Episode #15 : Keep your money. Solo 401k tax shelters with Dmitriy Fomichenko
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Investment options that allow you to save money tax-free can be few and far between. But when they do crop up, it’s a great idea to take advantage if you can. Solo 401ks are an especially excellent option, especially if you have the flexibility to do some self-employed work - whether it’s full time or part-time. This can be anything from a bit of consulting, to being a real estate agent for yourself and your family, or flipping houses.
Dmitriy Fomichenko is the founder and president of Sense Financial Services LLC, a boutique financial firm specializing in self-directed retirement accounts with checkbook control. He began his career in financial planning and real estate investing in 2000, owns multiple investment properties in various states, and is a licensed California Real Estate Broker.
Dmitriy is an expert on solo investment options, and today we’re doing a deep dive into the solo 401k investment vehicle. We talk about who might benefit from investing in a solo 401k, why it’s such a good option if you do any work for yourself, and the requirements for investing in one. We also discuss the timeline for opening a solo 401k and why it’s such an excellent option if you’d like to make alternative investments.
In this episode, we’re discussing…
What a solo 401k is and why it’s a good investment vehicle.
The requirements for investing in a solo 401k.
How the solo 401k allows you to shelter a good percentage of money tax free.
The differences between a solo 401k, a Roth IRA, and other common investment accounts.
What a prohibited transaction is and what to watch out for.
The process for opening a solo 401k and how long it typically takes.
Dmitriy’s Top Tips:
You can save a lot by skipping the middleman and opening a solo 401k - cutting out custodian fees is one of the biggest benefits of opening this type of investment account.
It can be easy to add some self-employment activities to your resume – if you become a licensed real estate agent or do some consulting on the side with your existing skills, you can keep your W2 and utilize a solo 401k .
A solo 401k can be a much more flexible investment option – make sure you’re aware of the types of transactions that are allowed using your solo 401k funds, but know that it’s a great choice for making alternative investments and accessing your money more quickly than other investment vehicles.
Resources:
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+ Read the transcript
Today's episode is focused around the advanced strategy to create a tax sheltered account that you can then leverage to invest in alternative investments like real estate. If you're doing any solo work that pays you outside of your W2, like consulting, freelancing, getting paid as a speaker, for example, or even becoming a real estate agent, this could be an interesting strategy to explore. I really love the real estate agent idea. Because if you became a real estate agent to buy your own rental properties, and that's all you did, you didn't sell for anyone else or buy for anyone else. And you receive the commission, just in something you were already going to do buying your own properties. You can put those commissions into this vehicle, not pay any taxes on that income, and then from there you can invest in more real estate which continues to be tax sheltered all of your profits, income, etc. I'm really excited to have our guest today Dmitriy Fomichenko. Dmitriy is the founder and president of sense financial services, which is a boutique financial firm that specializes in self directed retirement accounts with checkbook control. We'll get into that in a little more detail. He began his career in financial planning, he does real estate investing as well, and he owns multiple investment properties, and is also a licensed California real estate broker. Over the years, Dmitriy has taught hundreds of investment and financial planning seminars. So we're going to get a little mini one today, and he has mentored thousands of investors. Dmitriy, welcome to the show.
Thank you, Nichole, it's great to be on the show.
Let's get into this little mini seminar, which is answering some of those questions that I was talking about in the beginning: what is a self directed retirement account with checkbook control?
Some of your listeners might be familiar with self directed IRA, and truly self directed IRAs, an IRA that is held with a custodian that allows alternative investments. But the the downside of this type of account is that the custodian which is a Trust Company, they act, in essence, as a middleman, they hold to your IRA assets, and cash and for every transaction, you have to go through your custodian, whether it's buying an investment, or just simply paying investment related expense. Some people don't like that they don't want to have a middleman to go true every time they do a transaction. And that's where checkbook control comes in. And there are still vehicles for that. And I think, for your audience, the second one will be most beneficial, he probably should focus on that because it's too much information to the board. But I'll explain each option, the subject the checkbook IRA, is a vehicle where it is a self directed IRA held by the custodian, but then a special purpose single member LLC is created. And the LLC is used as a vehicle to make investments and the client becomes a manager of the LLC. And that's how the checkbook control is accomplished. And then second vehicle was a self directed solo 401k, which does not require a custodian and offers checkbook control as well.
Why would you Why would you do the first one, they're similar? Or is there some? I mean, why would you choose a little bit what sounds like a little more complicated?
