Costly 401(k) Mistakes That Could Wipe Out Your Retirement Plan
We were recently asked to help someone who had a very unusual problem with her 401(k). While the combination of problems was unusual, the situation illustrated several common mistakes people make. In this case the combination of mistakes compounded into a nightmare. Hopefully, after reading this article, you’ll be able to avoid that result.
Here’s a short synopsis of the situation: several years ago, her husband borrowed money from his solo 401(k) plan to purchase a building from which he ran his business. No payments were ever made on the loan. When they divorced, she accepted the building and the 401(k) as part of her share of the family assets in settling the divorce. She asked us what to do with the mortgage on the building (held by the 401(k) plan.
Don’t lend to or invest in yourself through your retirement plan. There are about three or four mistakes just in this one sentence. As the trustee and beneficiary of the retirement plan, a business owner is a fiduciary to the plan, which makes him or her a “disqualified person.” Any ancestor or lineal descendant of that trustee is, too. Other relations like aunts and cousins can also be disqualified if they are influenced by the trustee. In essence, a “disqualified person” is prohibited from doing business with the retirement plan because that allows them to use the retirement plan assets without being taxed on them.
Several examples of prohibited transactions include:
• Buying collectibles like art, rugs, jewelry or most coins
• Buying life insurance
• Buying alcohol or other tangible personal property
• Lending money to a disqualified person
• The sale, lease or exchange of property between the plan and a qualified person
• Pretty much any act in which plan assets or income benefit a disqualified person, except a normal distribution to a plan beneficiary.
In the case above, a disqualified person (the business owner and plan trustee) lent himself money to buy a building. That he didn’t make payments on the “loan” compounded the problem.
If you make a mistake, fix it fast. In the year that a prohibited transaction happens, the IRS will impose a 15 percent excise tax on the amount of the transaction. If it is not corrected in the year it happens, that becomes a 100 percent excise tax. Basically, what happens is that your 401(k) plan or IRA stops being a retirement plan and is treated as having been fully distributed as taxable income as of the first day of the year the transaction happens. Making a mistake is expensive, but not correcting it is devastating.
Look at both the asset values and liabilities in a divorce settlement. In the case above, the wife accepted as part of her divorce a building with a defaulted mortgage and a 401k, which wasn’t actually a 401k anymore. The husband got the family home and she was inheriting some very big business problems.
What’s the bottom line in this story? In all likelihood, the IRS will decide that the husband’s entire 401k should have been distributed and taxed in the year the original transaction happened. They probably owe several years’ worth of unpaid taxes and penalties on that alone, but that’s a question for tax and ERISA attorneys. And they might need to go back to the negotiating table for that divorce, since their assets probably aren’t what they thought they were.
Mission Hills resident Linda Podhorski is a qualified plan consultant with National Retirement Services, an Ascensus Company. “With a Qualified Plan like a 401(k) or IRA, the investments have to be viewed differently than a personal account because there are very complex rules involved. Transaction costs and appraisals for property and collectibles are already very high, and unwinding these transactions inside a Plan gets very expensive,” she said.
Investing in real assets in a qualified plan can be tricky and expensive. The rules are complex, and the penalties for non-compliance can be severe. Real assets, private placements and partnership interests require annual valuations that can be expensive. Discussing transactions like this beforehand with your professional advisors can help you avoid very costly mistakes.
This column is prepared by Rick Brooks, CFA®, CFP®. Rick is director/chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.
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