One of the questions we get the most from clients concerns the use of qualified funds to invest in a SmartLock™. The short answer: this can be done! To accomplish this, we must use a relatively underutilized tool called a Checkbook Solo 401(k).

In recent years, the use of a Solo 401(k) has gained popularity among self-employed individuals and small business owners seeking greater control over their retirement investments. This article explores how this strategy works, its benefits, and important considerations.

What is a Checkbook Solo 401(k)?

A Solo 401(k), also known as an Individual 401(k), is a retirement plan designed for self-employed individuals or business owners with no employees other than their spouse. The checkbook control feature allows plan participants to manage their investments directly by writing checks or transferring funds without the delays typically associated with a custodian-managed account.

How Do I Qualify?

Opening a Solo 401k account requires two elements of qualification:

1. You must own a business
2. Your business must have zero employees (excluding your spouse or other partners in the business). Employees are defined as those who work for you more than 1000 hours per year and receive W-2 wages.

Business ownership can be as simple as creating income on the side. Even full-time employees can separately be business owners too. You are allowed to have a checkbook solo 401(k) in addition to your employer's 401(k) ... and contribute to both!

Business ownership can be structured as:

1. C or S Corporation
2. LLC or Single Member LLC
3. Partnership
4. Sole Proprietorship - most common

IRS rules state that your business venture must be an ongoing business seeking profit. It can even be a new business! There must be intent to earn revenue and make contributions to the Solo 401k, but there are no minimum annual amounts. Self-employment income does not need to be reported every year, but too many years without any income is a red flag to the IRS and will open you up to scrutiny. The IRS does not discriminate against business owners and today it’s easy to have some amount of legitimate business activity each year.

How Does It Work?

1. Establishing the Solo 401(k): To begin, you need to set up a Solo 401(k) plan with a custodian that allows for checkbook control. This involves completing the necessary paperwork and ensuring compliance with IRS regulations. We have partnered with several solo 401(k) providers that will help with this.
2. Funding the Account: You can contribute to the Solo 401(k) through salary deferrals and employer contributions up to the IRS limits. The rules permit you to roll over other qualified plans into your checkbook solo 401(k) tax-free (excluding Roth IRA). Once the account is funded, you have direct control over the funds. Your ongoing contribution limits are determined by your self-employment income.
3. Investing in SmartLock™: With a checkbook Solo 401(k), you can purchase a SmartLock™ directly from your retirement account. The policy must comply with IRS regulations, meaning the Solo 401(k) must be the owner and the beneficiary of the policy.

Structure

Each Checkbook Solo 401(k) has two parts:

1. 401(k) plan: The plan is the documents that the IRS-approved document provider prepares for you.
2. Trust: The trust has its own tax ID number and holds the assets (you are the trustee). This is simply a "container" the IRS and DOL have created so that your qualified funds are separate from you.

Generally, all qualified plans hold their assets "in trust". Even your employer-sponsored plans will hold all participant assets in one trust, managed by a custodian. With the Checkbook Solo 401(k), you directly manage what the trust invests in. Any assets, investments, or documents held by your checkbook solo 401(k) should reflect the 401(k) plan name. When you open your bank account and/or brokerage account to make investments, you'll use the 401(k) trust name and 401(k) trust tax ID number.

Plan setup is relatively quick. The checkbook 401(k) can typically be created in as little as a few hours up to a few days.

Fees

There are usually two types of fees associated with qualified accounts:

1. Admin Fees: Admin fees include operational costs and servicing that are essential for the plan to function. These fees are typically hidden as investment fees within your employer-sponsored account, however, you have the option to pay your checkbook solo 401(k) admin fees yourself. This generally minimizes the amount you pay and makes the admin fees tax-deductible. With most checkbook solo 401(k) plans, admin fees include a one-time setup fee and a monthly or annual fee to cover the cost of ongoing plan maintenance, support, and document filing.
2. Investment Fees: Most employer-sponsored or brokerage retirement accounts have investment fees associated with transactions, charges, or the management of funds in the account. With the third-party providers that we partner with to offer a checkbook solo 401(k) to our clients, there are no investment fees.

Filing Requirements

A one-participant 401(k) plan is generally required to file an annual report on Form 5500-EZ if it has $250,000 or more in assets at the end of the year. A one-participant plan with fewer assets is usually exempt from any annual filing requirements.

Incidental Benefit

The purchase of insurance must be incidental to the primary purpose of providing retirement benefits under the plan. Under treasury regulations, this incidental benefit results in limits being placed on the amount of premiums paid as follows: Initially, half of your new 401(k) contributions can be transferred to a SmartLock™. In comparison, only a quarter of 401(k) contributions can buy term or variable universal life insurance.

‍However, after you’ve participated in the plan for five years, you can use all of your account balance to purchase a SmartLock™. Furthermore, all assets that have been in the plan for two years or more, all after-tax employee contributions, and all rollover contributions may be used to fund a SmartLock™ and are not subject to the incidental rules.

Taxable Portion of SmartLock™ Premium - P.S. 58

The insurance protection portion of the premium must be taken as a taxable economic benefit by the insured plan participant. This is called a P.S. 58 cost. The IRS has a table (Table 2001) outlining the determination of the insurance protection amount at a particular age. The formula is as follows: Face amount less cash value divided by $1,000 times the table factor. The insurer’s published rates may be used instead, but caution should be taken for policies issued after 2003. Check with a CPA for more details on your situation.

Benefits

1. Tax Advantages: SmartLock™ growth inside a Solo 401(k) can grow tax-deferred. This means that the cash value of the policy will not be taxed until you take distributions from the retirement account, potentially leading to significant tax savings over time.
2. Liquidity and Flexibility: Checkbook control allows for quick access to funds, enabling you to respond swiftly to investment opportunities or financial needs. You can borrow against the cash value of the SmartLock™ policy without traditional bank restrictions.
3. Asset Protection: SmartLock™ policies may offer certain protections from creditors, providing a layer of security for your retirement assets.
4. Diverse Investment Strategy: Adding SmartLock™ to your portfolio can diversify your retirement investments, which can mitigate risks and enhance overall financial security.
5. Owner Options: You can name others, including your spouse, other relatives or a business partner, as the insured party on your 401(k) life insurance policy.
6. Loan Options: 401(k) loans, if allowed, can be used to access funds. Because the SmartLock™ is owned by the checkbook solo 401(k), taxes and penalties on gains are sent to the tax-exempt 401(k) trust. All distributions are handled at the 401(k) level, creating more options for accessing money.
7. SmartLock™ Compatibility: Unlike other policies, the single premium and MEC rules that come with SmartLock™ make it a great investment for qualified plans because we don't have to worry about ongoing taxes on premiums or the loss of tax-advantaged status.

Summary

Using a Checkbook Solo 401(k) to invest in SmartLock™ can be a strategic move for self-employed individuals looking to diversify their retirement portfolio while enjoying tax benefits and enhanced control over their investments. However, it's crucial to ensure that your investments comply with IRS rules. Improper use of retirement funds can lead to penalties and taxes. Consulting with a financial advisor or tax professional is recommended. At Y-UFinancial, we've partnered with advisors, CPAs, and IRS-approved document providers that have significant experience working with these plans and can help our clients navigate their options as efficiently as possible. Contact us for more information!