Confusion over Schwab and SD401k.

Schwab do not host a self directed 401k plan directly. You will need to use a third party to set up the plan get it approved by the IRS and then have the custodian open the account with Schwab. From there you can purchase assets such as real estate.

Can I invest in the stock of private companies?

As mentioned in an earlier Blog I have my checking account at a brokerage firm. This gives me access to any publicly traded stock, bonds, etc. But what about privately owned companies? The management of private companies can do as they please with regard to financing. Public stock is traded under the rules of the SEC with strict controls. Is that good? In a way yes, but in protecting the investor with information, it exposes the investor to other risks. For example a sudden drop in the price of the stock when negative news is announced, or a sudden rise when an acquisition is announced. 

So what about private placements? There is some regulation, based on the State of incorporation, but in practice it is down to the investor to do their own due diligence. Sounds risky! It is, but this type of investment provides the biggest return.

What about capital gains/losses? This is the key question. If I invest personally and a company fails, I can write of the loss against other capital gains. If I have no other capital gains then I only get to write of $3,000 in that year. If I invest personally and I make a profit, it is either taxed at short or long term capital gains. Short term is taxed at the rates of ordinary income, long term is currently 15%. Don’t forget State taxes if you have them. 

So what happens if you invest in a private placement using your IRA or 401k? These entities are not taxed so for practical purposes these capital losses are gone forever. (Not quite true in all cases, so you should keep track of losses.) But what happens to capital gains. They are yours to keep. Imagine if you had invested in Google before they were public, that stock could now be sold tax free. (Remember the rules of self dealing. You cannot work for the company in which you invest. Even offering phone consulting is considered self dealing. Some ERISA attorneys even warn against attending the shareholder’s meeting of private companies. Though the law allows, and encourages, the management of the assets so it is permitted to keep a close watch on the private investment. )

Self directed 401k for husband and wife companies.

Can I have complete control over my 401k? Yes, as long as you follow the rules.

The problem is that most companies do not want to offer you checkbook control over your 401k. There are good reasons for this.  It is not just the administrative cost but the company has a responsibility for educating all employees about the investment options. So in practice all employers go with a plan sponsored by a brokerage firm or similar. The brokerage firm has an incentive to keep your money in their products, mutual funds, stocks, bonds, etc., the most risky of all investments. The typical employer only wants to offer a few options so for most people their 401k consists of five or six mutual funds. Maybe a bond fund, balanced fund, large cap, small cap, etc. And even worse there may be significant limitations on how many times you can change the allocation.

This is how Wall Street gets rich on the back of YOUR money.

So how can you control your 401k funds. I will discuss one option here. It is not for everyone as it requires you to have your own business. So if you are starting a company, or have a company, that company can sponsor a 401k plan. This is very easy if the company is just you, or you and your spouse. When you have employees you have to be in compliance with the regulations laid down by the Dept. of Labor. This includes things like non-discrimination etc. But if it is just you and your spouse it is very easy. Special plans are available for husband and wife businesses. (In later blogs I will show how our tax laws treat husband and wife businesses. They get the best tax breaks of all.)

The company sponsors a 401k plan, one person becomes the Trustee, the plan then opens accounts in the name of the husband and wife. These are called FBO accounts, that is “for the benefit of”. The reason for this is the way the law is structured. A pension plan is an individual plan within the 401k plan. There is no joint tenancy in a pension plan. You can transfer the pension funds by will between husband and wife, but the plans are treat husband and wife as individuals. This is the case on the tax side.

I will cover the differences between using an LLC and C corporation to sponsor the 401k plan in a later blog, as the amount that can be contributed is related to the salary compensation.

It gets better, now you are not limited to the allowable contributions, to the 401k and Roth 401k. In a business you can also contribute based on profit sharing. up to 25% of the companies profits can flow into the Traditional 401k. This makes for a great tax break.

If you are really profitable it gets even better. But more about that in a future blog.

Self Directed IRA

So you have an IRA, either traditional or Roth. It is with a broker like Charles Schwab. All they will let you invest in is mutual funds, stocks, bonds etc. In other words THEIR products. They have no interest in you taking YOUR money out and investing it in other assets such as real estate, tax leans, or startup companies.

So how do you get control over your IRA?

The process is simple, using an approved third party they sweep all or part of the money from your IRA. A LLC, limited liability company, is formed in whatever State suits your needs. The LLC opens a checking account. It could be at a bank or a checking/brokerage account such as Schwab One. The third party then purchases stock in the LLC and sends the funds to the checking account. In other words your IRA owns the LLC. The LLC can invest in whatever it likes within the IRS rules.

Can I do this by myself? Yes, but there are so many legal issues which if there is one mistake it could invalidate the IRA and the IRS might force you to close the IRA and you would pay the 10% penalty. Not a good idea. But the good news is that there are many companies who can do this for you. They will take care of everything, and even give you advice on what is permitted. They are there to make sure your IRA/LLC is operated within the IRS rules. You get checkbook control and can make investments that suit your retirement needs, reduce the risk of being limited to the stock market and other financial products.

The writer has a IRA/LLC for both the Traditional and Roth IRAs.

Is it legal?

The question everyone seems to ask is “is this legal?”. Can I run my own pension plan? The simple answer is Yes. The slightly more complete answer is Yes, as long as you follow the rules.

Before we get into what you can do let me break down the major categories so we can discuss them individually, the rules are slightly different for each situation.

At the top level there are two types of pension plan. One is a defined benefit plan, the other a defined contribution plan. I don’t want to involve politics, so this blog is only about what the plans are, and how you can use them. They each have their advantages and disadvantages, later blog entries will discuss these in more detail.

To keep it simple a defined benefit plan is where you pay into the plan over time and when you retire you get monthly payments until you die. If you have a plan with your employer when you die the plan ends and you get no further monthly payments. Of course some plans pay a lump sum on death, some may continue to make monthly payments to your spouse. At the end of the day it is a actuarial calculation which determines the monthly payment.

A defined contribution plan is where you make payments to the plan. They maximum payments are determined by government. To keep it simple there are two categories of plan, and within each plan there are two types of plan. The two main types are the IRA and 401k. Within these two plan types there are two categories, one is the Traditional Plan the other is the Roth Plan. In simple terms you contribute to the Roth with after tax dollars but take the money out tax free after you retire, contributions to the Traditional are tax deductible but when you take money out it is taxes at the then current rate.

I will not be discussing other plans such as a SEP as this blog is not about the usual way people use this type of pension plan. As the title of this Blog states, this is about Self Directed Pension Plans. That is to say it is how you can own your own pension plan. Make any investment you like, including real estate, tax leans, private placements in startups. Anything which is not prohibited by the tax code.

What is prohibited. There are two types of investments which are prohibited. One is specific investments, things like collectables are prohibited. The second type is about people. You cannot invest in yourself your parents, your children, but strangely you can work with your sister or brother. I will expand on this later as almost everyone’s first investment idea is prohibited by self dealing. Many people’s first idea is to use their self directed pension to buy a house and they will live in it, and pay rent to the pension plan. Nice idea, but not permitted. But who cares there are so many great investments out there.

This is a massive subject so now I have Blogged the overview I will break down the subject into blog entries and cover the key information you will need to self direct your own pension plans. (Plans because each type of plan has it’s own benefits.)