“Error is the portal of discovery.” ~ James Joyce
There is no doubt that mistakes are the true precursors of great discoveries, and making mistakes shows that you are working hard to improve your life. However, some errors are more expensive than others. For example, launching a product does not get the attention it deserves, which will increase your learning experience, but financial errors can lead to severe penalties and waste your financial resources, which is an expensive job.
One of the so expensive mistakes in the financial life of Solo 401k retirement plan owners is to participate in prohibited transactions. Our main clients include small business owners and self-employed professionals, and we carry out events to discuss the responsibilities of plan owners and the latest regulations. Our team decided to study some of the most common mistakes made by Solo 401k retirement plan owners.
What are the prohibited transactions in the Solo 401k retirement plan?
For the Solo 401k retirement plan, no regulatory documents (including the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code (IRC)) define eligible transactions for the plan. Instead, they discuss who or what is prohibited from investing, and these transactions are called prohibited transactions in the Solo 401k plan.
One of the common characteristics of prohibited transactions is the participation of disqualified persons. Simply put, the disqualified person is the owner or service provider of the Solo 401k plan, or beneficiary, or certain family members of these groups. The key reason behind the description of prohibited transactions is to ensure that the retirement tool is not used for the personal benefit of the plan owner.
Sell, lease or exchange property to a disqualified person
4975(c)(1)(A): Sell, trade or lease property directly or indirectly between the Solo 401k plan and the “disqualified person”.
The IRS allows you to invest in real estate, but it is important that these transactions must be traded fairly, which means that the plan owner or anyone else who is disqualified should not receive personal benefits from the plan. Let us look at some examples of prohibited transactions.
Nathan used his Solo 401k fund to buy his father’s property.
Amanda sells her own property to her Solo 401k plan.
Mark leased the property owned by his Solo 401k plan to his son.
Joe uses his personal funds to pay the transaction costs involved in the Solo 401k real estate investment.
Each of these examples has the participation of unqualified people, including the plan owner or his immediate descendants or ancestors. The Internal Revenue Service prohibits any such transactions that directly or indirectly involve unqualified persons.
Loan or credit to a disqualified person
4975(c)(1)(B): Borrowing money or other credit extensions directly or indirectly between the Solo 401k plan and the “disqualified person”.
According to the guidelines of the Internal Taxation Law, the Solo 401k plan that borrows money or any form of credit from unqualified persons is considered a prohibited transaction. Some examples of such transactions are listed below.
Judy provides personal guarantees for mortgage loans for residential properties in his Solo 401k plan.
Martha borrowed $30,000 from her husband from her Solo 401k plan.
Mitchell obtained a credit card for his Solo 401k bank account.
Jason provides loans to a limited liability company controlled and owned by his father.
Exchange goods, services or facilities with disqualified persons
4975(c)(1)(C): Provide goods, services or facilities directly or indirectly between the Solo 401k plan and the “disqualified person”.
Current IRC guidelines prohibit the Solo 401k plan from receiving any type of service from unqualified people. It may be as simple as painting a house and can solve major structural problems. Some examples of such prohibited transactions are described below.
Ron used his Solo 401k to buy the property and repair it himself.
Sally hired her father to manage the property owned by her Solo 401k plan.
Tiffany (Tiffany) prepared an investment plan for her Solo 401k and received compensation.
Doug acts as a real estate agent for the property purchased by his Solo 401k.
Transfer income or assets to a disqualified person
4975(c)(1)(D): Transfer Solo 401(k) plan income or assets directly or indirectly to “disqualified persons”.
The assets or income generated by the Solo 401k plan investment should not directly or indirectly benefit the disqualified person. Some examples of such prohibited transactions are discussed below.
Merissa used $10,000 of Solo 401k funds to pay personal debts.
Harry lives in a house owned by his Solo 401k plan.
Steve deposits the rental income from the Solo 401k property into his personal bank account.
Rob lent money from his Solo 401k to a company he controls.
The Solo 401k plan can speed up your retirement savings and help you quickly build a larger nest. However, as the sponsor/trustee of the plan, you are responsible for ensuring the legal compliance of the plan. Do not hesitate to seek professional help, especially when it comes to important aspects such as retirement planning.