Well, let's focus on solo 401k. Solo 401k is more advantageous, if you compare that with an IRA. But there is a tweak that you need to be aware of, it's not for everyone. It's designed for those people who are self employed. So you must have some sort of self employment activity, whether it's your have your own side business, your own business, or maybe doing something on the side. So it can be part time or full time. But the self employment acuity is required for the solo 401k.
Okay, I got it. So if someone is looking to very, very passively invest, they may use just a self directed IRA. And because they don't actually have a business, they don't have another LLC, they don't have an entity. Whereas with a solo 401k, you can still work full time have your W two income, but at the same time, you have something on the side, which could be a real estate investment.
Yeah, exactly. If somebody is working full time, just a normal w two job. And that's the only source of income for them, they will not be eligible for solo 401k. Also, if somebody is retired, I don't know if you have listeners like that. But if somebody is retired and they don't have active source of income, then they they will not qualify. But if somebody has some sort of self employment activity or active income that they generate, whether full time or part time, then solo 401k will be more advantageous. Okay.
So some sort of business that are self employment activity, what are the requirements then specifically for the solo 401k? Well,
there's two requirements, it's twofold. Number one, you have to have a presence of self employment that key we can that can be in any shape or form. It can be a full time business, you can own a corporation or LLC and provide services from that now, not that it must be active income, if you have an LLC, with a rental property rental property generates rental income, and the rental income is considered passive in its nature. So LLC with rental income is not technically a business, because it's it's just a whole demented your for your investment property, it must generate your income. But again, it can be for full time, part time. few examples, I have a client who does, who has a full time job working in IT industry. But he's also using his expertise to help clients and decide he does not have a formal business setup. He doesn't have a corporation or LLC, he simply does not as a sole proprietor, he has the two clients that he helps basically provide him consulting services. And the income that he receives is important to him and a 1099, which he will include report on the schedule, see when he files his taxes. So he is technically a sole proprietor, and that's a legitimate business type that can adopt the solo 401k. Another example of a client who's a real estate agent, again, simply helping people buy and sell properties, that receives commissions for that. And that's his self employment business, what I do have a client who's actually full time real estate investor, and what I mean by that he's actually flipping properties, he's buying distressed real estate, he basically makes improvements, he makes that ugly property into a nice property. And then he sells not for profit, and he does his own Corporation, corporation can build up the 401k. And she can take advantage of all the benefits that it has to offer. You know, you mentioned the client that you have, it's a real estate agent. So I actually know quite a few people that work full time in tech and have their license, and then they may be sell like a house or two a year. So not not that many, it's not super active in that respect. But it probably would qualify based on what you're talking about. But lots of perfect example Nicola for over client who will benefit from the solo 401k, because they do have legitimate business activity on the side. Again, there is no requirement that you have to work so many hours in your business. But the requirement is that is that you have to have legitimate self employment activity. And the second one, we kind of got sidetracked, I did not mention the second requirement is that your business cannot have any full time employees working for you, other than business owner and the spouse. So you can have part time assistant and full time definition in the IRS language is 1000 hours a year. So that's approximately 20 hours a week. So you can have, you can be a real estate agent, let's say full time real estate agent, and you can have an assistant who works for you 1015 hours a week. So that's going to keep that employee under 1000 hours threshold. And you can still adopt the 401k solo 401k plan without offering this to your part time employees. And the reason is for this restriction because solo 401k is a simplified version of the full blown 401k because there is no other participants other than the owners and perhaps their spouses. So because of that it's a lot easier and simpler to administer, and does not have all the requirements that your full blown 401k has. So if you do have an employee working over 1000 hours for you, again, an employee, formal employee on the payroll, receiving w two wages, then if you do have somebody working over 1000 hours, then the law says that you must offer them retirement benefits and solo 401k simply not designed to accommodate the employee. So again, you probably have many of your listeners who will fit into that.
I think so one thing we haven't really talked, we've kind of gone into, like, what is it and what are some of the requirements. But why would someone want to look at it and what are the overall benefits?
Well, the first main benefit of the self directed solo 401k, it is a great tax shelter, whether you have a full time job and you like in your example a real estate agent from the side just doing a few sales. Let's say it's, again, an agent who does presales and may be generates $30,000 a year in commissions. Well, that income is subject to taxes, in addition to normal w two wages. Well, solo 401k allows you to contribute up to $62,000 per year into solo 401k. So there is a little formula, basically its first $19,000 up 200% of your earnings plus $6,000 catch up for those four or 50 years of age. And then on top of that additional up to 25% of your net self employment earnings for the combined total of $56,000. So again, in this example, somebody generates $30,000 of income. And I'll give you approximate numbers here just trying to do the calculation in my head. And let's say that person is over 50, 52 years old. So they can put $19,000 plus $6,000 catch up, which is total $25,000 plus the $6,000, which is 20% of the $20,000, which is net self employment income. So essentially, that person can put away all of his side buildings, the Commission's into solo 401k. So all of that will be sheltered from taxes, it's a great tax shelter. So again, up to $56,000 plus $6,000 catch up, if you're over 50. And that's that's a great talk shelter, if you're in business full time and your spouse is helping you also in the business, potentially you can put over $100,000, you can shelter over $100,000 of your income from taxes. I mean, if you're in, let's say 30% tax bracket, that's going to result in the media savings of about $30,000. from taxes. So it's it's a huge, huge benefit for those people who are self employed.
