Individual 401(k) Plans – Investment Benefits and Qualifications

As an experienced IRA custodian, we have seen over 10,000 clients purchase real estate in their IRAs. Whether you are new to self-direction or an old hand at investing, you may know that most IRA deals utilize cash.

Cash purchases are quick and easy, regardless of whether they are in an IRA or owned personally. 95% of our clients buy real estate with cash, not just for ease, but to avoid tax. Leveraged IRAs are subject to an additional tax called Unrelated Debt-Financed Income (UDFI).

What is UDFI?

If you use debt to acquire an asset within a tax-advantaged account (such as a self-directed IRA), you have to pay UDFI on a portion of your net income from that asset. UDFI applies to rental income and capital gains from debt-financed property. If you want to avoid it, you cannot finance your property purchase with debt. The percentage of income derived from the debt is subject to UDFI. UDFI tax rates are the same as the tax rates for Unrelated Business Income Tax (UDFI is a type of UBIT), which for 2023 can be as high as 37%.

$0 – $2,550 = 10% of taxable income
$2,551 – $9,150 = $255 + 24% of the amount over $2,550
$9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
$12,501 + = $3,011.50 + 37% of the amount over $12,500

How do I avoid UDFI?

While UDFI can’t be avoided if you use leverage to finance an asset, are exempt from UDFI given their status as tax-exempt trusts. This exemption means that you can use leverage in your 401(k) and avoid this tax altogether by utilizing this type of account. For years, the SEP IRA was the go-to choice for self-employed individuals. However, if you are looking to use leverage to finance an asset, you can’t avoid UDFI in a SEP. Over the last decade, as investors have become more sophisticated and hands-on, Individual 401(k)s have become the new gold standard.

Do I qualify for an Individual 401(k)?

To qualify for an Individual 401(k), you need to be self-employed with no full-time employees. If your spouse works for the company, they are eligible to participate in the plan as well.

Learn more about Individual 401(k)s.

If you are looking to invest in alternatives, an Individual 401(k) offers you high contribution limits, making it pretty attractive. You can contribute up to $66,000 in 2023. . If you’re 50 or older, there is an additional $7,500catch-up contribution allowing total contributions of $73,700 in 2023 Employer nonelective contributions can be made up to 25% of compensation as long as the total of employee elective deferrals, employee catch-up contributions (if over 50 years old) and non-elective contributions do not exceed $73,700 in 2023.

Individual 401(k)s also have many other unique benefits that apply. The most notable benefits are:

• Highest contribution limits (and accelerated contributions for lower-income participants)
• Ability to take a loan for up to 50% of your plan with a maximum of $50,000
• As the Trustee of your plan, you can have checkbook control of your funds, so you have control of your money when you need it
• Avoid UBIT and UDFI taxes

For more information regarding Individual 401(k) plans, please visit our website. If you have additional questions or want to talk through your specific scenario, please call our 401(k) specialist, Matt Calhoun, at (239) 333-4461.