The most notable difference between endeavors down the path of using a self directed IRA versus traditional investing is the unique rules that apply to the former. The extremely simple rule is that an IRA (specifically) cannot buy life insurance or collectibles (such as rugs, works of art, alcohol, bullion).
The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:
- The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
- Companies who provide services
- A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
- A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
- An officer, director, 10% or more owner, or highly compensated employee of #4 above.
- A 10% or more (in capital of profits) partner or joint venturer of #4 above
Every self directed IRA/401(k) investor should make this DQP list before making any investments.
Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.
So, what is a prohibited transaction?
In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:
- sale, exchange or lease of property
- lending of money or extension of credit
- furnishing of goods, services, or facilities
So I consider that to be the general rule. There are a couple of special rules and they consider a PT to also include:
- When plan assets are transferred to, used by or creating benefit to a DQP
- When the accountholder/participant directs his plan in his own interests (to benefit him now instead of through a proper distribution)
- When the accountholder/participant receives compensation from anybody in connection with plan income or assets
The reason I call these last three items “special rules” is because they transcend the 50% rule in determining when corporations are DQPs. In other words, if XYZ Corp is owned 49% by the accountholder’s mother then XYZ Corp isn’t techinically a DQP. Buuuuuut, if the plan then transacts with XYZ Corp it is obvious that the transaction might violate one of these special rules simply because you can’t ignore that the mother’s position in XYZ Corp was probably considered in the decision to direct the plan into that transaction.
All in all, a little common sense goes a long way. The intent of IRC 4975 is to obviously keep the plan out of transactions connected to people that the #1 & #2 DQPs might be able to control or use as a strawperson. So, clever concoctions that aim to evade prohibited transactions rules by a technicality often times still violate the last 3 special rules. It all comes down to intent, and this is something that DOL (the Department of Labor – the government agency that solely bears the responsibility and authority to interpret prohibited transaction expemtions) concludes based on assembling a fact pattern.
So the “directly or indirectly” part of the rule allows them to let some common sense override the technical rules. It also means that if a plan invests into an entity (Corp, LLC, etc) and that entity invests with disqualified person, it may still be a PT. More on that (plan asset rule) in a later post.
In summary, every self directed IRA/401(k) investor should make a disqualified person list before doing any transactions that involve the plan. Overlooking this is on par with a teenager not making and reviewing a budget because he thinks he can learn from and apply the concepts without actually doing the budget. Once this list is made, prohibited transactions can easily be avoided as long as the plan is never involved in any deals connected to anyone on the DQP list.
@Laurencio, possibly yes. Make sure there is no other conflict of interest though.
@Patrick, I wouldn’t recommend using a custodian at all. A custodian isn’t required and only adds cost, delay, and lack of direct control. Setup a self-trustee 401k for the most personal power.
@Marc, nope.
Hi Jeff,
I have a couple questions based on the response you gave to John H on June 3rd , 2009 in regard to borrowing money from a solo 401-K…..”No use of participant loan proceeds will create a prohibited transaction.”
I am a real estate broker/appraiser/investor and I own three separate single-member LLCs. One is a real estate brokerage, one is an appraisal company, and the other is a real estate investment company.
My wife lost her job and we have been looking for a vehicle that would allow us to use the money within her 401K to flip real estate without liquidating the 401K and incurring tax penalties, etc….
If she rolls her old employer 401K into a solo 401K, can she take out a personal loan from the solo 401K, then personally loan money to my investment business without creating a prohibited transaction?
The investment company would use the money it borrowed from her to buy & flip a property. Upon the successful sale of the property, the investment company would pay back the money it borrowed from her directly to her. She would then in turn pay back the loan she borrowed from the solo 401K.
1.)Is this a legitimate way to accomplish what we want to do or am I under or over complicating the issue?
2.)Would it make a difference if the solo 401K is in her name, both our names or is it even possible to have a joint solo 401K……
3.)She currently doesn’t own a business, so would she need to become self employed in order to have a solo 401K or could the funds in the current account be rolled into an account in my or even someone else’s name?
Tracy,
Here’s some feedback:
1) Yes.
2) You can have a “joint” 401k. Your existing retirement money would be rolled over into the Solo 401k for you in your subaccount. Hers would go into hers.
3) For her to participate in the Solo 401k, she would need to have self-employment activity.
I have new trainings coming out soon that cover these kinds of details so make sure you get on my email list to be notified of their release
Jeff
Jeff,
X (75%) and Z (25%) are sole members of LLC. IRA is an IRA owned by A, Z’s mother. Let’s say in March 2009, IRA loaned money to X, and then X loaned money to LLC (to avoid prohibited transaction). Now, 2 years later, LLC wants to increase Z’s ownership to 44%. Does this violate the “special rules” of prohibited transactions?
I have a “check writing” self-directed LLC. In a financial bind I wrote a check to myself, thinking all I had to do was put the premaure distribution on my taxes and pay the penalties. Now I find out I should have sent the check to my IRA custodian and they would send the distribution minus the withouldings to me. Any thoughts on how to proceed? Early distribution or did I just make a prohibited transaction and kill my IRA?
Is a “hard money” loan to an unrelated entity considered a DT?
Also, if the company provides general contracting services, would that make it a DT?
Is a “hard money” loan to a general contractor (service company) a prohibited transaction?
After one phone call to your firm, and hours spent reading much/most of the info on your webpages, incl. this blog, I still need clarification, if possible. (By the way, I’m awe of your seeming ability to answer all of the questions on this blog, from ’08 till the present!) I’m brand-new to the Solo 401K “game” so, here goes:
1. I’m retired, over 65. and have over $ 50K in a 457 savings account (from state government employment). I’ve previously transferred $$ from that 457, into a Roth IRA, now invested in a well-known, U.S. financial/brokerage firm. The IRS, as des-
cribed in their Fed.income tax forms, considers the 457 to be
the same as a “regular” 401K, with corresponding tax/penalty rules for any transfer/rollover actions.
2. Can I set up a Solo 401 K from these remaining 457 $$ ? I’m not aware of any limitations in doing so, from current custodian of the 457.
(In other words… no problem putting 457 $$ into a Roth; how
about a Solo 401K? (Obviously, I could continue doing so. adding to a Roth, but I’m currently interested in using the remaining 457 $$ to utilize other investment options, and/pr buying real estate, without incurring the taxes from a 457 to Roth transfer. (Current investment options in that 457 are severely limited to a retired person of my age.)
3. If..IF…I could set up Solo 401K, per above, could I take a personal $$ loan, and purchase property outside of the U.S.?
I’m aware of the many possible investment options within the U.S….. how above overseas? (Property and/or house, NOT for
investment purposes, but for personal use.) I’ve read most/all of your info on DQP’s/PT’s, etc. and, other than the “overseas”
aspect, I should be OK. (No DQP’s, as you’ve described, in any
of my desired loan uses.)
So, that’s it for now. I’ll try calling you, if you so desire, for
clarification. Thanks, in advance
I just rolled some IRA money into an investment in which I own less than 5%. Can I be a director (and receive nominal fee for mileage) of this entity, or is that a prohibited transaction? Thanks.