be appointed as trustee of the plan. The trustee is responsible for making all plan decisions, including investment options. For many small businesses, the business will work with a TPA who will help administer the plan and handle all IRS annual administration, such as the filing of IRS Forms 1099-R and 5500.
Solo 401(k) Plan Documents
The following are the primary 401(k) plan documents.
Basic Plan Document
The basic plan document contains all of the non-elective provisions and rules governing the plan that are applicable to all adopting employers. It explains the terms and conditions under which the plan must operate in order to remain in compliance with regulatory requirements.
Adoption Agreement
The adoption agreement contains the elective provisions that are included in the basic plan document. These are the choices the employer makes about how the plan will operate in terms of eligibility requirements, vesting schedule, loan feature, contributions, allocations, and so on. The adoption agreement is not the complete plan document, as it generally indicates only the plan features that would be available to plan participants.
Essentially, the adoption agreement identifies which of the plan features included in the Basic Plan Document apply to the company plan. Most of the brokerage firms and banks will limit the plan options, whereas clients of IRA Financial will have an open architecture plan in which they can include any provision they want, such as investment choices, the ability to make Roth contributions, and gain access to the loan option.
Summary Plan Description (SPD)
A summary plan description (SPD) document is generally not required for a Solo 401(k) plan since the plan will typically only cover the owner and his or her spouse. Nevertheless, it is common practice to provide an SPD to each participant in a Solo 401(k) plan. The information must also be written in a way that the average plan participant can understand.
401(k) EIN
A 401(k) plan will generally acquire an EIN from the IRS that will allow the 401(k) to open a bank or brokerage account. Most 401(k) plans now have sub-accounts under the main plan account for each plan participant.
Not All 401(k) Documents Are the Same
For a business with employees, your TPA will work with you to help customize your 401(k) plan that best suits your business and retirement needs. Whereas in the case of a self-employed individual or a small business that has no full-time employees, using the right Solo 401(k) plan documents is crucial.
The most significant advantage of the IRA Financial Solo 401(k) plan versus one established at a bank or financial institution is "checkbook control." IRA Financial is a self-directed retirement provider and does not sell investments or offer investment advice. We are plan experts and focus on helping our clients manage and administer their plan. Hence, our Solo 401(k) plan documents are self-directed and open architecture allowing the plan participant to essentially make any investment they wish, including alternative assets such as real estate and precious metals.
On the other hand, with a "standard" plan, one is relegated to only making traditional investments such as stocks and mutual funds. In addition, the plan account is required to be opened at the bank or financial institution that provided the plan documents. With IRA Financial, the plan account can be opened at any local bank, including Capital One, Wells Fargo, and even Fidelity.
Plus, as we mentioned earlier, you can use the IRA Financial app to answer some basic questions to get the Solo 401(k) paperwork filled out correctly and promptly.
Safe Harbor 401(k) - The Best Small Business 401(k) Plan
Employers start a 401(k) plan for many reasons. A well-designed 401(k) plan can help attract and keep talented employees and allows participants to decide how much to contribute to their accounts. In addition, a 401(k) plan offers employers a tax deduction for employee contributions. This can also benefit a mix of rank-and-file employees and owners/managers.
- Every small business should have a retirement plan
- Safe Harbor 401(k) plans do not require plan testing
- Owners and highly compensated employees can maximize contributions easier
Any U.S. business can establish a 401(k) plan. The business can be a solo proprietorship, LLC, corporation, partnership, or any other legal entity. The biggest advantage of saving through a 401(k) plan is that contributions are elective and can create a tax deduction. In addition, all income and gains from plan assets grow without tax. This is known as tax-deferral (or tax-free growth in the case of a Roth 401(k) plan contribution).
The Most Common 401(k) Plans
Safe Harbor
Safe Harbor 401(k) Plans are very popular with business owners and plan participants alike.
A Safe Harbor 401(k) is a way to structure a plan that automatically passes the complex ERISA non-discrimination test, which could limit the amount the owners and highly compensated employees can contribute to the plan. A safe harbor plan essentially requires the employer must make contributions to each employee's plan -- the same percentage of salary for everyone. However, it allows the business owner(s) and highly compensated employees to max out their plan contributions.
Advantage: Provides a guarantee to the business owner(s) or highly compensated employees that they will be able to max out their plan contributions. Plus, safe harbor contributions are tax-deductible.
Disadvantage: Must provide at least a three percent safe harbor contribution annually based on the employee’s salary.
Traditional 401(k) Plan
A 401(k) plan that is not covered by the safe harbor rules will need to comply with a number of complex ERISA tests in order to allow the business owner(s) and highly compensated employees to max out their contributions. In a traditional 401(k) plan, the business owner(s) have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both.
Advantage: Not required to make safe harbor contributions of at least three percent of each eligible employees' salary.
Disadvantage: Subject to complex plan testing and does not provide the business owner(s) or highly compensated employees with the guarantee that they will be able to max out their contributions.