Well, and then what can you do with the funds? Where can you apply them?
Well, the beauty of the again, self directed solo 401k, that it does not require a custodian. So you can open a solo 401k to brokerage, like fidelity, but you'll be stuck with their investment options and their investment options, always confined to the stock market. So you can only invest in stocks, bonds and mutual funds. But with the truly self directed solo 401k you have unlimited investment options virtually, except collectibles. And so many of our clients, they realize that they have no control over the stock market, they have been gone in the last downturn, and they don't want to risk their future, given the minute to the stock broker, who also doesn't have control over the stock market. So it's more like a like a gamble in Europe. If you invest in a stock market, you can hope and pray that it's going to do okay, but you have no guarantees that well, there are other investment opportunities, alternative opportunities that can provide by three tunes and minimize the risk and give you a greater control, such as real estate investing. I'm a real estate investor myself been investing for almost 20 years now. And lately I switched, I started with rental properties. In the last five, six years, I've been doing private lending. So I basically invest in trust dates, I use my retirement account as a bank, and I lend money to others.
So what you've just described to is, so it's interesting to hear you are you're working full time, you're doing something some kind of small, self employed something on the side, let's just take real estate agent, you sell a couple of houses a year for your friends and family, right? You're not for yourself, you
wasn't for yourself, you know, to buy a couple of investment properties a year.
That's true. That's true. So you get the Commission's off of that you put the Commission's into the solo 401k. And you get to keep all of those their tax shelter, then you can take that money. And you can apply it toward other real estate investments or, or really other things like you mentioned, except for collectibles, so you can you can do a lot of different things with that. And you have that flexibility. And that is while you're also still have your W two still investing in your employers 401k. It's just an additional vehicle.
That's right.
So how does the process work? And how long does it take?
Well, before I answer this question might be I'll spend just a couple more minutes explaining or finishing up between benefits, because you asked me that question, I didn't quite complete that. So let me do this. Besides having a high contribution limit. Solo 401k has some other advantages. And here's an example. It has a built in a long feature, just like a 401k that you might have with your current employer, you can take a loan, you can take a personal loan from your 401k. Or guess what solo 401k comes with the same feature, there is the ability to take a personal loan up to $50,000 from your own solo 401k. And you can do that anytime for any reason. So it's like I can put it out with Heaven, your own private bank that you always have access to for any reason. And you're the one who's actually approving the loan with your 401k fork, you have to go to your plan administrator, complete the loan application and wait for the approval. Well, here you are the plant administrator, and you're the applicant. So you signing into spots you sign in to apply for a loan and then below that you're signing in as an administrator a program Dylon so it's a great feature. It's not something to abuse, but it is there available for you should you ever need some caches, so it's a nice feature to have. Another nice feature is that solo 401k has the ability to make postdocs contributions into what sub account, it's basically works just like a Roth IRA, you pay the taxes up front, and then you contribute postdocs. So your investments are growing tax free. And the distributions at retirement is also tax free. And the limit on direct contributions in a solo 401k is up to $25,000. And there is no income limitation. And like with the Roth IRA, if your income is over a certain threshold, you're not allowed to contribute to rod, well, there is no limitation for a rod solo 401k. But regardless of your income, you can contribute to an absolute Frank. And then one more benefit that I will mention is that unlike a self directed IRA, if you use self directed IRA to buy a property and you use leverage, you get another court salon with a solo 401k, you can do the same thing. But if you do get it inside of an IRA, certain portion of the income that comes from the leverage portion of the property will be subject to unrelated business income tax, and solo 401k is exempt from that taxation. So it's another bonus, and basically, a beauty of buying property inside of your 401k and not being subject to taxation. Again, those are just you know, most common benefits of most people, you'll probably benefit, there's more benefits, such as it's what it cost effective, because there is no custodian fees, no transaction fees, because you eliminate the middleman. It also offers greater greater protection, if if you get sued or if you have a judgment against you, the creators potentially can access your IRA money 401k funds cannot be touched that we're under no circumstances. And also if you can meet the prohibited transaction inside of an IRA, the whole account field is could it will be considered a distribution but the whole account with the 401k you have the ability to correct a prohibited transaction. So you can actually undo it. And if you have not done it, then only amount that is involved in the transaction will be considered distribution, not the entire 401k account. So that's also major, major deal.
