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UBTI / UBIT / UDFI and your Solo 401k

Or the rare cases when a Solo 401k must pay annual taxes

One of several useful features of a Solo 401k plan is its tax-deferred status, meaning that no income taxes are paid on the annual income from investments.

However, in certain situations a Solo 401k must pay income taxes on investments such as when investing in LLCs or other pass-through tax entities.

UBIT taxes when investing in LLCs / Pass-Throughs

As with an IRA, UBIT tax applies to Solo 401k plans when generating income from an investment in an active trade or business, such as an LLC or other pass through entity.

The reason for this is that pass-through entities (such as an LLC), as their name indicates, do not pay taxes directly. Rather the income passes through to the owning entity. In the case of an LLC owned by a person, the owner pays taxes from the LLC income based on their personal tax rate.

However, in the case of an LLC owned by a 401k that income would pass through to the 401k which does not pay annual taxes.

Great, that means the income from the business is tax deferred, right?

Unfortunately, no. The IRS saw this loophole and closed it via the UBTI rules. UBTI, or Unrelated Business Taxable Income tax (also referred to as UBIT, the Unrelated Business Income Tax), was created for two reasons:

  1. So business would not avoid taxes by placing their ownership inside of a retirement plan
  2. So other business would not be the unfair position of competing with a company that doesn’t pay taxes anytime soon.

Towards these ends, the UBTI tax is a hefty tax at nearly 40%. So whenever possible you want to avoid paying UBTI.

UBIT tax and C-Corps

However, there is good news when it comes to investing in C-Corps. Because C-Corps are not pass through entities - meaning the corporation pays a tax bill each year - that they are exempt from UBTI.

And the even better news about UBTI/UDFI and Real Estate

And the even better news is this: unlike IRAs, a Solo 401k is not subject to UBTI/UBIT tax on Unrelated Debt Financed Income (UDFI).

Why is this significant? Because using what is called a non-recourse business loan (debt financing), a Solo 401k can borrow from an individual or company to invest in real estate without UDFI rules applying.

Because of this, the UBTI tax does not apply to debt-financed real estate investments with a Solo 401k.

This is highly advantageous because UBTI tax rates are at a significant 40% as of 2017, making Solo 401k plans the ideal plan (among other reasons) for those looking to invest in real estate.

UBTI / UDFI Exemption is only the beginning

With powerful and unique investment options, sky-high contribution limits, convenient and flexible loans (with no approval process), and the ability to bypass custodian approval, a Solo 401k is ripe with features that make investing easier and more worthwhile.

Opening a Solo 401k plan was once cumbersome and time-consuming, but now, with Maverick, your end of the setup process has been simplified and can even be completed entirely online (we take care of the rest). Whether rolling over money or making a new contribution, we make set up easy and hassle-free.

To take advantage of these great features and open your own Solo 401k, click here to set up an account.

Questions about UBTI/UBIT or otherwise? Contact us here and we’ll be more than happy to help answer them for you.

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