Profit Sharing Plan
Retirement benefits are based on the amount in the participant’s individual account balance at retirement. The account balance depends on contributions made and earnings credited through the years. The maximum employer profit sharing contribution is 25% of compensation or 20% if self-employed or single member LLC.
Advantage: Simple to operate and employer has control over contributions.
Disadvantage: No employee deferrals and limits contributions to a percentage of compensation. Also – profit sharing contributions must be made to all eligible employees.
The Safe Harbor 401(k) Plan – Most Popular Choice for Small Business Owners
Safe Harbor 401(k) Plans are very popular with business owners and plan participants alike. The Safe Harbor 401(k) provisions have some very big benefits, with a few drawbacks.
Beginning in 1999, the Safe Harbor rules were designed to make 401(k) plans more popular with small business owners. If the rules are followed, a Safe Harbor 401(k) Plan is allowed a free pass on the Actual Deferral Percentage (ADP) test, the Actual Contribution Percentage (ACP) test and the Top Heavy minimum contributions.
A Safe Harbor 401(k) is a way to structure a plan that automatically passes the non-discrimination test or avoid it altogether. This test could limit the amount the owners or highly compensated employees can contribute to the plan. Under a safe harbor plan, one can match each eligible employees contribution, dollar for dollar, up to three percent of the employees compensation. Plus, 50 cents on the dollar for the employee's contribution that exceeds three percent, but not five percent. Alternatively, one can make a non-elective contribution equal to three percent of compensation to each eligible employees' account.
The main advantage of an employer using a Safe Harbor 401(k) Plan is that the business owner can gain the right to make maximum employee deferrals without having to satisfy the complex ADP & ACP ERISA plan tests. The downside is that the employer will likely be required to have at least a minimum three percent tax deductible contribution to all eligible employees, based on their compensation.
Safe Harbor & Alternative Assets
The plan documents determine whether a plan participant is permitted to invest plan funds in alternative assets, such as real estate. The majority of all 401(k) plans do not allow their plan participants to invest in alternative assets. The main reason behind this is the business owner is typically acting as the plan trustee and does not want to be involved in the facilitation or approval of an employee’s investment. It is a lot easier to have a registered financial advisor select the plan investments and assist the employees with investment decisions. However, there are a growing number of small businesses that will allow their employees to have alternative asset investment options.
IRA Financial is one of the few 401(k) plan providers in the country that has the expertise and experience to allow clients to invest their 401(k) plan assets in traditional investments, such as mutual funds and ETFs, but also alternative assets, such as real estate or private investment funds.
Safe Harbor & ROBS
The Rollover Business Start-Up Solution (ROBS) is the only legal way one can use his or her retirement funds to start a business they will be personally involved with. As part of the ROBS solution, the business must be operated though a C Corporation and a 401(k) plan must be used to fund the C Corporation by the purchase of corporate stock or qualifying employer securities. Accordingly, in order to establish a ROBS solution, the C Corporation will need to have adopted a 401(k) plan.
The Safe Harbor 401(k) plan is the most popular 401(k) plan established by ROBS investors. Why? Because it is easy to operate and administer, and allows the business owner to max out their plan contributions without having to worry about failing the very complex ERISA plan tests. By establishing a Safe Harbor 401(k) plan, the business owner can save for retirement, generate tax deductions, as well as help attract and keep talented employees.
Get in Touch
To learn more about the benefits of establishing a Safe Harbor 401(k) plan, please contact one of our 401(k) plan specialists at 800-472-0646. Be sure to check out our YouTube page for tons of videos about retirement planning and investing!
Use a Solo 401(k) to Buy Cryptocurrency
If you are self-employed, you can use the Solo 401(k) to buy cryptocurrency. The Solo 401(k) is a unique retirement plan designed for self-employed individuals and small business owners. Individuals who do not meet the eligibility to open a Solo 401(k) can still use a Self-Directed IRA to buy Cryptocurrency.
What is Cryptocurrency?
For a growing number of investors, cryptocurrency is not only the future of money, it's an attractive and potentially profitable investment asset. Bitcoin has become the public’s most visible and popular cryptocurrency and it's among the oldest. (It first emerged in 2009). Over one year, the market capitalization for Bitcoin has increased enormously.
Like Bitcoin, Ethereum has also made substantial gains and hit record highs. The growing popularity and rising prices of Cryptocurrency has led many individuals to explore using retirement funds to invest in Cryptocurrency.
The process of buying cryptocurrency is still somewhat unclear for a lot of people. It's not a stock or a traditional investment. For most people in the U.S., an exchange, such as Bitstamp, may be the easiest option to buy cryptocurrency. This includes the most popular:
After verifying the account, you can add a number of payment methods. This includes credit or debit cards, U.S. bank accounts, or transfer wire funds.
Cryptocurrency transactions are not anonymous and it's easy to identify the currency to a real-world identity.