It is can you share what a prohibited transaction might be like an example or
Yes, that's what a good question, Nicole. Because if you're considering going this route, self directing your retirement account, you need to understand what the prohibited transaction rules are. And basically prohibit the transaction takes place when you invest in prohibited investment. And like I said, with solo 401k, its collectibles, you're not allowed to invest in collectibles with your retirement account. With an IRA. It's also life insurance contracts. But in addition to that, there is a prohibited transaction that involves disqualified person and disqualified person is yourself count owner and your immediate family members, which is your spouse, your parents, grandparents, your kids and grandkids and their spouses. So as you can see, it's a vertical line, you cannot engage in a transaction with one of those persons in who fall into the disqualified person from example, if you're buying a property inside of your 401k rental property, cannot run that to your to your son and his family. Right? If your father is a handyman, he will not be able to work on the property, you cannot hire him to work on the property that your 401k owns. Another example if you are buying this property, and your spouse is a real estate agent, your spouse cannot represent the 401k in this transaction, because your spouse is disqualified person. So again, most prohibited transactions happen when there is a immediate family member is involved in the transaction. So you got to stay away from that.
Yeah, it's interesting that all the examples you gave I think, you know, maybe people wouldn't have thought about those. So that's super helpful. Okay, so how does how does the process work? And how long does it take?
Sure, so the process works. First, you have to have that activity in place. Whether you have a formal entity, LLC Corporation, or if you're just a sole proprietor like in your example, Nicole, somebody who's a real estate agent, then sole proprietor can adopt the 401k plan. So the first step is the plan is created. Once the plan is created. part of the plan, there is also trust that is created and trust is a vehicle to hold 401k plan assets. So once it's created, then the client will receive the paperwork, signed them and up makes the plan effect. So once the plan is effective, then the next step is to fund it. And you can find your 401k with one of two ways. You can rollover existing retirement account into it as a director or lower, and solo 401k will accept rollovers from any qualified retirement plans. So any retirement account can be rolled over with one single exemption. And that is a rotten Alright. So if you have a Roth IRA, unfortunately cannot move that into solo 401k. Roth IRA can only be moved into another Roth IRA, if you have a Roth 401k Doe, if your employer or former employer, if you have some rotten non rock bands of death can be moved or if you have a help client recently who had a tsp, which is some sort of a government retirement vehicle and he had some rock money in there, he was able to move bought the bread tax and postdocs rod funds into the solo 401k. Then once you receive that role, our check, the check will be mailed to you at the address you specify it will be made payable to your 401k for example, ABC 401k, plan FBO and followed by your name. And once you receive that check, then the final step is to open business chicken account in the name of your solo 401k. Trust and deposit the funds in doubt. Because solo 401k Trust is a separate entity, it separate entity from you its separate entity from your business. It has its own unique name and its own unique tax ID number that IRS will assigned to it. So you can you go to the bank, you provide the paperwork and you open a business checking account in the name of your 401k trust. And once you deposit the rollover check in there, then you can stop investing immediately you can write the check and you make a loan to somebody else you can become a private lender just like I do. Or you can go ahead and buy a property with your 401k can do that as well or any other investments.
Thank you for talking to us through those steps. Gosh, I just I'm thinking of there's so many possibilities. There's so many interesting things that you can do. And it just opens up whole world. And what I think is also kind of interesting, because I do have a self directed IRA. So I'm very familiar with kind of the approval process. And there's there's a lot more involved in being able to leverage those funds, as opposed to just like, go to a bank, open a checking account, deposit the money and you're off and running. So I can see where that's a much more simplified process.
Yeah, so it streamlines it, there is no delays, there is no wasted time, because often bit alternative investments, you need to act quickly, I was listening to listening to another podcast, actually, if it's somebody else, it's real estate related podcast, and they were talking about how these days, if you want to get a deal, you need to act on it quickly. If you find the deal, you have to move on it immediately because it's probably going to be gone tomorrow. And if the custodial IRA, if you have to go through that process, you have to submit the paperwork to the custodian, wait a few years for the approval. And then once it's approved, you have to wait for the funds for them to get you the check. Well, by that time, the deal probably going to be gone. If you're with the solo 401k option, then you found the deal. And you can act in it immediately by simply writing a check and securing the deal. So
it brings up two questions that I have. The first is let's say you What if our listeners, they already have a self directed IRA, and then they do qualify, let's go back to the real estate agent example. So they do have real estate license and they are selling a few homes a year. And that's self directed IRA, let's say it's invested in something passive and fairly quickly, they'll be getting out of it not not like actual property. Can they switch? Do you see that?
