Hidden Strategies to Maximize Your Retirement That You May Not Know

One way to reduce taxes and build for your future is to put money into retirement accounts. Most people may be familiar with regular retirement accounts like IRA, Roth IRA, and 401(k) . Regular retirement accounts are usually open with financial institutions or banks. Once the account is open, there is a list of mutual funds and stocks that taxpayers can choose to invest in. However, self- directed retirement account is open with a self-directed custodian. For self-directed accounts, taxpayers can invest in almost anything; moreover, the investment decision is up to the taxpayers rather than being restricted with few of mutual funds and stock choices. Self-Directed Retirement Account is one of good strategies to maximize your retirement. I also have a blog post Tax-Efficient Strategies for Investments to Consider; the post provides investment strategies for both pre-tax and post-tax money.

Self-Directed Account Eligibility

In general, almost everyone is eligible for a self-directed retirement account. If a taxpayer is eligible for a traditional IRA or Roth IRA, he/she is eligible for a self-directed IRA or Roth IRA. If a taxpayer has a small business, he/she is eligible to open a SEP-IRA or Solo 401(k). So keep in mind that almost all retirement accounts can be self-directed retirement accounts

When I mentioned about having a small business to be eligible for SEP-IRA or Solo 401(k), it doesn’t mean that taxpayers need to have a legal entity. A home-based business selling a product or service and operating as a sole proprietor could allow the owner to be eligible for these retirement accounts.

What types of investments a self-directed retirement account can invest in?

A self-directed retirement account can invest in almost anything that you can think of. However, there are some exceptions

• S Corporation Stock: IRS tax code for S corporation doesn’t allow a retirement account to be a shareholder of a S corporation. However, a retirement can invest in LCCs, partnerships and C corporations
• Life insurance: In general, a retirement account can’t be on the title or the owner of a life insurance policy; however, it can be a beneficiary of a life insurance policy
• Collectibles: Retirement accounts can’t invest in collectibles except for certain coins and precious metals.

Besides above exceptions, a self-directed retirement accounts can invest in many categories such as real estates, promissory notes, business, cryptocurrency, REITs, etc.

Cautious for retirement investing tax traps

In general, self-directed retirement account is subject to both UBIT (Unrelated Business Income Tax) and UDFI (Unrelated Debt Finance Income) Tax. You read it right, retirement accounts are subject to these 2 tax traps. In addition, later when taxpayers reach the retirement age, distribution is also subject to income tax. To maximize your retirement, strategies to avoid UBIT and UDFI are essential

Unrelated Debt Finance Income Tax (UDFI) and strategies to avoid

UDFI is assessed when a retirement accounts invest in assets that use leverage. In another word, if a retirement accounts have to borrow money to invest, it will be subject to UDFI tax on profit that is related to debt. Most of real-estate investors fall into this category because leverage is a part of the deal for them to get a maximum return on investments. For example, if a retirement account purchases a $1,000,000 rental property. Out of $1,000,000 of the purchase price, $600,000 is the cash down payment and $400,000 is financed with mortgage. In this case, the debt ratio is 40% ($400,000/$1,000,000). If the property has $15,000 income during a particular tax year, 40% of $15,000 may be assessed for UDFI tax.

Strategies to avoid UDFI

• Avoid Debt – consider to invest into assets without any financing
• Partner with another retirement account: Same example as above but if the taxpayer can find another taxpayer to partner with to make the purchase. The partner also use cash in his/her retirement accounts to fund $400,000 to purchase the property. This way there is no leverage on the investment, so the UDI would not apply.
• Use solo 401(k) for investment: one great benefit of solo 401(k) which will be discussed below over other retirement accounts is that IRS allows solo 401(k) to invest into leverage assets without UDFI tax. Please keep in-mind, this only applies to loan incurred with respect to purchase the property. Same example as above, if the taxpayer uses solo 401(k) to purchase the rental property with the debt ratio of 40%, the taxpayer is tax-free from UDFI

Unrelated Business Income Tax (UBIT) and strategies to avoid

This tax is imposed on ordinary income of retirement accounts. So if a taxpayer uses his/her retirement money to open a restaurant, income generated from the restaurant is considered as ordinary income which could be subject to UBIT. However, UBIT is not applicable to investment income (rent, interest, dividends).   This is ideal for real estate investment because rental income, or capital gains from selling real estate properties won’t be subject to UBIT.  Unfortunately, income from flipping a house is ordinary and UBIT might apply.

Strategies to avoid UBIT

• Avoid investing in businesses that generate business income.
• Invest in non-ordinary investments like rental real-estate properties or lending the money out to others to get interest income (be aware of disqualified persons)
• For real-estate investors: Don’t “flip” out as flipping will generate business income which is subject to UBIT. Other options for real-estate investors to consider
  • Rent the property and hold it for long-term
  • Rent the property, then sell the property after 1 year. The gain from the property sold is capital gain, not ordinary gain and escape UBIT.

One of strategies to maximize retirement benefit is not to avoid UBIT. If the return on investments for the ordinary income is higher than UBIT that the taxpayer has to pay, then UBIT may not necessarily be a bad thing. Please check with your tax advisor for more information on UBIT.