Read More: Solo 401(k) Investments
Mining
Bitcoin comes from the process of "mining." Essentially, this uses your computer's processing power to solve complex algorithms called "blocks." You can buy and sell Bitcoin on an exchange, much like a physical currency exchange. This converts wealth from Bitcoin to U.S. dollars and other national currencies, back to dollars or Bitcoin. And that's how you make money.
Tax-Treatment for Cryptocurrency with Non-Retirement Funds
Many people label Bitcoin as a “cryptocurrency." However, from a federal income tax standpoint, Bitcoins and other cryptocurrency are not truly “currency.” On March 25, 2014, the IRS issued Notice 2014-21. For the first time the IRS set forth a position on the taxation of virtual currencies, such as Bitcoins.
According to the IRS Notice, "Virtual currency is treated as property for U.S. federal tax purposes." The Notice further stated, "General tax principles that apply to property transactions apply to transactions using virtual currency."
Essentially, the IRS treats the income or gains from the sale of a virtual currency (such as Bitcoins) as a capital asset. This makes virtual currency subject to short-term (ordinary income tax rates). And if held greater than 12 months, long term capital gains tax rates. (15% or 20% tax rates based on income).
By treating bitcoins and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules - and significant taxes - on its use.
Related: Solo 401(k) Loan
Benefits of a Self-Directed Solo 401(k) for Cryptocurrency
The Internal Revenue Code does not describe what a retirement plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain types of transactions. This includes the purchase of collectibles, life insurance (in the case of an IRA), as well as any transaction that directly or indirectly benefits a disqualified person.
Read More: Solo 401(k) Eligibility
Disqualified Persons
The definition of a “disqualified person” extends into a variety of scenarios. However, it generally includes the Solo 401(k) Plan participant and his/her lineal descendants. This includes parents, children, spouse and daughter/son-in-law. It also includes any entities in which the plan participant or a disqualified person has a controlling equity or management interest.
Bitcoin and the Prohibited Transaction Rules
Cryptocurrency does not generally fall into any category of prohibited transactions. Therefore, it is an allowable investment for a Solo 401(k) plan.
The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors. Usually, when a retirement account generates income or gains from the purchase/sale of a capital asset, the retirement account doesn't pay tax on the transaction.
Taxes are deferred to the future when the retirement account holder taxes a distribution. Therefore, when you use retirement funds to invest in cryptocurrencies, such as Bitcoin, the investor can defer or eliminate (in the case of a Roth) any tax due from the investment.
Note: Retirement account investors who have interest in mining Bitcoin versus trading may become subject to the Unrelated Business Taxable Income tax rules. This is if the "mining" constitutes a trade or business.
The IRA Financial Cold Wallet Crypto Solo 401(k) Plan Solution
The IRA Financial cold wallet crypto Solo 401(k) plan solution will allow a Solo 401(k) plan trustee to hold 401(k) plan-owned cryptos off the exchange and in a cold wallet.
Who Can Setup a Solo 401(k) Plan?
A Solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. In general, to be eligible to establish a Solo 401(K) plan, one must be self-employed or have a small business with no full-time employees (over 1000 hours during the year) other than a spouse or other owner(s).
How Does the Solo 401(k) Crypto Wallet Solution Work?
The IRA Financial Solo 401(k) cold wallet crypto solution will allow a plan participant to purchase cryptos using 401(k) funds and then hold the cryptos in a cold wallet off the exchange. The reason that a Solo 401(k) plan trustee can hold cryptos off in an exchange in a cold wallet and not an IRA relates to the nature of the role of a 401(k)-plan trustee.
In the case of an IRA, the IRA custodian is the trustee of the IRA and is required to custody IRA assets. Whereas, regarding a Solo 401(k) plan, the trustee of the plan is required to hold plan assets in trust on behalf of the plan participant. The trustee of a 401(K) plan may be an individual. Below is an excerpt from the IRA Financial 401(k) plan document which has been approved by the IRS:
Powers of the Trustee
The Trustee will have the power, but, in the absence of proper direction from the Plan Administrator, not the duty, to take any action set forth below:
- purchase or subscribe for securities or other property and to retain them in trust; to sell any such property at any time held by it for cash or other consideration at such time or times and on such terms and conditions as may be deemed appropriate.
Therefore, based on the IRS-approved 401(k) plan documents, a Solo 401(k) plan trustee can hold 401(k) owned property, such as cryptos, and “retain them in trust.” Whereas, using a self-directed IRA would not offer the IRA owner the same right since the IRA rules require the custodian or trustee to retain full control over the assets. Hence, the IRA Financial Solo 401(k) plan cold wallet crypto solution would allow one to have 401(k) plan-owned cryptos moved off-exchange and held “in trust” by the trustee of the plan. The Solo 401(k) plan solution would seemingly not violate the McNulty ruling, since McNulty only addressed the personal possession of an IRA-owned asset, which involves different rules than what would apply to the possession plan assets by a 401(k) plan trustee.
