Checkbook IRA/ Checkbook 401K: Its is Legal or Illegal

[Stephen E.]

I have known about self direct IRA but not Self Directed 401K and 'Checkbook' IRAs. I wanted to take control of my personal debt and let my IRA benefit from the loan but still maintain tax preference.

• What circustances and conditions would i have to follow for this to be legal?
• What kind of reporting is needed for this to maintain a legal status? 
• If this completely illlegal, what areas would this follow under?

Thanks

[Carl Fischer]

@Stephen E.

Illegal to borrow from your Ira— reference irs publication 590 and irc sect 4975

You can borrow from your 401k $50k or 50% of the the 401kaccount balance whichever is less. Irs form 5500 is for 401ks. Do you have your own company? Do you work for a company with a 401k etc are some questions that need to be explored before you get the the correct answer. You probably need a conversation versus an email or forum post. Good luck! 

[Dmitriy Fomichenko]

@Stephen E.

A Checkbook IRA is a self-directed IRA that uses special purpose, single-member LLC as an investment vehicle. It is perfectly legal and millions have used it.

Just like an IRA, a 401k can be setup in a conventional way, or it can be setup as self-directed, giving you unlimited investment options. The advantage it has over an IRA is that it does not require a use of third party custodian, and you don't need an LLC to gain checkbook control. It has contributions limits that are 10 times higher than an IRA, allows you to invest tax-free using Roth sub-account, allows you to access up to $50,000 via participant loan feature, exempt from UDFI tax on leveraged real estate, and more! However, it is not for everyone, to qualify you must be self-employed or own a business without full time employees.

When you create this vehicle, the plan document provider firm will provide you with IRS Determination letter, this will address your question about the legality and validity of the plan. They will also help you with required reporting, form 5500EZ, which is pretty simply to complete (only two pages). As document sponsor they will report your plan as "active" to the IRS annually. 

You can and should be in control of your debt. However your IRA can't benefit from it, it's quite the opposite. Taking early distribution from an IRA (resulting in steep taxes/penalties) to payoff your debt would be unwise. To begin this process you should evaluate all of your expenses, get rid of all non-essential and start tacking your debt using "snowball" strategy (you can google it, I'm sure you can also find discussion of this strategy on BiggerPockets forum). The bottom line is you need to live below your means, spend less than you make, otherwise you will never reach financial independence.

[Stephen E.]

From my understanding is the a loan feature is only available if the IRA is loaning to an investment or just a 401K.

A withdrawal would be legal in this situation for an IRA?

What limitations could i expect when using this stategy to do what is listed below? What are the pitfall for each to maintain legal aspects of each?

Goal: Convert uncollateralized personalized bank debt into a debt to that is assumed by the IRA/401K at interest (8-20%) and similar terms thereby creating opportunity for freeing more captial and increasing my ability to retain cashflow into investments at a rate that was being paid out to external institutions. See below for the idea of what i trying to accomplish.

Figures are for example and not representative of true statements or balances.

• Prior to conversion to Checkbook IRA or S401k
• Ex. $100,000 of uncollateralized debt at 20% for 72 months.
  
  • Total payment: $2395.28
  • Interest: $1666.67
  • Principal: $728.61

• Conversion to Checkbook IRA or S401K. Loaned
  • Ex. $100,000 of uncollateralized debt at 10% for 72 months.
  • Total payment: $1753.32
  • Interest: $666.67
  • Principal: $1086.65

Overall increasing saving rate, debt paydown, overall ability to continue investing. Thoughts?

@Carl Fischer

@Dmitriy Fomichenko

[Carl Fischer]

You can't borrow from your IRA to pay off your personal debt whether it is done through the Ira or through a checkbook LLC. It is self dealing.

 Your Ira could lend money to another investor either through the ira or with the checkbook controlled Ira. 

[Dmitriy Fomichenko]

Stephen,

There is absolutely NO WAY to convert personal debt into a debt assumed by your IRA/401k. All transactions involving an IRA must be "arms length", meaning that you personally (or any other disqualified person) CANNOT be part of the transaction, directly or indirectly. 

[Brian Eastman]

@Stephen E.

The piece you are missing is that neither an IRA or 401(k) can invest in YOUR PERSONAL debt. That would be a self-dealing prohibited transaction that would destroy the retirement plan and create a huge tax penalty. There is no direct or indirect way you can accomplish this goal.

All activities of a self-directed retirement plan are exclusively for the benefit of the plan, and may in no direct or indirect way benefit you personally (other than by accumulating more money for your future retired self).

From an IRA, there is no option other than a taxable distribution to you from the IRA, with any attendant penalties if you are under age 59 1/2.

If you are eligible for a Solo 401(k), you could establish a plan and then take a participant loan.  That is you personally borrowing from your plan with an obligation to pay the plan back at a set rate (typically Prime + 1 or 2%) over a maximum 5 year period.  The maximum you can borrow is the lesser of $50K or 50% of the 401k account value.  A self-directed 401k is not necessarily required, as many 401k plans offer the loan provision. 

This is generally not a smart long term financial move, and would only be a last option in the minds of any responsible financial planner.

[Justin Windham]

@Stephen E.

As others have mentioned, the prohibited transaction rules will prevent you from using your retirement money to pay of or assume your debt. The only exception is the participant loan feature of qualified plans such as the Solo 401k. While you may not want to setup a Solo 401k (if eligible) solely for this purpose, it might be a useful benefit in addition to other features of the plan:

• Compared to an IRA, Solo 401k contributions limits are roughly ten times higher.
• There is no custodial requirement for the 401k.
• You don't need the additional expense and administration of an LLC to have checkbook control.
• There is a built in-Roth component whereas IRAs are either traditional or Roth, not both.
• A spouse can also participate in the same Solo 401k plan.
• The Solo 401k has additional tax benefits over an IRA when investing into real estate using leverage.
• The penalties for prohibited transactions are less severe, though it's best not to utilize this benefit :)

[George Blower]

@Stephen E.

While the IRA participant cannot borrow from his or her IRA or process a promissory note that will benefit the participant directly, a participant loan can be processed from a solo 401k plan. See the following for the rules and the limits on participant loans. 

https://www.irs.gov/retirement-plans/retirement-pl...

[Stephen E.]

It wold seems a loan function would be the better option and have the most flexibilty. What other soultions would be available that i could pursue for this kind of idea?

[Justin Windham]

@Stephen E.

When is comes to using retirement funds for investment purposes, the loan feature is the only avenue that will provide that level of flexibility. Any direct investment of retirement funds will be subject to the prohibited transaction rules.

[Stephen E.]

Thank you!