Are you saving for your retirement years? For many, a 401(k) allows them to benchmark and grow their retirement account. Unlike an individual retirement account (IRA) or a traditional 401(k), a solo 401(k) allows you to invest in much more than just mutual funds, bonds and stocks. Real estate, precious metals, private placements, renewable energy sources and many other alternative assets become available to investors through a solo 401(k). Because of these investment options, a solo 401(k), also known as a self-directed 401(k), gives you plenty of options that will help you diversify your portfolio. Like a traditional IRA or 401(k), however, a solo 401(k) is typically considered a tax-deferred account. Why? Because most individuals choose to use their pre-tax dollars to fund the account. However, there are certain situations in which a solo 401(k) account will owe taxes prior to a distribution at the age of retirement.
As with all other forms of income, the Internal Revenue Service (IRS) has established regulations that govern retirement accounts. Because solo 401(k), and a few other investment vehicles, are able to invest in business entities, the IRS recognized a potential loophole. To prevent this, the IRS establish the “Unrelated Business Taxable Income (UBTI) Rule.” (UBTI is referred to as an Unrelated Business Income Tax (UBIT) as well.) Defined under the Internal Revenue Code Section 512(a)(1), the UBTI Rule basically stated that income is to be treated as unrelated if the income generating activity is:
- A business or trade;
- Regularly carried on; and
- Not substantially related to furthering the organization’s exempt purpose.
The three factors above are very important to understand. A business or trade, as defined by the IRS, is any activity that results in the generation of income through the sale of goods or providing of services. A regularly carried on activity is one that is occurs on a repetitive cycle. This even extends to seasonal activities, such as the sale of holiday postcards to raise money for a non-profit. The size and extent of an activity is important in the determination of a tax-exempt status. If an activity appears larger than necessary, the IRS is likely to treat is as unrelated. The IRS will examine the sale of each item in order to determine if it is considered “related” or “unrelated” and if the UBTI rule applies. Why does this mean your solo 401(k) may need to pay taxes? Let us take a look.
UBTI Taxes and Pass-Through Entities
Pass-through entities, such as a limited liability company (LLC), do not directly pay taxes. Instead, their income passes through them and to the entity that owns them. If an LLC is owned by an individual, that person pays those taxes as it is considered a personal income. However, many solo 401(k) owners opt to establish their own LLC’s, or other pass-through entities, in order to protect their investments and increase their capital. For more information, check out our previous piece on how to protect your assets with an LLC or other business entity. This is where the UBTI rule comes into play.
- The UBTI prevents business from unfairly avoiding taxes because their owners have established them within a retirement plan.
- The UBTI also prevents these businesses from holding an unfair position when competing with other entities that do have to pay taxes. (If one business does not pay taxes, it has a potential financial advantage over others that do.)
The UBTI tax is rather large. At 40%, most owners do try to avoid incurring this tax. If you own or invest in a C-Corporation, however, you are in luck. C-Corporations are not considered pass-through entities. They pay taxes every year. Because of this, they are exempt from the UBTI rule.
UBTI/UDFI and Solo 401(k) Real Estate
One of the many benefits of a solo 401(k) account can take out a non-recourse business loan. This is often borrowed from an individual or a business entity. A non-recourse loan is typically considered debt financing. This means the solo 401(k) is not subjected to paying UBTI taxes on any incomes generated through that loan. (An Unrelated Debt Financed Income (UDFI) is not subjected to the UBTI rule.) Therefore, if the solo 401(k) uses a non-recourse business loan to purchase real estate, instead of using a LLC directly, the owner will not have to pay that 40% UBTI tax on any income generated by that property!
IRA Business Trust Can Help
The professionals at Royal Legal Solutions know how important it is to avoid violating tax regulations. We also know that you worked hard for your retirement finances and you deserve to keep as much of them as possible. If you would like to learn more about retirement accounts, like a solo 401(k), IRA Business Trust can help.