IRS Rules for Self-Directed 401(k) Plans
The Internal Revenue Service (IRS) imposes specific rules and regulations on self-directed 401(k) plans, also known as Solo 401(k) plans, to ensure these retirement savings vehicles are used according to their intended purpose. This article outlines the key IRS rules that individuals and small business owners must comply with to maintain their self-directed 401(k) plans.
1. Eligibility:
Only self-employed individuals with no full-time employees other than themselves or their spouses are eligible to set up a self-directed 401(k). Part-time employees who work less than 1,000 hours per year can be excluded from eligibility.
2. Contribution Limits:
For the tax year 2021, combined elective deferral and employer contributions cannot exceed $58,000 for those under 50 years old, or $64,500 for those 50 or older. This limit includes both employee elective deferrals (up to $19,500) and profit-sharing contributions from the employer (up to 25% of earned income).
3. Rollover Rules:
Participants can roll over funds from other qualified retirement plans, such as traditional IRAs or previous employer-sponsored 401(k) plans into their self-directed 401(k) account. However, Roth IRAs cannot be rolled over.
4. Investment Options:
Self-directed 401(k)s offer a broad range of investment options like real estate, precious metals, private placements and more. However, they’re subject to IRC Section 4975’s prohibited transaction rules. Individuals cannot invest in life insurance contracts or collectibles like art or antiques with their self-directed accounts.
5. Required Minimum Distributions (RMDs):
Starting at age 72 (or age 70½ if you reached that age before January 1, 2020), individuals must take required minimum distributions from their self-directed accounts each year according to the IRS Uniform Lifetime Table. Failing to take RMDs results in a 50% penalty on the undistributed amount.
6. UBIT and UDFI:
Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI) taxes can apply if an individual uses their self-directed account to invest in operating businesses or leveraged real estate. Consulting a tax professional is advisable for understanding how these taxes may affect plan investments.
7. Loan Provisions:
While self-directed 401(k) plans allow participants to borrow up to 50% of their account balance, or a maximum of $50,000, individuals must adhere to repayment schedules and interest rates established by the IRS. Loans must generally be repaid within five years, unless used for purchasing a primary residence.
8. Roth Solo 401(k):
Some self-directed 401(k) plans offer Roth accounts which allow after-tax contributions, subject to the same contribution limits as pre-tax deferrals. The investment gains in Roth accounts grow tax-free and are generally distributed free of federal income taxes if the owner has had the account for at least five years and has reached age 59½.
Complying with these key IRS rules will help individuals maintain their self-directed 401(k) plans, invest in their preferred assets, and avoid unexpected consequences or penalties that could disrupt their long-term retirement strategy.