Yes, we've seen dot and dots possible, you can certainly switch because again, some of the next day or it's still an IRA, unless it's all right, if it is a Roth IRA, then you know, they cannot move it to solo 401k. But if it is a traditional or a simple or a self, self directed IRA, it can be moved over to a solo 401k. And even if there are assets inside of an IRA, like you own a rental property in an IRA, you can still move IRA to solo 401k. And you can do what's called in kind rollover. So you basically moving assets in kind so rather than moving cash, you can move asset from an IRA to solo 401k. It obviously more complex and more labor intensive to move the assets rather than cash. And you have to change the dial, you have to record it and so forth. But it's definitely possible.
Now, you talked about five steps here, basically to that point where you can now go out and buy something or be a private lender, whatever the case may be, how long does that overall process take?
Typically, it takes three, four or five days to create the plan. Yeah, and talking about I'm talking about the upgrades and all the plan documents, so three to five days. And then once the plan is created, the next step is that a lower or lower typically takes about a week. In my experience in that depends on different custodians depending on your custodian what the money is at. So if you're moving money from an irate fidelity, then the request will be submitted to fidelity. And they will have to process that typically can be done in about a week. If it's a 401k, that you're moving, then you have to submit that to the to your administrator, it might take a little longer, but still under two weeks is what a reasonable timeframe to expect to be in the possession of your funds.
That's pretty fast. Okay. And what about going logistics? What kind of management or reporting because with the self directed IRA, you also have to do reporting? How does that work with a solo 401k?
Yeah, so the solo 401k, there is a report that we must do as a document provider, we must report all the active plans to the IRS, we do that annually. And also, there are certain changes that take place in the IRS code that affect the solo 401k plan. And when that happens, the plan must be amended. So that's going to be our responsibility as well. So we handle that for our clients. But there is certainly responsibility and a client. And as well, number one, its annual report in on a forum 5500. Easy. So it's a short form, it's only two pages. And that reporting is required only if you have over $250,000 Senior planners. So if it signed up to 50, you don't have to submit that the board can if it's over to 50, you have to submit that form. But again, it's pretty simple. It's only two pages, we provide help complete in that step by step. And once you do it once, then you'll be able to do it on your own next time. It's only done once a year. And then obviously, when you make contributions to your 401k, you will report it out on your tax return. So your CPA will help with that. If you are incorporated, for example, if you're not an S corp, or C Corp, that has two types of contributions can be made employee contribution which will be reported on your personal tax return. And then profit sharing contributions which is done by the employer by the company. So your company will contribute that will be reported on your corporate tax return. And again, your CPA will know what to do. Okay.
He's talked about some of that, I thought immediately, I would be calling my CPA and, and giving them all the paperwork to handle. But it doesn't sound too bad. And again, I love the flexibility that you talked about, and just the fact that you can move rather quickly. And this takes, you know, a very short time to set up and this tax sheltering capability and could add so much incremental funds to this and and protect that from, you know, taxes, which you also are getting hit quite heavily having a W two income. So it really helps offset that as well. Yep. So where can listeners find more resources or get in touch with you?
Dmitriy Fomichenko 31:45
Well, we put quite a bit of effort in developing our website. It's it has a lot of education there. So go into our website, which is sense financial, common sense is like common sense SESE. So since financial.com, is our website, and they can click on the solo 401k and just explore different pages there and learn more. Perfect. Thanks so much. It was a pleasure to have you on Dimitri. Sure. You're very welcome. It was great to be that and I just one last thought is that all of your listeners are entitled for a complimentary 15 minute consultation. So once they explored the website, they can contact our office and I can speak with anybody, just one on one because obviously, we can't address everything and a short webcast like this, but getting one on one will be beneficial.
Now that's great. So we get into each person's specific scenarios and situation and kind of see what might make sense for them.
That's right. Thanks, Nichole, for having me. It was great discussing the topic.
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ABOUT DMITRIY FOMICHENKO
Dmitriy Fomichenko is the founder and president of Sense Financial Services LLC, a boutique financial firm specializing in self-directed retirement accounts with checkbook control. He began his career in financial planning and real estate investing in 2000. He owns multiple investment properties in various states and is a licensed California Real Estate Broker.