How to Use a Self-Directed Solo 401(k) Plan to Buy Cryptocurrency
When you work with IRA Financial Group to purchase cryptocurrency, like Bitcoin, the process is simple with a Bitcoin 401(k) (Solo 401k Plan for Bitcoin investments).
1. Confirm Eligibility
Confirm you are eligible to establish a Crypto 401(k). Essentially, this is a Solo 401(k) plan to buy cryptocurrency, like Bitcoin. You must be self-employed or have a small business with no full-time employees other than the owner(s) or owner(s) spouse(s).
2. Establish Account
Work with IRA Financial Group to establish an IRS approved Self-Directed Solo 401(k).
3. Open a Bank Account
Next, open a bank account for the Self-Directed Solo 401(k) plan at a local bank or financial institution, such as Fidelity or Schwab. IRA Financial has relationships with most of the popular banks and financial institutions, so opening a bank account will be quick and easy.
4. Rollover Funds
Rollover of retirement funds, cash or in-kind, tax-free to the new self-directed Solo 401(k) account. Note – a Roth IRA cannot roll into a Solo 401(k) plan.
Learn More: How to Complete a Solo 401(k) Rollover
5. Gain Checkbook Control
Because you're trustee of the Solo 401(k) plan, you have checkbook control over all assets/funds in the plan to make cryptocurrency investments.
6. Earn Tax-free Gains
Since a 401(k) plan is exempt from tax pursuant to Internal Revenue Code Section 401, all income and gains from the cryptocurrency investment will flow back to the 401(k) plan without tax.
*If you are not eligible for a Solo 401(k) you may still be eligible for a SEP IRA.
Be Cautious with Your Crypto 401(k)
Cryptocurrency investments, such as Bitcoins, are risky and highly volatile. Any investor who has an interest in learning more about Bitcoins should do their diligence and proceed with caution.
The IRA Financial Group will take care of the entire set-up of your Self-Directed Solo 401(k) Bitcoin plan. We can handle the process by phone, email, fax, or mail. It typically takes between 4-10 days to complete, but the timing is largely dependent on the custodian holding your retirement funds.
Our Self-Directed 401(k) experts and tax and ERISA attorneys are on site and can significantly reduce set-up time and cost. More importantly, each client of the IRA Financial Group receives a tax professional. This will further help you establish an IRS approved self-directed Solo 401k plan structure.
Note:
It doesn't matter what platform you choose to invest your retirement funds in cryptocurrencies. The important element is to understand the financial risks with such an investment. Cryptocurrency is still extremely risky and volatile. Investors must have the financial ability to bear the risks of a cryptocurrency investment, and the potential total loss of that investment.
Any Bitcoin 401(k) investor interested in using retirement funds to invest in cryptocurrencies should do their diligence, learn about virtual currency and its blockchain technology, and proceed with caution.
Get in Touch
Do you have questions about using your Solo 401(k) for Bitcoin and/or other cryptocurrency? You can contact IRA Financial Group at 800-472-0646. Or speak with an on-site 401(k) specialist to answer your questions.
Did you know?
Because the IRS treats cryptocurrency, including Bitcoin and Ethereum, as property for income tax purposes, you can buy virtual currency (cryptocurrency) with your Solo 401(k). Opening a self-directed retirement account allows you to invest in a wide range of alternative assets including gold, real estate, private businesses, and more.
Options for Reducing California Franchise Fee for a Self-Directed IRA LLC
One of the most common questions for any potential Self-Directed IRA LLC investor who is a resident of the state of California, or is seeking to invest in the state, is how can they avoid the minimum California annual corporate franchise fee of $800. This article will examine how the California franchise fee impacts the Self-Directed IRA LLC solution and some of the solutions for minimizing its impact on investors.
- Virtually every state requires an annual fee for an LLC
- California's annual franchise fee is a whopping $800
- There are options for Self-Directed IRA investors looking to eliminate the fee
What is a Self-Directed IRA LLC?
There are two types of Self-Directed IRAs: (i) full-service IRA and (ii) Checkbook Control IRA LLC.
With a full-service Self-Directed IRA, a special IRA custodian will serve as the custodian of the IRA that will allow the IRA to invest in alternative assets, such as real estate. The IRA funds are generally held with the IRA custodian and at the IRA owner’s sole direction, the custodian will make the investment. Since an IRA is tax-exempt, in general, all income and gains will flow back to the IRA without tax.
Whereas, with a Self-Directed IRA LLC with “checkbook control,” a limited liability company (LLC) is created, funded, and owned by the IRA and managed by the IRA owner. The LLC can be owned by one or more IRAs. It offers the IRA owner limited liability protection and allows one to act quickly when the right investment opportunity presents itself cost effectively and without delay. Since an LLC is taxed as a pass-through entity, all LLC income will flow back to the IRA without tax.
