Self-Employed? SEP vs. Solo 401(k) (Part 3)

In this post, we are going to expand on a couple more advantages of the Solo 401(k) over the SEP-IRA.  However, while we are not spending significant time on these two benefits, don’t be fooled into thinking they are not important.  Depending on your interest in how you make your contributions and your investment strategies, these two benefits are important for you understand.

Roth Contributions

More and more people are making Roth contributions.  Even if you were saying to yourself right now “ah, I am not going to make Roth contributions”, wouldn’t you still want to the option to do so?  All SEP-IRA contributions must be made in a pre-tax manner.  In fact, in contrast to the user-friendly Solo 401(k) plan, pre-tax contributions are the only contribution option you have with the SEP.

In contrast, with the Solo 401(k) you have more contribution options:  Pre-Tax Elective Deferrals (check), Business Profit Sharing contributions (check), After-Tax Contributions (check) and, yes, even Roth Elective Deferrals.  You are not just limited to pre-tax contributions, you can make Roth contributions as well. Oh, and there is another benefit.  Due to the 2012 fiscal cliff legislation, you now can practically convert any and all funds within your plan to Roth.  Obviously, you must pay taxes on the “conversion”, but you have the ability to convert funds to Roth within the plan.  Please note that your plan documents must permit Roth conversion of funds within the plan….but, it is an option. In the world of SEP-IRA vs. Solo 401(k) contributions, the option of having more is probably better.

UDFI and UBIT

Very few people are aware that an IRA (including a SEP) and a 401(k) can assume a mortgage for leveraging an investment.  However, the IRA or 401(k) must secure a non-recourse mortgage so as to not violate Prohibited Transactions related to self-dealing.  Regardless, any IRA that utilizes leverage with an investment will incur UDFI and UBIT tax.  Yes, a tax on profit generated from a leveraged investment…in this case, the investment of the IRA.

But, good news!

Your Solo 401(k) plan can leverage an investment in real estate with non-recourse lending without incurring this tax.  It is a special exception that it provided to a qualified plan, and, yes, a 401(k) plan is a qualified plan.  It is not available to any IRA (including a SEP).  Should your 401(k) (or IRA for that matter) leverage investments in real estate?  That is for you to determine with professional guidance; however, isn’t it nice to know that your 401(k) has the benefit of not incurring UDFI and UBIT on real estate investments?  It sure should be.  Again, even IF you never used leveraging with your real estate investments, isn’t it nice to know that you at least have this benefit?

In these first three posts, we have explored the benefits of the Solo 401(k) over the SEP-IRA as it relates to higher contribution limits, participant loans and, now, the benefit of Roth contributions and freedom from UDFI and UBIT for correctly structured 401(k) real estate investments.

Think we have provided enough benefits?  Each of these first four, in and of themselves, would be reason enough to elect the Solo 401(k) over the SEP. But….

we aren’t done yet.  In the next post, we are going to explore more!

As always, the information is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.