There are two major rules to keep in mind when dealing with a self-directed 401k. These rules govern other popular retirement plans. First, are the rules related to prohibited investments. Second, are rules related to “prohibited transactions.” The latter are a bit more nuanced, which is why I’ll give an overview and specific examples of prohibited transactions. If you’re considering a self-directed 401k, read on to avoid these costly rule violations.
The IRS clearly prohibits two types of self-directed 401k investments, life insurance and collectibles. Collectibles include art, antiques, gems, vehicles, stamps and some coins such as gold and silver. The IRS doesn’t specifically endorse several non-traditional investments such as real estate. However, this doesn’t mean investors shouldn’t be cautious with these investments and the “self-dealing” rules associated with them.
Self-dealing rules exist to prevent retirement plan owners from using one of their 401k investments for their own personal use. This would lead to an unfair double benefit: a tax benefit and a personal use benefit.
To illustrate, let’s look at Carol. Carol is a 40-year-old with a self-directed 401k. She invests in some apartments nearby and decides to also manage the property part-time. Carol takes a small compensation for property management. This results in an unfair double benefit, since Carol’s property investment not only enjoys tax-deferred status but also yields her a small salary on the side.
Prohibited transactions aren’t just direct dealings such as the one above between an individual and his or her self-directed 401k. They also extend to dealings with “disqualified persons.” Disqualified persons include lineal family members, spouses, parents and grandparents. For instance, Carol would also be prohibited from renting out a property to her daughter, even for just a short summer stay. This would trigger a double benefit as well, since Carol’s daughter is considered a “disqualified person.”
Outside of family members, plan owners should also be cautious about other conflicts of interests that can trigger a double benefit. For instance, a retirement plan custodian or anyone else servicing the plan is a “disqualified person.” If the self-directed 401k is employer sponsored, then the employer and anyone who owns at least 50% of the company is also disqualified.
As you can see, the rules regarding a self-directed 401k can get complicated. While these plans allow a wider variety of investment options, you aren’t free to conduct transactions with anyone you please. Prohibited transactions limit you from unfairly gaining both a tax and personal benefit from your plan. Prohibited transactions also discourage your family members or anyone with significant power over your plan, such as custodians or employers to conduct transactions with you. We hope that going over these rules has helped you decide whether a self-directed 401k is right for you. If you’d like more information about setting up your self-directed 401k plan, contact us now.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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