LLC State Formation Rules
All 50 states have LLC statutes and recognize the LLC entity. Every state imposes a fee to set up an LLC, however, the annual LLC state fees vary by state. Some states, such as Missouri, do not have an annual state filing fee; the majority of states impose an annual LLC fee of between $50-$150. Although, Massachusetts has an annual LLC fee of $500. However, California has the highest annual LLC filing fees because of its franchise fee.
California LLC Annual Fee/Franchise Fees
A California LLC must file a Biennial Report on Form LLC-E012R. The Biennial Report may be filed five (5) months prior to the filing month. The report is due by the end of the filing month. California LLC's and foreign California LLC's registered to do business in California are required to file an Initial Report (California Statement of information) within 90 days of the date the LLC was formed. Typically, you will receive the Initial Report mailed back to you with your completed file stamped "filing."
Every LLC that is doing business or organized in California must pay an annual tax of $800. In addition to the minimum franchise fee, LLCs are subject to a gross receipts-based annual fee, regardless of their federal entity classification. The fee is based on a graduated scale and ranges from $900 for LLCs with receipts from California between $250,000 and $500,000 to $11,790 for LLCs with California receipts more than $5 million.
This yearly tax will be due even if the LLC is passive and not actually conducting business. The LLC manager will have until the 15th day of the 4th month from the date the LLC was filed with the Secretary of State to pay the first-year annual tax. The subsequent annual tax payments will continue to be due on the 15th day of the 4th month of the taxable year.
California Annual Franchise Fees & The IRA LLC
As the most populous state, California is obviously a very popular state from an investment perspective. Hence, many investors will look to investment opportunities in California, such a real estate or otherwise. With the emergence of the IRA LLC as a popular investment structure for investors, finding a way to limit the application of the California LLC annual franchise fee of $800 becomes paramount. Since the fee is far and away the largest annual LLC fee in the country, and the fact that the state of California is super aggressive in protecting its state tax base, finding solutions to minimize the annual California LLC franchise fees has become a popular topic.
California State Franchise Tax in a Nutshell
In general, for an LLC to be subject to taxation in the state, the LLC must have a nexus or connection to the state. For most LLC’s that is as simple as having an office or employee in the state. However, in the case of a passive investment LLC, most states will only deem the LLC to have a nexus to the state if the LLC owns or leases real estate. Most states will not deem an LLC to have a connection to the state if its only link is a passive investment into a business in the state or via a loan to a resident of the state. Then there is the case of California.
The state of California is by far the most aggressive state when it comes to claiming an LLC has nexus to the state. For example, California takes the position as long as an LLC has a California resident as manager of the LLC, even if the LLC is formed in a different state and is not doing business in California, the state of California takes the position that the LLC has nexus to the state and is subject to the California LLC franchise fee. For example, in the case of a Self-Directed IRA LLC where the IRA is the sole owner of the LLC, if the manager of the LLC is a California resident (the IRA owner), even if the LLC is formed in a different state and is not doing any investments in California, simply because the manager is a California resident, the LLC would be subject to the California annual franchise fee.
Reducing the Franchise Tax
The following are the most common solutions for eliminating or reducing the impact of the annual California minimum franchise fee
Full-Service Self-Directed IRA
Using a full-service Self-Directed IRA, as described above, would allow one to make investments in California without being subject to the annual franchise fee. Of course, the full-service option would not provide the IRA owner with limited liability protection.
One of the other downsides is that the IRA investment will be in the name of the IRA. For example, title to an IRA investment into an investment fund or real estate would be as follows: IRA Financial Trust Custodian of the John Doe IRA. Whereas if the IRA owner used an LLC to make the investment, title of the investment would be in the name of the LLC and not the IRA. Some investors wish for the anonymity the LLC provides.
Lastly, since you do not have checkbook control, you must go through your custodian for all IRA-related transactions.
Related: California Self-Directed IRA
The Solo 401(k) Plan
The Solo 401(k) plan has become known as the most popular retirement plan for the self-employed or small business owner with no full-time employees. The plan can be adopted by a sole proprietor or any type of business entity. The trustee of the plan is typically the business owner.
A Solo 401(k) plan can be established with “self-directed” features, such as a Self-Directed IRA, giving you the opportunity to invest in alternative assets, such as real estate. In addition, it has high annual contribution limits, the $50,000 tax-free loan option, powerful Roth options, and strong asset and creditor protection.
For a resident of California, establishing a Solo 401(k) plan would allow the individual to invest in alternative assets in the state of California without being subject to the annual California franchise fee. Of course, you must meet the eligibility requirements to consider this option.
Revocable Grantor Trust
There is a belief by some that establishing a trust instead of an LLC will solve all state California problems for IRA LLC investors. Unfortunately, that is not the case. A California trust should technically not be subject to the annual California franchise fee, however, the State of California will impose a state tax on grantor revocable trusts that operate in the state. A trust is subject to tax in California “if the fiduciary or beneficiary – the trustee of the trust - (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor.” See Cal. Rev. & Tax 1774(a).
