Start a business just so I can have a Solo 401(k)?

[Paul B.]

I searched through the existing discussions as best I could to make sure I wasn't asking a common question...and I just didn't see it. I believe have learned the ins and outs of a Solo 401k. The reason I want to have one is that a typical self-directed IRA is subject to taxes because I intend to use it for passive investments in debt-financed multifamily deals. So a Solo 401k is the way to go for me. But, I have also learned that not just anyone can have one. In fact, I wondered why everyone doesn't do it instead of an SD IRA because there seem to be many advantages. Turns out I need to have some self-employment income, although there does not appear to be strict criteria on what that constitutes. It seems a good rule of thumb is that I am declaring some sort of income on my taxes. Just creating an LLC and calling it a business is not enough.

I work a W-2 job which I do not intend to leave, and it takes up a lot of my time and energy, which is why I am only passively investing in real estate at this time.

So, has anyone taken steps to become self-employed just for the sake of having a Solo 401k, because it has so many advantages over an SD IRA?

[Brian Eastman]

@Paul B.

We would generally not recommend that someone who does not currently or who cannot easily and permanently qualify for a Solo 401(k) "create" self-employment simply to qualify for a plan.

A Solo 401(k) is an employer sponsored retirement plan, designed for owner-only businesses with no full time employees other than the business owner.  Self-employment is earned income such as from providing a service or selling a product.  Passive income such as that from rentals does not qualify.

The bar is rather low to be self-employed, but you not only have to be self-employed to establish the plan, you need to remain self-employed to continue to maintain the plan. One can have a sole proprietorship, LLC, corporation, etc. That business activity will need to operate properly including any licensing at the state or local level, tax filings, etc. There is a cost of doing that.

Many investors, especially on a web forum, over promote the Solo 401(k) and I very frequently see folks with or looking to setup such plans that do not belong in the plan. There are several advantages to the Solo 401(k) for those who do qualify, but maintaining qualification and compliance is important. It is not just an "account" that you setup and forget. If you find yourself in a situation where you are no longer self-employed, then the plan may need to be terminated and rolled over to an IRA.

The avoidance of UDFI taxation on debt-financed real estate is a nice feature of the Solo 401(k). Most folks think that paying taxes in an IRA is a bad thing, and want to avoid that at all costs. When you run the numbers, however, you will see that UDFI is not generally a huge factor, and that the IRA is still receiving the significant benefits of using leverage and a higher cash-on-cash return as a result.

Without taking the time for a full example, consider this.  A $100K property where 60% is borrowed and income is 10% will pay about $175-200 in UDFI taxation for a year.  How much work do you need to go through to avoid that small tax?

There are several qualified professionals here on BP who can help you evaluate your specific situation and determine if a Solo 401(k) is a good long term fit. If not, the IRA LLC is an excellent tool and a potential means to get much better results for your retirement savings through investments such as real estate.