Solo 401(k)

Once a taxpayer owns a business, he/she is eligible to open solo 401(k) account which allows they to contribute more to the retirement accounts each year. As mentioned above, a business doesn’t need to be a legal entity; in fact, sole propriety owners can also qualify for solo 401 (k). A solo 401(k) is an individual 401(k) designed for a business owner with no employees. However, if the business has W-2 staff, the business can still maintain solo 401(k) plan if the employee is under 21 or if the employee is over 21 and he/she works under 1,000 hours per year. So if the business owner has few independent contractors worked under, the owner is eligible for solo 401(k). However, it doesn’t mean taxpayers try to make their employees independent contractors which may violate employment rules.

Why Solo 401(k)?

Higher Contribution

Higher contribution limit is one of advantages of solo 401(k) over IRA or Roth IRA. Small business owners with solo 401(k) can contribute $19,500 (2020 tax-year), another $6,500 for catchup contribution for those who are older than 50. This is the same type of 401(k) contribution that almost everyone who works can contribute. In addition, the business can make a contribution into owner’s and spouse’s retirement accounts.

Owner’s spouse can also have the same contributions if the spouse also works for the business. Depending on how much income the spouse earns from business, the spouse may be able to maximize the solo 401(k) contribution. A sole proprietorship can contribute a 20% of the business net profits while it’s 25% of the owner’s W2 receiving from S corporation for S corporation’s case. The total of maximum contribution for each of the owners and their spouse is $57,000 for 2020. Therefore, a married couple can contribute $57,000 x 2 = $114,000 per year.

Other Advantages

Taxpayers can borrow against 401(k) up to the lesser of 50% of the account balance or $50,000. Taxpayers can use the loan amount for any purposes like purchasing a new car or having a vacation. Be sure to have the loan document in place and make loan repayment at least once every quarter which includes principal and interest. The maximum loan period is 5 years.

Another advantage of solo 401(k) over IRA or Roth IRA is that taxpayers have additional time to contribute in solo 401(k). For IRA or Roth IRA, the deadline for contribution is April 15 of the year following the tax year. However, the deadline for solo 401(k) contribution is when the business files the tax return. So if the business files the tax return (with extension) on September 15, the deadline for solo 401(k) contribution is also September 15.

My favorite advantage of solo 401(k) over IRA or Roth IRA is its ability to avoid UDFI tax which was discussed above.

Large deferred tax contribution and avoiding UDFI can make solo 401(k) one of best strategies to maximize retirement benefits

Limitation of investing with retirement accounts

Self-directed retirement accounts provide a lot of flexibility; however, there are some restrictions that taxpayers should understand before making an investment using self-directed retirement accounts

The main idea is that IRS doesn’t want taxpayers to use retirement money to have transactions or business with are disqualified persons such as yourself, your relatives or your business. Therefore, IRS defines a list of disqualified persons and prohibited transactions

Disqualified Persons and Disqualified Transactions

Below is the list of disqualified persons who can’t do the business or transactions with the retirement investment

• Retirement account owner and his/her spouse
• Brother and Sisters
• Aunts and Uncles
• Nephews and Nieces
• Spouse’s Siblings
• In-laws

In addition to the above list, anyone who provides services to the retirement accounts is also disqualified persons such as CPA, lawyer, financial advisor and their employees. Entities which disqualified persons own more than 50% are also disqualified persons

• If a taxpayer invests into a rental property using his/her self-directed retirement accounts, he/she and disqualified persons can’t rent the property nor purchase the property. In addition, if the property needs repairs, he/she can’t repair the property. Someone who is not under disqualified persons list can repair the property; however, the service fees need to be paid from the retirement account. Hint, cousins are not on the disqualified persons list

Please note that it’s not worth to violate the rule because the penalty is large for the violation. For example, if a taxpayer has $200,000 invested in stocks and lends out $50,000 to his/her sister. IRS could close the whole retirement accounts and assess tax/penalties on the whole $250,000. Understanding these restrictions can help taxpayers to avoid disqualified transactions with disqualified persons; hence it helps with strategies to maximize the retirement income

Author’s Recommendations

• Self-directed retirement accounts provide taxpayers investment flexibilities compared to regular retirement accounts. Taxpayers can invest in rental properties, stocks, lend money to others, invest in start-up business, etc. Taxpayers can open self-directed retirement accounts with self-directed custodian; then roll over the retirement money from regular retirement accounts to self-direct retirement accounts. For rolling regular 401(k) to self-directed retirement accounts, you should check with your financial institution and current employer. Taxpayers may not be permitted to rollover a 401(k) with the current employer.

Be aware of UDFI and UBIT which are levied on ordinary income and leveraged assets

• If you own a business, solo 401(k) is the best choice for self-directed retirement accounts; it can void UDFI tax, higher contribution ($114,000 in 2020 for husband and wife who work in the business). If your company has a define benefit plan (not discussed in this post), the contribution is much more. You can borrow a maximum of $50,000 from solo 401(k) for use without any reasons.

Reducing taxes, investment choice flexibility and avoiding UDFI, solo 401(k) is considered one of good strategies to maximize your retirement.