Hence, even if the IRA would be the grantor settlor of the trust, the trustee, as the trust fiduciary, would likely have to file a California state tax return and could even be subject to California state tax. The bottom line is that trust tax rules are very complex and vary by state. Hence, a trust in Florida will operate under different rules than a trust from Iowa or California.
Conclusion
California is one of the most beautiful states but also one of the most expensive to live in. The saying goes you get what you pay for. However, in the case of a Self-Directed IRA LLC, which is tax-exempt, being subject to an annual $800 franchise fee becomes a financial headache. For some investors who wish to have an LLC, the $800 California minimum franchise fee is a cost of doing business and something they will put up with.
However, for other IRA investors, the full-service option is a viable solution to eliminating the franchise fee. If you are self-employed, not only is the Solo 401(k) a great retirement plan, but it will also help eliminate the annual fee. The trust solution could be an option for reducing the impact of the $800 fee, but remember that state trust rules are complex and could trigger additional state tax and filing requirements.
What Is the 4% Rule for Retirement?
Planning for retirement can be daunting. Questions about how much to save, when to start withdrawing, and how to ensure your money lasts throughout your retirement years can leave anyone feeling overwhelmed. One concept that frequently arises in retirement planning is the 4% rule - a straightforward guideline designed to help retirees sustainably withdraw money from their savings.
But what exactly is the 4% rule, and how can it be applied to your financial plans? In this article, we’ll explore everything you need to know about this rule, its origins, benefits, limitations, and how to adapt it to your unique situation.
Understanding the 4% Rule
The 4% rule is a financial guideline suggesting that retirees can withdraw 4% of their total retirement savings in the first year of retirement, then adjust that amount annually for inflation. This strategy aims to provide a steady income stream while preserving the principal balance over a 30-year retirement period.
For example, if you have $1 million in retirement savings, the 4% rule suggests you could withdraw $40,000 in your first year of retirement. In subsequent years, you would adjust that amount based on the rate of inflation to maintain your purchasing power.
The Origins of the 4% Rule
The 4% rule was first introduced in 1994 by financial planner William Bengen, who conducted a study to determine a sustainable withdrawal rate for retirees. Using historical data on stock and bond performance, Bengen analyzed various portfolio withdrawal strategies over 30-year periods. He concluded that a 4% withdrawal rate, coupled with a balanced portfolio of stocks and bonds, provided retirees with a high probability of not running out of money.
His research assumed a portfolio with 50-60% invested in stocks and the remainder in bonds—a mix designed to balance growth potential with stability. Bengen’s work laid the foundation for how many financial planners approach retirement income strategies today.
How the 4% Rule Works
The 4% rule relies on several key principles:
- Initial Withdrawal Rate
In the first year of retirement, you withdraw 4% of your total portfolio value. This is your baseline withdrawal amount. - Annual Adjustments for Inflation
Each year, you increase the withdrawal amount based on the inflation rate. For instance, if inflation is 2% in a given year, you would increase your previous withdrawal by 2%. - Balanced Portfolio
The rule assumes a diversified portfolio with a mix of stocks and bonds. This balance aims to mitigate risks while allowing for moderate growth to sustain withdrawals. - 30-Year Timeline
The 4% rule is designed to last for 30 years, making it ideal for those who retire in their mid-60s and expect to live into their 90s.
Benefits of the 4% Rule
The simplicity and reliability of the 4% rule have made it a popular choice among retirees. Here are its primary benefits:
- Easy to Implement
Unlike complex financial strategies, the 4% rule is straightforward. Retirees don’t need extensive financial knowledge to apply it. - Predictable Income
By providing a consistent withdrawal strategy, the 4% rule offers retirees a sense of financial stability. - Reduces Risk of Running Out of Money
Historical data suggests that following the 4% rule gives retirees a high probability of preserving their savings over a 30-year period. - Adaptable Framework
While the 4% rule provides a starting point, retirees can adjust their withdrawal rates based on personal needs, investment performance, or changes in expenses.
Limitations of the 4% Rule
Despite its advantages, the 4% rule isn’t without its drawbacks. Here are some potential limitations to consider:
- Inflation Variability
The rule assumes a steady rate of inflation, but real-world inflation rates can fluctuate significantly, impacting purchasing power. - Market Volatility
The 4% rule relies on historical stock and bond performance, but future market conditions may differ. A prolonged bear market or economic downturn could deplete savings faster than expected. - Longevity Risk
With people living longer, a 30-year retirement horizon may not be sufficient for everyone. Those who live into their late 90s or beyond may outlast their savings. - Rigid Assumptions
The rule assumes consistent withdrawals and portfolio allocations, but real-life expenses and investment returns often vary. - One-Size-Fits-All Approach
The 4% rule doesn’t account for individual circumstances such as healthcare costs, lifestyle choices, or varying income needs.
