The 401k that is offered by an employer is very familiar to most people. Many private companies offer the opportunity to participate in their 401k tax-advantaged retirement savings account. The plan is typically structured so that the employee directs a portion of their pre-tax or post-tax earnings to an account and the employer may match a percentage of that investment. The 401k is held in a brokerage firm and allows the employee to invest in various mutual funds.
The 401k limits how much people can contribute to the account. For example, in 2020 the limit for the employee’s contribution is $19.500. What most people do not realize is that the combined contribution limit for the employee’s and employers’ contribution is much higher at $57,000. This much higher number becomes important when setting up a Solo 401k as explained below
Challenges With the 401k
As I wrote in my article about the Self Directed IRA, the investment options that are typically offered in a 401k and a traditional IRA are limited to various mutual funds. Quite often these funds have high fees and limit the freedom of investment choices for the participant. An article in Investopedia shows that fees can range from less than 0.5% for large plans to over 2% for smaller plans. It may not seem like a lot, but compounded over a lifetime of investing the difference can be 50-100% more in the final account balance for the investor in the account with the lower expenses. So, the fees in the plan offered by an employer are something to pay attention to.
Of course, it is still a great idea to enroll in the plan to start saving. Especially if the employer matches the contributions by the employee. That is essentially free money, so most advisors recommend that participants invest at least the percentage that the employer matches.
The Self Directed Solo 401k
A possible alternative to the company-sponsored 401k is a Self Directed Solo 401k. If a person earns self-employment income, for example from a side gig, he or she can open a Self Directed Solo 401k. These types of plans are designed for people that are self-employed. But it doesn’t need to be a fulltime job. Just earning money from consulting work, driving for companies like Uber, or a number of other activities qualifies the person to open a Self Directed Solo 401k.
The Self Directed Solo 401k is a special kind of 401k that allows for the investment in stocks, bonds, mutual funds, as well as alternative assets such as real estate, mortgage notes, or syndications. This type of 401k can be opened at a brokerage firm, giving the owner of the account the flexibility to invest in the assets mentioned above. Some accounts allow check-book control, so participants can invest directly into the alternative asset without having to complete a lot of complicated paperwork.
As in a Self Directed IRA, some transactions are prohibited. For example, investments in life insurance and in collectibles such as artwork, rugs, antiques, metals, gems, stamps, and coins are prohibited.
The investments in the Solo 401k are for retirement savings, so the owner cannot have any direct benefit from the investment before retirement. For example, if the plan owns an AirBnb rental, it can’t be used for the participant’s own vacations.
There are also restrictions on which individuals that transactions are conducted with. Anyone involved in a deal with must be “arm’s length” from the owner of the 401k. The participant can’t enter into transactions with him/herself, a spouse, any lineal ascendants, or descendants (parents, children, grandchildren, and the spouses of children, grandchildren, etc.— including legally adopted children).
Higher Contribution Limits
A Solo 401k benefits from higher contributions limits than an IRA or 401k at work. This is because the owner of the plan is both the employer and employee, so the total contribution is $57,000. Of this amount, $19,500 is the employee’s contribution and the $37,500 is the employer’s contribution. However, if the participant also has a 401k at work, the $57,000 is the total contribution amount from all sources.
How to Establish a Solo 401k
Setting up a Solo 401k is usually pretty simple. Perform a Google search and find the company that meets the requirements. There are a handful of companies that can set up the plan, and the fees that they charge can vary significantly. The company needs to create a trust, write plan documents, and file various forms with the IRS.
The participant also needs to consider the types of investments to be held in the account and choose a custodian that fit the needs. Unlike the Self Directed IRA, the company that established the Solo 401k is not the custodian. The participant chooses a 3rd party custodian, which is either a bank or a brokerage firm.
My favorite account type is a non-prototype account held at a brokerage company. That way I can invest in mutual funds and real estate with checkbook control.
Avoidance of UBIT Taxes
As I described in my article about the Self Directed IRA, investment in debt-financed real estate may be subject to UBIT taxes. However, the 401k account is covered by a different area of the tax code and not subject to UBIT taxes. This is another great reason to open a Solo 401k and avoid this tax altogether.
The Solo 401k is a great way to get access to alternative investments in your retirement account. Getting money away from Wall Street and into Main Street can benefit a community directly and the participant has much more transparent investment opportunities.
Disclaimer; This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or investment advice. You should consult your own tax, legal and investment advisors before engaging in any transaction.