Independent real estate investors can set up their own retirement plan with the Solo 401k. This allows them to take advantages of the tax benefits just like a traditional 401k, while saving up for their retirement. The Solo 401k also allows plan holders to explore different investment options, including real estate properties, mortgage notes, and more. Without a custodian, the plan owners also have more control over their investments.
The flexibility of the plan, however, also allows plan owners more room to make mistakes. While the Solo 401k is very easy to maintain and administer, plan owners need to proceed with caution to avoid unnecessary penalty charges. Here are the three biggest mistakes a Solo 401k plan owner can make:
Engaging in a prohibited transaction:
When you buy a property under the Solo 401k plan, it’s easy to think that the property belongs to you. Perhaps, you would want to use it once in a while as a vacation home. Or rent it to your daughter who is in college. Or hire your son as a contractor or property manager. However, any of the above would constitute a prohibited transaction.
When purchasing property with the Solo 401k plan, keep in mind that you are doing so on behalf of the plan. This means that the property belongs to the Solo 401k plan, not you. You and other disqualified person cannot personally benefit from this property. Otherwise, it will be considered a prohibited transaction, which will result in hefty fines and even disqualification of the plan. To learn more about prohibited transaction and disqualified person, visit this page.
Using a recourse-loan to leverage the purchase
To real estate investors, the biggest advantage of the Solo 401k plan is the ability to leverage real estate purchases within the retirement account without any Unrelated Business Income Tax (UBIT).
That does not mean, however, that you can go to any lender and apply for any loan to fund your Solo 401k property purchase. For a Solo 401k, the only type of leverage allowed is through a non-recourse loan. With a non-recourse loan, the property acts as collateral and the loan is granted without any other guarantor. As the plan trustee and plan owner, you cannot extend credit to the plan. Therefore, a non-recourse loan is the only way a Solo 401k plan can leverage a real estate investment.
Withdrawing from the plan early
We all find ourselves strapped for cash once in a while, but withdrawing from your retirement savings should be the very last resort. For those who are less than 59 ½ years old, the transaction is considered an early withdrawal. This means you will need to pay income tax on the withdrawal amount, plus a 10% penalty for withdrawing early. Depending on your tax bracket, this can be a very expensive mistake.
To avoid this early withdrawing penalty, you can opt for the Solo 401k loan option instead. The plan allows you to borrow up to $50,000 or 50% of the account balance. There is no tax or penalty to borrow from the plan, as long as you pay back the borrowed amount and interest according to the loan terms.
Another option is to contribute to a Roth Solo 401k. This way, you will have to pay income tax in advance. However, the contributed amount (not investment gains) can be withdrawn at any time without penalty or tax.
While taking money away from your retirement account is not recommended, these solutions can help with urgent cash needs without subjecting to an expensive penalty charge.