Is the 4% Rule Right for You?
While the 4% rule can serve as a helpful starting point, it’s essential to assess whether it aligns with your specific retirement goals and financial situation. Here are some factors to consider:
- Your Risk Tolerance
If you’re uncomfortable with market fluctuations, you may prefer a more conservative withdrawal strategy or portfolio allocation. - Your Expected Lifespan
If you anticipate a longer-than-average retirement, consider a lower withdrawal rate to reduce the risk of depleting your savings. - Healthcare Costs
Rising healthcare expenses can significantly impact retirement budgets. Factor in potential medical costs when determining your withdrawal strategy. - Other Sources of Income
Social Security, pensions, or rental income can supplement your withdrawals, reducing reliance on the 4% rule. - Economic Conditions
During periods of market downturns, you may need to adjust withdrawals or reconsider your allocation strategy.
Alternatives to the 4% Rule
If the 4% rule doesn’t fit your retirement planning needs, consider these alternatives:
- Dynamic Withdrawal Strategies
Adjust your withdrawals based on market performance. For example, withdraw less during market downturns and more during prosperous periods. - Bucket Strategy
Divide your savings into “buckets” for different time horizons, such as short-term, medium-term, and long-term needs. This approach allows for greater flexibility. - Annuities
Consider purchasing an annuity to guarantee a steady income stream for life. While this may reduce flexibility, it can provide peace of mind. - Hybrid Approaches
Combine the 4% rule with other strategies, such as dynamic withdrawals or part-time work, to create a more tailored plan.
Tips for Maximizing Retirement Success
To ensure a financially secure retirement, consider these tips:
- Start Saving Early
The earlier you start saving and investing, the more time your money has to grow. - Diversify Your Portfolio
A well-diversified portfolio can help mitigate risks and optimize returns. - Monitor Your Spending
Regularly review your expenses to identify areas where you can cut back if necessary. - Seek Professional Advice
A financial advisor can help you develop a personalized retirement plan that aligns with your goals. - Stay Flexible
Be prepared to adjust your strategy as circumstances change, whether due to market conditions or personal needs.
Final Thoughts: The 4% Rule as a Starting Point
The 4% rule is a time-tested guideline that has helped countless retirees plan for their financial futures. While it provides a solid foundation, it’s not a one-size-fits-all solution. By understanding its principles, benefits, and limitations, you can make informed decisions about your retirement strategy.
Remember, retirement planning is a deeply personal process. Tailor your approach to reflect your goals, lifestyle, and financial situation. Whether you choose to follow the 4% rule, adapt it, or explore alternative strategies, the key is to remain proactive and informed. With careful planning and a commitment to financial discipline, you can enjoy a secure and fulfilling retirement.
Using a Gift to Fund an IRA
For many grandparents or parents seeking to help family members pay for college, buy a home, or just have extra money for retirement, gifting funds to an IRA or Roth IRA can make a great deal of tax sense. When one invests funds in an IRA, the income and gains are not subject to tax. Whereas, if one invests funds outside of an IRA, those earnings are subject to tax right away. For this reason alone, gifting funds to a family member to contribute to an IRA is the smartest way to boost ones savings.
- Gifting funds to a family member generally do not have tax implications
- You can help a loved one fund his or her IRA
- You can gift up to $17,000 without it affecting your basic exclusion amount
Tax Implications of a Gift
The general rule is that any gift is a taxable gift, however, there are many exceptions. Generally, the following gifts are not taxable gifts:
- Gifts that are not more than the annual exclusion for the calendar year.
- Tuition or medical expenses you pay for someone (the educational and medical exclusions).
- Gifts to your spouse.
- Gifts to a political organization for its use.
In addition to this, gifts to qualifying charities are deductible from the value of the gift(s) made.
Making a gift does not ordinarily affect your federal income tax. The annual exclusion applies to gifts to each individual. In other words, if you give each of your children $17,000 in 2023, the annual exclusion applies to each gift. Each spouse is entitled to the annual exclusion amount on the gift.
In sum, in 2023, an individual can gift up to $17,000 to a family member ($34,000 if married) without impacting their lifetime unified credit or basic exclusion amount (BEA).
How Does the Gift Tax Work?
The individual making the gift is generally responsible for paying the gift tax. The tax reform law doubled the BEA for tax-years 2018 through 2025. Because the BEA is adjusted annually for inflation, the 2023 BEA is $12,920,000. In 2026, the BEA is due to revert to its pre-2018 level of $5 million, as adjusted for inflation. Hence, so long as you will be gifting under $17,000 for 2023, the gift will not impact your lifetime BEA amount. Any gift above the $17,000 limit, will reduce that amount.
The Gift Tax & Your IRA
Because the 2023 maximum annual IRA contribution limit is $6,500 or $7,500 if you are least age 50, one can gift up to $17,000 to multiple family members to help fund an IRA. The donor should gift the funds directly to the family member or friend and then that individual can make the IRA contribution into the IRA from the funds gifted. The IRA owner could then decide if the funds will be used to fund a traditional IRA or a Roth IRA.
The one caveat is you need to have earned income, or a spouse that does. Only earned income is considered when determining how much you can contribute to an IRA. For example, if you only work a temporary job during the year and earn $2,000, that's the maximum amount you can contribute to an IRA, no matter how much the gift was for.
Conclusion
The tax rules are very flexible giving the one the ability to gift funds to another individual without impacting his or her lifetime BEA. One can always gift more than the $17,000 in a year, but it would reduce their BEA amount. However, helping a family member save in a tax-advantaged retirement account may be worth it for some. Help them save for the future and take full advantage of the power of compounding returns and tax deferral. Additionally, you can make the gift during any year(s) you wish.
Can I be an Officer of a Company my IRA will Invest In?
One of the most misunderstood facets about the IRS prohibited transaction rules involves using a Self-Directed IRA to invest in a business where one is an officer or highly compensated employee. This article will detail how the IRS prohibited transaction rules under Internal Revenue Code (IRC) Section 4975 work involving a retirement account investment into an entity where the retirement account owner is an officer or executive.
- The prohibited transaction rules determine whether an investment is allowed within a retirement plan
- Just because your are an officer of a company, does not automatically mean your IRA cannot invest in it
- Many factors determine whether or not an investment is prohibited
What are the IRS Prohibited Transaction Rules?
Ever since IRAs were created in 1974 by ERISA, the IRC does not describe what a retirement account can invest in, only what it cannot invest in. Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain types of transactions. In general, as long as the Self-Directed IRA does not purchase life insurance, collectibles, or engage in a prohibited transaction outlined in 4975, the investment can be made.
Who is a “Disqualified Person”
To trigger the IRS prohibited transaction rules, one must involve his or her retirement account into a transaction with a “disqualified person.”
As per IRC Section 4975(e)(2):
For purposes of this section, the term “disqualified person” means a person who is—
- (A) a fiduciary;
- (B) a person providing services to the plan;
- (C) an employer any of whose employees are covered by the plan;
- (D) an employee organization any of whose members are covered by the plan;
- (E) an owner, direct or indirect, of 50 percent or more of—
- (i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
- (ii) the capital interest or the profits interest of a partnership, or
- (iii) the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);
- (F) a member of the family (as defined in paragraph (6)) of any individual described in subparagraph (A), (B), (C), or (E);
- (G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of—
- (i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
- (ii) the capital interest or profits interest of such partnership, or
- (iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E);
- (H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or
- (I) a 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (C), (D), (E), or (G).
In sum, the definition of a disqualified person 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.
Officer, Director, Executive, or 10% or More Shareholder
In most cases, the determination of whether an individual or entity will be treated as a disqualified person is quite obvious. For example, a lineal descendant or an entity 50% or more owned or controlled by a disqualified person will be deemed disqualified. For some reason, when it comes to analyzing transactions involving a company officer, director, highly compensated employer or 10% or more shareholder of an entity, the prohibited transaction analysis seems unclear. However, the analysis is actually quite simple.
If you refer to Sections H & I above, the Code does not suggest that an officer, director, highly compensated employee, or a 10% or more shareholder makes the entity a disqualified person. What is does state is that only where an entity is deemed a disqualified person, meaning it is owned or controlled 50% or more by disqualified persons, will an officer, etc. be deemed a disqualified person.
Below are two examples that best demonstrate the application of IRC Code Sections 4975(e)(2)(h) & (i):
Example 1: Ken owns 60% of ABC Inc. Lori is an officer of ABC Inc. Lori needs money for a new home and asks Ken for a loan. If Ken used his IRA to lend money to Lori, the transaction would likely violate the IRC prohibited transaction rules. Ken owns 50% or more of ABC Inc., and Lori is an officer of the company making Ken and Lori disqualified persons and prevent them from transacting using a retirement account
Example 2: Ken owns 46% of ABC Inc. Lori is an officer of ABC Inc. Lori needs money for a new home and asks Ken for a loan. Ken would be able to use his IRA to lend funds to Lori because Ken did not own more than 50% of ABC Inc.; Ken and Lori will not be treated as “disqualified persons to each other.”
Conclusion
The IRC prohibited transaction rules are not as complicated as some make them out to be. Just because one is an officer at a company doesn't automatically preclude that person from using his or her Self-Directed IRA to invest in the business. However, other factors may deem the business a disqualified person under the rules listed in this article. If that's the case, it would indeed be a prohibited transaction and the IRA would not be able to invest in the business.
Obviously, you need to check the specifics before making the investment. You don't want to make the investment if it could be a prohibited transaction, which would have a negative impact on your tax-advantaged IRA. Don't be afraid to make an investment just because you think it may be prohibited. Do you homework to determine if it is, and then proceed accordingly.